1. Break-out Session 1A: Federal tax planning
Break-out Session 1A: Federal tax planning
Pat Mahoney, Partner, Detroit
Bill Gonterman, Partner, Detroit
Ann Kruse, Partner, St. Louis

2. Research tax credits and related planning
Pat Mahoney, Partner, Detroit

3. Credit for increasing research activities and research and experimentation expenditures
Permanent Credit
Final Internal Use Software Regulations
Section 174 Final Regulations
Controversy and Other Considerations

4. Permanent credit PATH Act – December 18, 2015 Permanent Extension
Other Modifications
Small Businesses – $50 million in Gross Receipts – AMT
Qualified Small Business – $5 million in Gross Receipts – Payroll
Other Updates
Reg. Section (b)(2) – Allows taxpayers to make a “late” ASC election if no other election exists on a tax return

5. Final Internal Use Software (IUS) regulations
Relevant IRC and Treasury Regulations
IRC Section 41(d)(4)(E)
Final Treasury Regulations (a)(8) and (c)(6)
Relevant Case Law
Norwest
Fedex

6. Final IUS regulations – Process of experimentation examples
Treasury Regulation (a)(8) examples 5 – 10
Evaluating Software Package does not satisfy POE test
Custom Development related to ERP implementation can satisfy POE test

7. Final IUS regulations Overview
Section 41(d)(4) The term “qualified research” shall not include any of the following…(E) Computer Software – Except to the extent provided by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer… Prior to IUS Regulations: Treasury Regulation (c)(6) – Internal use software for taxable years beginning on or after December 31, [Reserved.] Post IUS Regulations: Comprehensive Regulations (c)(6)(i) – (viii) including 18 examples.

8. Final IUS regulations (continued) Overview
Taxpayers and practitioners have long awaited additional IRS guidance regarding eligibility of internal-use software (IUS) for Section 41 research credit.
The proposed regulations (REG ) released January 16, 2015.
The final regulations (TD 9736) released October 3, 2016.
The preamble to the proposed and final regulations was positive in tone, clearly written, and generally provides taxpayer-friendly guidance with respect to third-party- facing software

9. Final IUS regulations Definition of software developed primarily for IUS
The regulations define IUS as software developed by the taxpayer for use in ‘general and administrative functions’ that facilitate or support the conduct of the taxpayer’s trade or business. These functions are limited to:
Financial management functions,
Human resource management functions, and
Support services functions
Not Software Developed Primarily for IUS
Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, or
Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system
Time and manner of determination – Intent and facts and circumstances at the beginning of the software development

10. Final IUS regulations Dual-function software
It is not always possible to distinguish software sub-components based on function. This is addressed in the final regulations in a section on so-called dual- function software.
These rules begin with a presumption that dual-function software is designed primarily for a taxpayer’s internal use.
That presumption will not apply if the taxpayer can identify a subset of elements of the software that only enables the taxpayer to interact with third parties or allows third parties to initiate functions or review data.
The portion of expenditures allocable to this third-party subset needs meet only the less stringent four-part test.
For cases in which it is not possible to isolate the third-party subset, the new dual- function software rules also include a 25% safe harbor.

11. Final IUS regulations High threshold of innovation test
The legislative history of TRA 86 sets forth Congressional intent that some research activities related to IUS could be credit-eligible if the three-part high threshold of innovation test is met.
The preamble makes clear that this test should not be so restrictive so as to be impossible to meet.
The proposed regulations include rules of application of the test that are designed to reflect this purpose.
3-Part Test
Innovative
Significant economic risk
Not commercially available

12. Final IUS regulations Examples
Example 1 – Single Product
Example 7 – Not Internal Use; third party interaction
Example 10 – Improvements to existing software
Example 15 – Internal use software; application of the high threshold of innovation test
Example 16 – Internal use software; application of the high threshold of innovation test

13. Final IUS regulations Effective date
Final regulations are effective for tax years beginning on or after October 3, 2016
IRS will not challenge application of these final regulations or the proposed regulations for tax years that end on or after January 20, 2015
For tax years ending before January 20, 2015 taxpayers may choose to follow either all of the 2001 Proposed or Final Treasury Regulation
Duty of Consistency

14. Section 174 final regulations
Clarify “Look-Back” – referencing T.G. Missouri
“Depreciable property rule”
Define Pilot Model
Ability to “shrink-back”
Multiple examples

15. Section 174 final regulations (continued)
Example 10. New process development. Z is a wine producer. Z is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes. In order to test the effectiveness of the new method of crushing wine grapes, Z incurs$2,000 in labor and materials to conduct the test on this part of the new manufacturing process. The $2,000 of costs represents research and development costs in the experimental or laboratory sense. Therefore, the $2,000 incurred qualifies as research or experimental expenditures undersection 174 because it is a cost incident to the development or improvement of a component of a process.

16. Section 174 final regulations (continued)
Example 3. Pilot model. U is engaged in the manufacture and sale of custom machines. U contracts to design and produce a machine to meet a customer's specifications. Because U has never designed a machine with these specifications, U is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine. U incurs a total of $31,000 on the project. Of the$31,000, U incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design. U also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine. This $11,000 of costs represents research and development costs in the experimental or laboratory sense. After uncertainty is eliminated, U incurs $20,000 to produce the machine for sale to the customer based on the appropriate design. The model produced and used to evaluate and resolve uncertainty is a pilot model within the meaning of paragraph (a)(4) of this section. Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under section However, section174 does not apply to the $20,000 that U incurred to produce the machine for sale to the customer based on the appropriate design. See paragraph (a)(2) of this section (relating to production costs).

17. Section 174 final regulations Evaluating supplies expenditures for research tax credits
3 P’s (Prototypes, Production Tools, and Pilot Models)
Relevant Case law 
Trinity Industries, Inc. – Fifth Circuit Court of Appeals applies “substantially all” process of experimentation rule to cost incidental to design, construction, and testing of prototypes
TG Missouri – US Tax Court held that a significant amount of supplies purchased from a third party and later resold to a customer could be included in a taxpayer’s section 41 research credit calculation
Union Carbide Corporation – US Tax Court decision that qualified wages for research activities for enhancements to existing production processes, but disqualified the raw materials used in the conduct of trials
Lead in…why are we talking about supplies…there has been recent guidance associated with supplies that would cause taxpayers to evaluate their supplies positions to see if there are opportunities for an enhanced position….

18. Controversy and Other considerations
Product development/manufacturing processes
Supply Expenditures
Directly supporting or directly supervising
Contrasting Suder and Shami
Base period consistency
Acquisitions/dispositions – Calculation of credits
Other Considerations
Web-enabled research credit solutions – Sharepoint based technology
State Credits
Interplay with section 199

19. Fixed asset tax planning
Bill Gonterman, Partner, Detroit

20. Developments and Legislative outlook
PATH Act
Extended Bonus
Retail/Restaurant IIR and FAQs
Updated Audit Techniques Guide for Capitalization of Tangible Property
House Republican Tax Reform Blueprint
Full expensing
20% Rate and Rate Arbitrage

21. Fixed assets – Income tax planning
Companies have cash tax savings opportunities embedded within their annual capital additions, as well as their tax depreciation report
Taxpayers that own personal and real property can manage their cash taxes through a number of income tax planning initiatives. One way is by determining whether capital additions as determined for financial accounting purposes are also capital for tax purposes or if they are deductible in the year incurred.
If determined to be capital, then determining the appropriate tax recovery life through a cost segregation study or invoice review provides cash tax savings due to accelerated tax depreciation.
Taxpayers also have the ability to change their current accounting method related to tax depreciation for assets placed in service in prior years to “catch-up” their missed deductions.

22. Repairs versus capital in nature
Property owners can claim current tax deductions related to property currently being capitalized on the tax books to improve cash flow.
The tangible property regulations released in the fall of 2013 provide guidance related to the current deductibility of certain costs incurred in years after units of property are placed into service, as well as tax losses due to full or partial dispositions.
Automatic accounting method change rules allow taxpayers to claim the costs of any missed repairs and routine maintenance or any asset dispositions on the next filed tax return (by including a Form 3115).
Targeted types of costs are related to major rebuilds and routine maintenance of equipment; renovations, replacements and maintenance of real property.

23. Capital in nature versus Repairs
Property owners can use automatic method change rules to eliminate any exposures related to capital improvements being deducted.
While the tangible property regulations provide for a de minimis safe harbor election that is connected to the capitalization threshold for financial statement purposes, it is very common for amounts greater than the threshold to be expensed and thus deducted as incurred. Understanding and developing the tax position(s) to continue deducting these items should be considered.
The use of valid statistical sampling to understand and support the current tax deductibility of targeted items should be considered. This will allow taxpayers that come under examination to understand any exposures before the IRS.
Automatic accounting method change rules allow taxpayers to correct any capitalization issues on the next filed tax return (by including a Form 3115).

24. Cost segregation
Property owners can properly classify the costs of new construction on the tax books to improve cash flow.
Property owners of real property typically depreciate their real estate holdings over 39 years or 27.5 years (residential property).
The IRS provides guidelines to classify certain components of a building as shorter-life assets. The classification allows the property owner to claim larger tax deductions over a shorter period, i.e., tax savings and improved cash flow, beginning in the year the property is placed into service
There is no effect on the classification of property for financial statement accounting purposes.

25. Accounting method changes related to prior treatment of capitalized expenditures
Property owners have the opportunity to reclassify property on the tax books to improve cash flow.
The IRS provides guidelines, and other guidance exists, that allow taxpayers to reclassify certain components of real or personal property placed in service in prior years to asset classes that require shorter recovery periods. The reclassification provides the property owner with larger tax deductions over a shorter period, i.e., tax savings and improved cash flow.
Automatic accounting method change rules allow taxpayers to claim the missed depreciation deductions on the next filed tax return (by including a Form 3115).
The tangible property regulations also provide guidance related to the current deductibility of certain renovation costs, as well as tax losses due to full or partial dispositions.

26. Performance of fixed asset planning projects
Step 1 – Examination of construction and accounting records
Step 1
Review most recent copy of Fixed Asset Depreciation report to establish a universe of items for review. For Cost Seg projects, upfront meeting with the design firm and general contractor to discuss documentation requirements and format. For renovation projects, gain an understanding of the history of the property and its previous use.

27. Performance of fixed asset planning projects (continued)
Step 2 – Site inspection
Step 1
Step 2
Review most recent copy of Fixed Asset Depreciation report to establish a universe of items for review. For Cost Seg projects, upfront meeting with the design firm and general contractor to discuss documentation requirements and format. For renovation projects, gain an understanding of the history of the property and its previous use.
Site inspection(s) to identify assets that qualify for shorter recovery periods.
As construction begins and progresses, review of AIA monthly budget vs actual schedules, as well as construction documents, including blueprints, construction invoices, architectural and engineering fees, closing costs, property appraisal report, etc.

28. Performance of fixed asset planning projects (continued)
Step 3 – Analysis and re-classification of property
Step 1
Step 2
Step 3
Review most recent copy of Fixed Asset Depreciation report to establish a universe of items for review. For Cost Seg projects, upfront meeting with the design firm and general contractor to discuss documentation requirements and format. For renovation projects, gain an understanding of the history of the property and its previous use.
Site inspection(s) to identify assets that qualify for shorter recovery periods.
As construction begins and progresses, review of AIA monthly budget vs actual schedules, as well as construction documents, including blueprints, construction invoices, architectural and engineering fees, closing costs, property appraisal report, etc.
Identification of appropriate units of property; analysis and assignment of the appropriate recovery period to each unit.
Calculation of the net present value of the after- tax cash flows of the Study.
Development of detailed, audit ready Cost Seg Report.
Assistance with recording of the identified units of property into the tax fixed asset system.

29. Accounting methods – Hot topics
Ann Kruse, Partner, St. Louis

30. Cash tax efficiency – Tax accounting methods
Recent developments
Issuance of Revenue Procedures and
Start-up expenditures under Section 195
Interest capitalization under Section 263A
Changes within the retail inventory method under Section 471
Long Term Contracts non-automatic method change opportunity (audit protection)
Proposed Section 263A regulations
Tax Reform – Potential reductions in corporate and individual tax rates
Prepaid Expenses
Inventory/Unicap
Transaction Costs
Depreciation and Amortization
Customer Incentives
Bonus Compensation
IBNR Medical
Pension
Service Liabilities
Recurring Item Exception

31. CBS corporation & Subsidiaries
Depreciation opportunity for FSC/ETI assets
A disposed of asset’s basis is not reduced by the depreciation allocated to exempt foreign trade income
If asset has $100 of basis, then in general $30 of basis remaining (equal to depreciation allocable to tax-exempt/excluded income)
3115’s filed in prior years to claim basis on disposed assets
Opportunity to depreciate the remaining $30 basis for retained assets
ILM – Can only depreciate the $30 if used deprecation tables
IRS now allowing taxpayers to depreciate remaining basis regardless of whether used depreciation tables
Granting non-automatic 3115’s
Forthcoming CCA or Rev. Proc. to provide methodology
Other technical issues being researched by IRS

32. Giant Eagle, Inc. Analysis of “all-events” test and year of deduction
Case analyzed certain reward points earned by customers
Customers earned reward points for buying groceries. The reward points could be redeemed for a discount on the price of gasoline
Reward points expired after 3 months
Giant Eagle deducted the reward points in the year earned; Tax Court ruled “all- events” test fixing the liability didn’t occur until the year of redemption
General Dynamics, Hughes Property, and Gold Coast
The 3rd Circuit Court of Appeals overturned the decision of the Tax Court and ruled in favor of Giant Eagle
IRS announced it won’t acquiesce

33. Thank you Pat Mahoney, Federal Partner Detroit, Michigan
(313)
Ann Kruse, Federal Partner
St. Louis, MO
(314)
Bill Gonterman, Partner
(313)
This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding US federal, state or local tax penalties.
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