The Fastest Deductions Are Not Always the Best

Tax advisers choose to accelerate the maximum deductions allowable and, therefore, often select the shortest life for depreciation—an accelerated method (rather than the straight-line method); immediate expensing under Sec. 179; immediate expensing of research and experimental expenses; 60 months (rather than some longer period) for amortizing startup expenses and organization expenses; the claiming of partial bad debts, etc. Accelerating deductions is probably (although not always) desirable if a taxpayer is presently enjoying taxable income and paying tax. However, when the taxpayer is not paying taxes currently, the fastest approach for deductions may not always be the best; larger net operating loss (NOL) carryovers may not be as desirable as future deductions.

Common Circumstances

Section 382. Once a deduction has been crystallized into an NOL, a Sec. 382 change in ownership will place limits on the use of the carryovers. In addition to the annual allowance (in which the long-term tax-exempt rate is a factor), there is an increase as a result of future realizations of built-in gains. However, such increase depends on actual disposition of assets with unrealized appreciation on the date of the ownership change, and such dispositions might not occur in time to be of real value. In addition, valuations on the date of the ownership change must be established. If an asset has built-in depreciation on the date of the ownership change, the reduction can be treated as an NOL carryover under the Sec. 382 limits.

Alternative minimum tax (AMT). The AMT NOL is limited to 90% of AMT taxable income. Actual current deductions incurred in future years are not subject to that limit.

State income taxes. Some states limit the use of NOL carryovers, which do not apply to actual current deductions in future years.

Outdated tax benefit rule. Sec. 111(c) provides that "an increase in a [net operating loss] carryover which has not expired before the beginning of the taxable year in which the recovery or adjustment takes place shall be treated as reducing tax imposed by this chapter." Thus, exclusion of the recovery item is not permitted. A valid partial bad-debt write-off that occurs before the year in which a Sec. 382 change in ownership occurs increases the NOL deduction in the year of the write-off, which, if not carried back, becomes a carryover for 20 years. Although Sec. 382 may severely restrict the use of such a carryover as part of an effective loss deduction in a subsequent year, it does not technically cause the carryover to lapse before its 20 years have run. Accordingly, Sec. 111 may not provide any benefit. Obviously, Sec. 111(c) should be coordinated with Sec. 382. This result would not occur if the partial bad-debt deduction had never been claimed. Collection in full of a doubtful receivable would not give rise to taxable income, although any shortfall in ultimate collection could result in a built-in loss.

Summary

Tax advisers must resist the temptation to simply take deductions as quickly as possible. There may be a desire to write off amortizable or depreciable assets as soon as possible, to "get rid of them" and thus end the need to continue to account for them over several years. However, the client can be properly served only if all considerations, including, but not limited to, those identified above are taken into account.

From Paul Farber, CPA, Richard A. Eisner & Company LLP, New York, NY