Depreciation method changes allowed without IRS consent.

If a business owner discovers material errors on depreciation schedules resulting in less than optimal depreciation expense in current and prior tax years, he cannot just make a simple correction. Instead, he must secure IRS consent before making any accounting-method change. As a result, he might decide against making these adjustments, fearing that the time, expense and paperwork (not to mention the threat of a Service audit) associated with simple depreciation corrections outweigh potential benefits.

However, correcting depreciation schedules may soon become routine. The recent Tax Court decision in Brookshire Brothers Holding, Inc., TC Memo 2001-150, may serve to simplify the process by which taxpayers make adjustments to their depreciation schedules, eliminating the need for the IRS's consent. In 1991, Brookshire Brothers (Brookshire) began transforming parking lot space at several of its convenience stores into gas stations, claiming depreciation expense over a 31.5- or 39-year recovery period on its 1993-1995 Federal income tax returns. Brookshire later amended these returns, relying on an Industry Specialization Program Coordinated Issue Paper for Petroleum and Retail Industries (ISP), with an effective date of March 1, 1995. The ISP indicates that a convenience store can qualify as 15-year property if it markets petroleum products as its primary purpose.

As a result, Brookshire reclassified its gas stations to 15-year property, recalculated depreciation expense for the 1993, 1994 and 1995 tax years, filed amended returns and received refunds. Brookshire also filed its 1996 and 1997 Federal returns using the 15-year classification. At no time did Brookshire file Form 3115, Application for Change in Method of Accounting, with the IRS.

Although the Service issued refunds for the 1993-1995 tax years, it issued Brookshire a notice of deficiency in December 1998 for the 1996 and 1997 tax years. The IRS cited Brookshire's failure to obtain consent prior to changing its method of accounting for its depreciation deduction. As a result, the Service reduced Brookshire's depreciation expense by a combined $550,000 for the 1996-1997 tax years.

Brookshire argued in Tax Court that the changes it made to its depreciation schedules for the 1996 and 1997 tax years were not accounting-method changes within the meaning of Sec. 446. It claimed that the reclassification from nonresidential 31.5- and 39-year property made to conform with the ISP-recommended 15-year recovery period "did not involve a material item, is analogous to a change in useful life, is a mere correction, and does not deviate from an established consistent method of treatment." Further, Brookshire argued that, if the depreciation schedule changes were an accounting-method change, the Service's acceptance of the 1993-1995 amended returns, and subsequent payment of the refunds, served to grant the required permission.

Note: Although Brookshire did not file Form 3115, it did attach the ISP paper to its 1993, 1994 and 1995 Forms 1120X, along with the explanation that "[t]he determination was made that gas station convenience stores should be reclassed from 31.5-and 39-year property to 15-year property based on the attached memo," referencing the ISP paper.

The IRS disagreed with these claims, arguing that the reclassification constituted an accounting-method change. First, the reclassification altered the recovery period substantially from, at most, 39 years to 15 years. Second, the method used to calculate reclassified assets was changed from straightline depreciation to the declining-balance method. In effect, the Service argued that Brookshire deviated "from a consistently established method" that was not immaterial, a correction of an error or a change in useful life. In addition, it asserted that Brookshire did not file Form 3115 and failed to follow the consent procedures as prescribed when making an accounting-method change. Finally, the IRS argued against Brookshire's claim that the receipt of refunds for the amended returns constituted the IRS's consent, and therefore the deficiency notice for the 1996 and 1997 tax years should stand.

In its opinion, the Tax Court cited Sec. 446(e), which requires taxpayers to secure the Service's consent before initiating an accounting-method change. The court also recognized that Regs. Sec. 1.446-1(e)(2)(ii)(b) provides taxpayers with a notable exception to the general rule set forth in Sec. 446(e): "A change in the method of accounting does not include ... an adjustment in the useful life of a depreciable asset." Although the change could be material in nature, it might not require the IRS's consent if a taxpayer meets the stipulated "useful life" exception.

The court expanded on the concept of "useful life" noting that before 1981, the depreciation deduction was based primarily on an asset's estimated longevity. In 1981, however,"accelerated recovery periods" replaced the useful-life concept, altering the methods used to calculate depreciation expense at various stages. The Service argued that the useful-life exception stipulated in the regulations could not continue to be relied on, as it applied to prior law. Further, with the additional change in the methodology now necessary, to calculate depreciation `expense under accelerated recovery periods, the IRS reasoned that the two concepts were dissimilar and that a change of a recovery period was not analogous to a change in useful life. A reclassification of an asset may not only alter the time period over which the depreciation expense will be recovered, it will also alter the method used to calculate the depreciation expense (in this case from straight-line to an accelerated declining-balance method). The court appears to agree with this reasoning, stating that recovery periods are linked "inextricably" with the asset's depreciation method under Sec. 168.

However, the court ruled in favor of Brookshire. Although the pre-1981 useful-life concept and the current accelerated recovery periods are not synonymous, the court concluded that the similarities between the two were greater than the differences:

Section 1.446-1 (e) (2) (ii) (b) ... was clearly intended to permit taxpayers to alter their depreciation schedules. The type of adjustment explicitly permitted--a change in useful life--would have resulted both in depreciation deductions over a longer or shorter period than originally contemplated and in an increased or decreased amount being deducted in any given period. A change in MACRS classification will have precisely these same two effects. Although a portion of the change in amount may be attributable to calculation method, as opposed to period length alone, such carries insufficient weight when balanced against severely limiting the intended relief.

Given the useful-life exception and that Brookshire's actions were analogous to a change in an asset's useful life, the court concluded that the change to 15-year assets was not an unauthorized change. Because Brookshire did not meet the definition of an accounting-method change requiring prior consent under Sec. 446(e), the court did not address the consent issue.

The court's ruling provides taxpayers another avenue when facing the option of correcting depreciation methods and changing accounting methods. Taxpayers can achieve substantial tax savings when they accelerate the recovery periods of 39-year assets to the 5-, 7- or 15-year category. Taxpayers should review their schedules to determine potential asset reclassifications and if the useful-life exception provided by Regs. Sec. 1.446-1(e) (2) (ii) (b) applies.

Further, in the final paragraph of its decision, the court indicated that neither of the parties specifically addressed either Sec. 168 or Rev. Proc. 97-10. Consequently, the court did not express an opinion "as to the reach of the useful life exception in the section 168 (e) (3) (E) (iii) context or in other circumstances where Congress or the Commissioner has explicitly set forth procedures relating to particular depreciation adjustments." The court did not refer to the rules for changing a method of accounting for depreciation contained in Rev. Proc. 99-49 or 96-31 or the impact either would have on altering depreciation schedules. Currently, the IRS allows taxpayers to adjust for prior depreciation in closed years through a four-year spread of a Sec. 481 (a) adjustment, which would not be allowed if the Service adopts the Tax Court's position in this case. Taxpayers should review all these issues when they consider making adjustments to their assets' depreciable lives.

FROM CHRISTOPHER D. BACHTEL, CPA, SOUTH BEND, IN

Editor:
Frank J. O'Connell, Jr., CPA, J.D.
Crowe Chizek
Oak Brook, IL