Accounting method change for depreciation attributable prior misclassification of property.

The IRS is actively working on a proposed revenue procedure that is likely to change the approach it has previously taken with respect to Form 3115, Application for Change in Accounting Method, on a request to change depreciation due to a prior misclassification of property. This topics is listed (as No. 20) among the tax accounting items included in the "Proposed 1993 Internal Revenue Service and Treasury Department Business Plan," issued Jan. 15, 1993.

Consider the following situation. A calendar-year taxpayer, engaged in a retail business, placed a substantial amount of depreciable real and personal property in service in 1988. As a result of a cost segregation study presently conducted with respect to additional property to be placed in service in 1993, the taxpayer discovered that some of the 1988 property was misclassified as real property rather than personal property. In addition, all of the personal property was misclassified as seven-year (rather than five-year) property (under Asset Class 57.0 in Rev. Proc. 87-56).

Accordingly, since Sec. 1016 requires an adjustment to basis equal to the greater of the depreciation "allowed" or "allowable," the required reduction to the basis of the misclassified 1988 property is greater than the depreciation claimed.

Previously, the Service treated this misclassification of property, having occurred more than two tax years ago, as a method of accounting, because it affected the tax year in which taxable income was reported rather than having a permanent effect on a taxpayer's lifetime taxable income. (See Rev. Rul. 90-38 and Rev. Proc. 91-31.) Therefore, the IRS would approve Form 3115 applications on such misclassifications and allow the taxpayer a negative Sec. 481 adjustment in the year of change, equal to the cumulative amount of the understated depreciation that had resulted since the property was placed in service. Because the Service required the prior misclassification to be remedied by a prospective change in accounting method with a Sec. 481 adjustment (rather than by filing amended returns to correct the prior error), it did not matter that some of the understated depreciation occurred in closed years.

The IRS is currently reconsidering its position. Without formal notice, the Service has suspended approval of Form 3115 applications to correct prior misclassifications of property if a negative Sec. 481 adjustment would result. Those Forms 3115 on hand at the IRS at the time of the suspension, or filed since then, are awaiting the completion of the revenue procedure project.

The Service appears to be concerned that approving a taxpayer's application to change its prior property misclassification and allowing a negative Sec. 481 adjustment in the year of change, equal to the cumulative understated depreciation, undermines the allowed/allowable rules under Sec. 1016 and the concept that depreciation each year is based on the property's "unrecovered basis." (Unrecovered basis is determined with reference to the Sec. 1016 adjustments; see Rev. Proc. 87-57, Section 6.03).

One possible IRS approach might be to allow taxpayers to file amended returns for open years. If so, taxpayers who file Form 3115 before the contemplated revenue procedure is issued (which is expected approximately in June 1993) will hopefully not be precluded from deducting depreciation that should have been claimed in closed years if the property were originally classified correctly.