Correcting depreciation errors.

The IRS recently issued Rev. Proc. 96-31 which allows a taxpayer that has claimed less than the allowable depreciation or amortization to change its method of accounting to claim the allowable amount. Presently, depreciable basis for any asset is reduced by depreciation allowed or allowable. Failure to claim the proper depreciation does not prevent a reduction in basis for depreciation allowable but not claimed. This revenue procedure permits a taxpayer to deduct currently allowable depreciation that had not been deducted in prior years.

In general, this automatic consent procedure applies to any taxpayer changing to a permissible method of accounting for depreciation for any item of property that: 1. Under the taxpayers present method of accounting, the taxpayer has not taken into account any depreciation allowance or has taken less than the depreciation allowable; 2. Is subject to Sec. 167, 168, 197 or 168 (prior to its amendment in (1986); and 3. Is held by the taxpayer as of the beginning of die year of change.

The automatic consent procedure does not allow a change in depreciation for die following types of property: 1. Property held by an exempt organization. 2. Intangible property, other than the following property generally acquired after Aug. 10, 1993: * Computer software. * Purchased mortgage servicing rights. * Certain other Interests or rights acquired separately, such as an interest in films, sound recordings, patents, copyrights, etc. 3. Property acquired prior to 1981, for which the taxpayer is changing only the estimated useful life. Such changes must be made on a prospective basis only. 4. Property that changes use but continues to be owned by the same taxpayer. 5. Property on which the taxpayer has claimed depreciation in excess of the amount otherwise allowable. 6. Any accounting method change involving die direct expensing of depreciable assets to a method requiring capitalization and depreciation. 7. Any accounting method change from one permissible method to another permissible method. This provision prevents taxpayers from retroactively changing from an acceptable accelerated method to an otherwise allowable straight-line method. 8. Any change in method of accounting for an item other than depreciation, even if the present method may have resulted in the taxpayer claiming less than the depreciation allowable. As an example, this may involve a change in the treatment of inventory costs, or the recharacterization of a transaction from a sale to a lease.

To effect the change, a taxpayer must complete and file a current Form 3115, Application for Change in Accounting Method, in duplicate. The original Form 3115 must be filed with the IRS in Washington on or before the 180th day of the year of change, and the copy must be attached to the taxpayers timely filed Federal income tax return for the year of change. No user fee is required for filing the Form 3115 and receipt of the Form 3115 will not be acknowledged by the IRS.

A change in method of accounting under Rev. Proc. 96-31 is treated as a voluntary change in accounting method initiated by the taxpayer. If all requirements of the procedure are met, the additional depreciation or amortization that should have been claimed in prior years (including years closed by the statute of limitations) can be deducted entirely in the year of change.

Generally, this automatic consent procedure is favorable for most taxpayers. However, as noted, it applies only to assets on hand as of die beginning of the year of change. Therefore, to the extent that depreciation had not been claimed correctly on assets disposed of in open years prior to the year of change, the taxpayer will not have audit protection against asset basis adjustments with respect to those dispositions. Also, although the Service win not acknowledge receipt of the Form 3115, if the taxpayer's proposed method of accounting for depreciation appears to be an impermissible method or the taxpayer or property appears to be outside the scope of the revenue procedure, the IRS National Office will notify the taxpayer in writing that consent to the proposed change in method will not be granted. Presently, there is no provision for a conference in the National Office to review the Form 3115 if the Service determines that consent is not to be granted. If consent is not granted, the taxpayer win be denied a deduction for depreciation not claimed and will be at risk to possible IRS asset basis adjustments based on the information in the Form 3115 as filed.

Taxpayers should carefully consider the use of Rev. Proc. 96-31 to correct prior-year depreciation errors. As noted, die automatic consent applies only when assets have been underdepreciated in prior years (including assigning assets to incorrect recovery periods); it does not apply if assets have been previously overdepreciated. A change for overdepreciated assets must be requested under Rev. Proc. O. Also, any additional depreciation currently deductible under Rev. Proc. 96-31 must be offset by any allowable but unclaimed depreciation required to be capitalized under any other provision of the Code (e.g., Sec. 263A).