Is property reclassification under MACRS an accounting-method change?

The Tax Court recently decided that a reclassification of properties under the modified accelerated cost recovery system (MACRS) was not an accounting-method change under Sec. 446, because it was excepted by regulation (Brookshire Bros., TC Memo 2001-150). It is uncertain whether the IRS will acquiesce in this decision. Until its response is known or additional cases are decided, taxpayers that want to make a MACRS class-life reclassification should consider protecting their positions by filing both a request for an accounting-method change and amended returns.

Facts

Beginning in September 1991, Brookshire Bros. began to build gas station properties accessible through the parking lots of certain of its grocery stores. The company classified the gas stations as nonresidential real property with 31.5- or 39-year recovery periods on its 1993-1995 returns. In 1996, the company filed amended returns for those years, reclassifying the gas stations as 15-year property, citing an IRS Industry Specialization Program (ISP) paper with an effective date of March 1, 1995 allowing this treatment. Accordingly, Brookshire's original returns for 1996 and 1997 depreciated the gas stations as 15-year property.

The Service issued refunds for the amount the taxpayer claimed in the amended returns for years ended in 1993 and 1994 and a partial refund of the amount claimed for the year ended in 1995. However, it subsequently examined Brookshire's 1996 and 1997 returns and issued a deficiency notice in December 1998. The IRS determined that Brookshire's deductions for depreciation had to be decreased; by treating the gas stations as 15-year property, it had engaged in an unauthorized accounting-method change. The Service never asserted that the gas stations could not be properly classified as 15-year property under the MACRS rules.

Accounting-Method Changes

Sec. 446(a) sets forth the general rule that, "[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." Sec. 446(e) then provides the particular standard governing changes in accounting methods as follows:

Requirement Respecting Change of Accounting Method.--Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.

In addition, Regs. Sec. 1.446-1 (e)(2)(i) further clarifies the operation of these statutory mandates:

Except as otherwise expressly provided in chapter 1 of the Code and the regulations thereunder, a taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. Consent must be secured whether or not such method is proper or is permitted under the Internal Revenue Code or the regulations thereunder.

Regs. Sec. 1.446-1(e)(2)(ii)(a) defines a change in accounting method as a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

Regs. Sec. 1.446-1(e)(2)(ii)(b) provides examples of items that do not constitute accounting-method changes. One of these exceptions is an adjustment in the useful life of a depreciable asset. Even though "such adjustments may involve the question of the proper time for the taking of a deduction, such items are traditionally corrected by adjustments in the current and future years."

Sec. 168

Sec. 168 governs the depreciation methods for tangible property placed in service after 1986. MACRS places assets into one of 10 classes. The classification of an item under MACRS determines both the recovery period and the method under which it is depreciated.

Findings

Regulatory exception. The Tax Court held that Brookshire's treatment did not constitute an accounting-method change under Sec. 446(e), because the regulation excepted it, providing that "a change in the method of accounting does not include ... an adjustment in the useful life of a depreciable asset."

The court acknowledged that, under MACRS, a reclassification could change not only an asset's recovery period but also its depreciation method. But the court concluded:

The similarities between a change in MACRS classification and a change in useful life are greater than the differences.... 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.

Further, the court explained:

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.

Rev. Proc. 97-10. The court noted its decision did not address the application of Rev. Proc. 97-10, issued after Sec. 168(e)(3)(E)(iii) was enacted under the Small Business Job Protection Act of 1996 (SBJPA). Under Sec. 168(e)(3)(E)(iii), 15-year property includes "any (`section 1250') property which is a retail motor fuels outlet (whether or not food or other convenience items are sold at the outlet)."

Rev. Proc. 97-10 provided the exclusive procedure for making the election under the SBJPA to treat a retail-motor-fuels outlet placed in service before Aug. 20, 1996, as 15-year property under Sec. 168. The election is available only for the taxpayer's tax year that includes Aug. 20, 1996 (enactment date of the SBJPA). The taxpayer must have completed and filed a current Form 3115, Application for Change in Accounting Method, with the original or amended return for the change year.

Rev. Proc. 97-10 stated that the SBJPA's legislative history provides that the Secretary may treat an election as a change in the taxpayer's accounting method for the property and provide rules similar to those provided in Rev. Proc. 96-31. Rev. Proc. 97-10 also stated that the SBJPA's legislative history further provides that if a taxpayer has already treated the property as 15-year property, the taxpayer would be deemed to have made the election for that property. (See the congressional Joint Committee on Taxation analysis, and the Senate report on the legislation, S. Rep. No. 104-281.)

Additionally, according to the SBJPA, a taxpayer may elect (in such form and manner as the Treasury may prescribe) to treat property placed in service before the enactment date as 15-year property. Brookshire filed the amended returns on July 15, 1996, before the enactment of Sec. 168(e)(3)(E)(iii). This also pre-dates Rev. Proc. 97-10. This means Brookshire followed only the ISP paper that allowed gas-station convenience stores to be classified as 15-year property as long as they met the ISP's two-pronged test.

Arguably, Brookshire Bros. may not have been correctly decided. For this reason, the IRS is unlikely to acquiesce in this decision. The Tax Court relied on the exception in Regs. Sec. 1.446-1 on a change in an asset's useful life. At the time this exception was written, however, assets were depreciated for tax purposes according to their useful lives, and the choice of an asset's useful life was not directly connected with the depreciation method under which the taxpayer depreciated the asset. The exception is more akin to a change in facts than a change in accounting method. For example, after using a particular asset in a trade or business for several years, a company could determine the asset's useful life as longer or shorter than initially anticipated, which would require a change in the asset's useful life for depreciation purposes. This would not change the depreciation method, however. The reclassification of an asset depreciated under MACRS might not follow the original intent of Regs. Sec. 1.446-1.

Lastly, further review of the SBJPA's legislative history reveals Congress's overwhelming support for treating a MACRS class-life reclassification as an accounting-method change. Both the congressional Joint Committee on Taxation's analysis and the Senate report state that Treasury may treat an election under the SBJPA as a change in the taxpayer's accounting method. Therefore, it appears that Congress intended to treat such MACRS reclassifications as accounting-method changes.

FROM SHARON D. HOLLAND, CPA, AND GLENN MACKLES, J.D., WASHINGTON, DC