Depreciation Method Changes

Recent taxpayer-favorable decisions from the Fifth and Eight Circuits have created a conflict on whether a change in a depreciable assets recovery period is an accounting-method change under Sec. 446, requiring IRS consent. In Brookshire Brothers Holding, Inc., 320 F3d 507 (5th Cir. 2003), and Roger OShaughnessy, 8th Cir., 6/13/03, the courts held that such changes were not accounting-method changes; however, three years earlier, in Kurzet, 222 F3d 830 (10th Cir. 2000), the Tenth Circuit had reached the opposite conclusion.

Reasoning

The Fifth and Eight Circuits relied heavily on the fact that a change to a depreciable assets recovery period is analogous to a change in the assets useful life under pre-modified accelerated cost recovery system (MACRS) law. They pointed to Regs. Sec. 1.446-1(e)(2)(ii)(b), under which an accounting-method change does not include an adjustment to a depreciable assets useful life.

In Kurzet, on the other hand, the Tenth Circuit deferred to the IRS as to how it interprets its own regulation. The fact that the Service amended the Sec. 446 regulations several times after Congress enacted MACRS without ever specifically stating that MACRS recovery-period changes did not require permission, indicated that such consent was required.

Changing Recovery Periods

A decision against the IRS is typically taxpayer-friendly. However, a closer look at the issues in Brookshire, Kurzet and OShaughnessy casts some doubt on that assumption. In at least one instance, Brookshire could create serious roadblocks for a taxpayer wanting to make a change.

Example 1: In 1997, X Co. (a passthrough entity with 10 individual owners), constructed a facility. It capitalized the entire cost as 39-year property for Federal depreciation purposes. In 2003, after conducting a cost-segregation study, X realizes that it should have classified 25% of the cost as five- or 15-year property. To effect recovery-period changes for the assets in question, it files Form 3115, Application for Change in Accounting Method, under Rev. Proc. 2002-9, for automatic consent to change the recovery periods, and takes the cumulative additional depreciation expense as a current-year deduction, under Sec. 481(a) and Rev. Proc. 2002-19.

Under the Brookshire methodology, a taxpayer would not have to file Form 3115, because a change in asset recovery periods is not an accounting-method change. In the example, Xs mechanism for recovering the accelerated depreciation it was supposed to take in prior years would be to file amended returns for those years. However, the statute of limitations (SOL) would preclude X from filing returns for tax periods more than three years prior to the current year, which effectively prohibits it from recovering much of the prior accelerated depreciation expense on the reclassified assets.

Even if all of the prior years were within the SOL, X would have to file amended returns for all of the affected years; each owner of X would also have to file an amended return to recover the lost depreciation expense. As a result, X would probably prefer to treat the asset-recovery-period changes as accounting-method changes.

On the other hand, a taxpayer under audit may find the OShaughnessy and Brookshire results preferable.

Example 2: The facts are the same as in Example 1, except when X capitalized the costs in 1997, it misclassified an additional 20% as five-year property; thus, it recorded more depreciation expense in 19972003 than it was supposed to record.

Under OShaughnessy and Brook-shire, X would not have to change its depreciation expense for closed years, if the IRS were to uncover the error in an audit.

Current Status

Since the Fifth Circuits decision in Brookshire, the IRS released Rev. Rul. 2003-54, which addresses proper classification of gasoline pump canopies for depreciation purposes. It states, [a]ny change in a taxpayers [sic] treatment of the cost of gasoline pump canopies or the cost of the supporting concrete footings to conform with this revenue ruling is a change in method of accounting to which the provisions of 446 and 481 and the regulations thereunder apply. This indicates that the Service has not changed its position; taxpayers have to treat recovery-period and method changes for MACRS purposes as accounting-method changes.

Conclusion

Until the issue is resolved by the Supreme Court or a new revenue procedure, taxpayers should assume the IRS still views asset-recovery-period changes as accounting-method changes, requiring consent. They would also be wise to consider that the IRS could change its position on the issuevoluntarily or otherwiseat any time.

From Edward D. Meyette, CPA, and Robert C. Zwiers, Grand Rapids, MI