Change in Depreciable Life Is Accounting-Method Change

Hospital Corporation of America (HCA), 109 TC 21 (1997), started a dramatic shift in how taxpayers compute depreciation. HCA convinced the court that breaking out specific portions of the cost of a building and assigning them shorter depreciable lives did not violate the Economic Recovery Tax Act of 1981s ban on component depreciation, but was an appropriate segregation of costs under the old investment tax credit rules. By the time the IRS acquiesced in the case (1999-2 CB xvi), cost segregation had started to become more prevalent.

Since then, taxpayers have been able to obtain cost-segregation studies and apply for an accounting-method change to catch up any missed depreciation from assigning longer depreciable lives to certain assets. The IRS allowed taxpayers to obtain automatic approval for such changes; in 2002, it made them even more desirable, by permitting taxpayers to deduct catch-up depreciation in one year, rather than spreading the benefit over what had historically been a four-year period. In several recent cases, however, taxpayers who were able to obtain a better result by treating the depreciation change as the correction of an error, rather than as an accounting-method change, challenged the latter approach by filing amended returns.

General Rule

Generally, an accounting method affects when something is deductible, not whether it is deductible. Sec. 446(c) grants Treasury the authority to issue legislative regulations defining permissible accounting methods; Sec. 446(e) further provides that taxpayers seeking to switch accounting methods must seek the IRSs permission.

Congresss grant of authority to issue legislative regulations meant that the IRS had the ability not only to interpret the law on accounting methods, but also, when Congress had provided little guidance, to create the law. Regs. Sec. 1.446-1 does just that. It specifies Congresss general rules for accounting methods and then fills in some of the gaps.

Brookshire Brothers

In Brookshire Brothers Holding, Inc., 320 F3d 507 (2003), the taxpayer had assigned 39- or 31.5-year depreciable lives to some gas stations. After depreciating them for several years, the taxpayer, relying on an IRS Industry Specialization Program position paper, determined that the gas stations should have been depreciated using 15-year lives. The taxpayer filed amended returns for the previous three years to claim 15-year depreciation.

The IRS challenged this; based on its interpretation of Regs. Sec. 1.446-1, the depreciable life assigned to an asset is an accounting method. Because the taxpayer had filed three returns using the 39- and 31.5-year lives, under Regs. Sec. 1.446-1 and Rev. Rul. 90-38, it had adopted those lives as an accounting method, as it had consistently used such lives for two or more years. The IRS argued that the taxpayer needed to seek permission to change its accounting method, in accordance with Rev. Proc. 96-31.

Tax Court: However, the Tax Court held that the taxpayers change was not a change in accounting method. The court relied almost exclusively on Regs. Sec. 1.446-1(e)(2)(ii)(b), which provided (before 2001) that a change in the method of accounting does not includean adjustment in the useful life of a depreciable asset. The court held that the choice of the appropriate recovery period for modified accelerated recovery system (MACRS) assets was within the useful life exception in Regs. Sec. 1.446-1.

Fifth Circuit: The Fifth Circuit upheld the Tax Courts ruling; the Eighth Circuit later followed the Tax Courts approach, in OShaughnessy, 332 F3d 1125 (2003). However, the IRS had also persuaded the Tenth Circuit, in Kurzet, 222 F3d 830 (2000), to agree that a change in an assets depreciable life is an accounting-method change, so the circuits were in conflict. 

New Regs.

The IRS, rather than appealing to the Supreme Court, decided to simply rewrite the portion of Regs. Sec. 1.446-1 that the taxpayers had relied on in Brookshire Brothers and OShaughnessy. Because the Service had been granted legislative authority in this area, the new regulations (TD 9105) essentially make the holdings in these cases moot for transactions after the effective date (tax years ending after Dec. 29, 2003).

New Temp. Regs. Sec. 1.446-1T(e)(2)(ii)(d)(2)(i) states that a change in the recovery period of an asset being depreciated under Sec. 168 (ACRS or MACRS) will be deemed an accounting-method change requiring IRS consent. An exception in prior Regs. Sec. 1.446-1 stated that an adjustment to an assets useful life did not constitute an accounting-method change; that would now only apply to assets being depreciated or amortized under Sec. 167 (which primarily applies to assets placed in service before 1981 and to certain assets not amortizable under Sec. 197).

In addition to clarifying that a change in depreciable life is an accounting-method change, the IRS also waived the rule that a taxpayer has adopted an accounting method once it has consistently treated an item in the same manner for at least two years. Thus, a taxpayer who has depreciated an asset for only one year now has a choice, under Temp. Regs. Sec. 1.446-1T(e)(2)(ii)(d)(3)(i): it either can file (1) an amended return to correct the life; or (2) Form 3115, Application for Change in Accounting Method, to obtain automatic approval to switch to a different depreciable life, thus avoiding an amended return.

Rev. Proc. 2004-11

The IRS will also allow taxpayers to avoid the age-old concern as to whether depreciation not taken in prior years reduces a taxpayers basis in an asset under Sec. 1016(a)(2). Rev. Proc. 2004-11 provides that a taxpayer may file an application for change in accounting method even after an asset has been disposed of, as long as it is filed before the expiration of the Sec. 6501(a) period of limitations on assessment. This provision not only eliminates the allowed vs. allowable depreciation concerns, but it may also provide post-disposition planning opportunities; a taxpayer will be able to take additional depreciation on a property already sold.

This additional depreciation would be deductible at the highest marginal rate and, to the extent the assets broken out were land improvements or other, shorter-lived Sec. 1250 property, the offsetting income, depending on the assets holding period, could be  unrecaptured Sec. 1250 (capital) gain, taxed at the lower 25% rate.

From Robert F. Kane, J.D., CPA, Rockville, MD