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MACRS depreciation for property placed in service in short tax years.

General rules

See. 168 determines the amount of depreciation allowed on property placed in service after Dec. 31, 1986. However, of practical importance {and which is absent from the statute)is the effect of a short tax year on the depreciation allowed. This amount affects not only the short tax year but all of the years that follow it.

To calculate the depreciation allowance, the following formula can be used:
Applicable
Adjusted x depreciation
 basis rate
 Number of months
x deemed in service
 12


The property's adjusted basis is the same amount used in computing depreciation for other purposes. The applicable depreciation rate is either the 2.00% declining-balance method the 150% declining-balance method, or the straight-line method generally depending on the class life of the property. For example, office furniture has a class life of 10 years and a depreciable recovery period of seven years.

Alter determining the class life or type of property, it must be determined whether the mid-month convention, mid-quarter convention or half-year convention applies. If the mid-quarter or half year convention applies, the number of months deemed in service must be determined. For a short tax year that begins on the first day of a month or ends on the last day of a month, the tax year consists of the number of months in the tax year. Also, if the short tax year consists of part of a month, the entire month generally is ineluded. For example, if the short tax year begins on April 20 and ends on December 31, the tax year is nine months.

However, according to Rev. Proc. 89-15, no month will be taken into account more than once. For example, with two successive short tax years, April 1 through September 15 and September 16 through December 31, the first short tax year consists of five months and the second short tax year consists of four months.

Mid-quarter convention

The mid-quarter convention will apply if more than 40% of the aggregate basis of property is placed in service in the last three months of the tax year. Nonresidential real property, residential real property, railroad grading or tunnel bore, and any property placed in service and disposed of during the same tax year are not considered when determining if the mid-quarter convention applies. If it does, the tax year must be divided into four quarters. If the short tax year consists of four or eight full calendar months, the quarters are determined based on whole months. For other short tax years, determine the number of days in the tax year and divide by four. Then to determine the midpoint of the quarter, divide the number of days in each quarter by two. If the midpoint is a day other than the first or midpoint of a month, property is deemed placed in service or disposed of on the nearest preceding first or midpoint of the month. If the mid-quarter convention is being used, the property is deemed placed in service at the midpoint of each quarter. The mid-quarter convention will always apply if the short tax year consists of three months or less.

Half-year convention

If the mid-quarter or raid-month convention does not apply, the half-year convention will be required. Property will be deemed placed in service at the midpoint of the tax year.

If the general rule does not apply because the short tax year begins on a day other than the first day of a month and ends on a day other than the last day of a month, the tax year is then measured by the number of days in the short tax year. The arithmetic midpoint is then the number of days in the tax year divided by two. If the arithmetic midpoint is a day other than the first or midpoint of a month, the property is treated as placed in service or disposed of on the nearest first or midpoint of the month.

Mid-month convention

According to Sec. 168(d1(2}, the mid-month convention will apply to nonresidential real property, residential real property, and any railroad grading or tunnel bore. Property is deemed placed in service or disposed of on the midpoint of the calendar month in which the property is placed in service or disposed of.

Future tax years

If the property is placed in service during a short tax year, the deductions allowed for all future years in the recovery period will also be affected. Under Rev. Proc. 89-15, taxpayers can use either the allocation method or the simplified method in computing depreciation allowances in future years so long as the method chosen is consistently applied. However, the tables reflected in Section 8 of Rev. Proc. 87-57 should not be used in calculating the depreciation allowance.

Alocation method

Under the allocation method, the depreciation allowance for each subsequent tax year is calculated by allocating to the tax year (whether a 12-month period or a short period) the depreciation attributable to each recovery year, or portion, that fails within the tax year. For each recovery period included, the depreciation attributable to each recovery year is multiplied by a fraction, the numerator of which is the number of months [including fractions of months] in both the tax year and the recovery year and the denominator of which is 12. See Example 1 on page 656.

For property disposed of before the end of the recovery period, the applicable convention determines when the property is treated as disposed of.

Simplified method

Under the simplified method, the property's unrecovered basis as of the beginning of the tax year is multiplied by the applicable depreciation rate. See Example 2 at right.

If a subsequent tax year during the recovery period is a short tax year, the depreciation allowance is calculated by multiplying the property% unrecovered basis as of the beginning of the tax year by the applicable depreciation rate and then multiplying this product by a fraction, the numerator of which is the number of months (including fractions) in the tax year and the denominator of which is 19,.

If the property is disposed of before the end of the recovery period, the applicable convention determines when the property is treated as disposed of. The depreciation allowance is calculated by multiplying the property% unrecovered basis as of the beginning of the tax year by the applicable depreciation rate and multiplying this product by a fraction, the numerator of which is the number 0f months (including fractions) the property is deemed in service during the tax year and the denominator of which is 12.

Straight-line method

Under both the allocation method and the simplified method, the taxpayer must switch to the straight-line method of depreciation in the first tax year that the straight-line method produces a larger depreciation allowance.

Property placed in service and disposed of in the same tax year

Different rules apply for property placed in service and disposed of during the same tax year.

From Richard 1. Mikuta:. I.D., CPA, and Joseph A. Odzer, MST, CPA, Chicago, Ill. 0@@127396365 6551XOCTO092CSPT0657

Accrual-basis taxpayers that delay the payment of accrued liabilities for compensation to independent contractors (e.g., accountants, lawyers, repair service people, computer programmers) beyond 21/2 months may find that the deduction will not be allowed until a tax year following the year of accrual. This results from the interaction of Regs. Sec. 1.461I[a][2] Sec. 404(d) and Sec. 404(b).

Generally, when services are performed before year-end for an accrual-basis taxpayer, an accrual for the related fees {or compensation} generally can be made at year-end. Regs. Sec. 1.461-Ha}{21 allows a liability to be accrued at such time as the liability is considered incurred. A liability is considered incurred in the tax year in which all the events establishing the fact of the liability have occurred, the amount of the liability is determinable with reasonable accuracy, and economic performance has occurred with respect to the liability. Economic performance with respect to a liability arising out of the provision of services to a taxpayer occurs when the services are provided [Regs. Sec. 1.461-4(d1).

Although compensation expense may be properly accrued under Regs. Sec. 1.461-4{d), Sec. 4041d) will govern the time for deduction of compensation incurred by a taxpayer under a plan, method or arrangement deferring its receipt by service providers for services for which there is no employer-employee relationship. Accordingly, compensation expense incurred under such circumstances is not deductible until the amount is includible in the gross income of the service provider. Temp. Regs. Sec. 1.404[d]-IT states that Sec. 404(a) and (b)-- both directed at employer-employee relationships--and the regulations thereunder apply as if the person providing the services was the employee and the person to whom the services are provided was the employer.

Compensation expense accrued at year-end and received later than 21/2 months after year-end by an employee for a service provider as provided under Temp. Regs. Sec. 1.4041dJ- IT)is presumed to be pursuant to a plan, method or arrangement deferring the receipt of compensation (Temp. Regs. Sec. 1.404[b] IT]. This determination is made separately for each service provider and the presumption of the existence of a plan, method or arrangement is rebuttable.

To rebut this presumption, a taxpayer must show that it is impracticable, either administratively or economically, to avoid the receipt of the compensation by the service provider after 2 1/2 months beyond year-end and that such impracticability was unforeseeable at year-end. Such a case would exist if, for example, a taxpayer could not make payment within the 2 1/2-month period because it would jeopardize the taxpayer's solvency and such circumstance was not foreseeable at year-end [Temp. Regs. Sec. 1.404(b)-ITJ.

A recent Tax Court decision demonstrates the application of both the impracticability and unforeseeable requirements. In National Medical Financial Services, Inc., TC Memo 1992-178, an accrual-basis corporation accrued bonuses as of Dec. 31, 1986 for its two unrelated 50% owner-employees. The bonuses were never paid. The IRS disallowed the deduction for the bonuses under Temp. Regs. Sec. 1.404[b]-IT because the bonuses were not paid within 2 1/2 months after year-end. Therefore a plan, method or arrangement deferring the receipt of the compensation was presumed to exist. It was the taxpayer's responsibility to rebut this presumption.

The taxpayer was in the business of renting and selling medical equipment to doctors and home care patients. A large portion of its income was from Medicare and Medicaid payments. Payment was delayed sometimes up to five or six months after the service was performed. In March and April 1987, the taxpayer deposited cash funds into an escrow account to purchase a blood and medical testing lab. The taxpayer had initially become interested in the business in 1985, started to negotiate the purchase in the middle of 1986, and infused cash into the business shortly after its acquisition. Additionally, the taxpayer used some of the cash to make numerous regular investments in stocks beginning in December 1986 and continuing through 1990.

The taxpayer argued that good business judgment required the retention of cash and liquid investments. The acquired business required unforeseeable amounts of cash and at times resulted in the taxpayer being technically insolvent. Furthermore, payments were slow in coming from Medicare and Medicaid. The taxpayer argued that paying the bonuses would have caused greater insolvency.

The IRS, in turn, argued that the taxpayer could have paid the bonuses if it had so desired, since it had substantial cash and investment balances at Dec. 31, 1986. It was the taxpayer's choice to make additional investments and conserve cash in anticipation of purchasing the blood and medical lab.

The Tax Court concluded that the taxpayer could have chosen to pay the bonuses rather than the other items, and did not demonstrate that paying the bonuses was impracticable. Furthermore, the court stated that the late payments from Medicare and Medicaid were not unforeseeable (nor was the cash investment into the blood and medical testing labs.

Accrual-basis taxpayers that have made an accrual for compensation to independent contractors at year-end would be well advised to review their cash flow projections to make sure that such amount can be paid within 2 1/2 months. The cash flow projections presumably should take into account expected business conditions and expected uses of cash. If it becomes evident that cash will be tight and that the compensation may not be paid within the 2 1/2-month period, the taxpayer may want to give a higher priority to payment of the accrued compensation or consider dipping into the credit line to make payment. Otherwise, nonpayment of the accrued compensation within the 2 1/2-month period could result in the disallowance of the deductions, unless, of course, the taxpayer can prove that it was impracticable to pay the bonuses or that the cash flow shortages were unforeseeable.

From Stephen G. Kafka, CPA, Los Angeles, Cal.
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Title Annotation:modified accelerated cost recovery system
Author:Odzer, Joseph A.
Publication:The Tax Adviser
Date:Oct 1, 1992
Words:2167
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