Proposed regs. shed light on income forecast method.

EXECUTIVE SUMMARY

* Under income forecast depreciation, the deduction for each year is the same proportion of basis as that year's income is to FTI.

* FTI is determined at the end of the year in which the property is placed in service; a revised computation applies when estimated total income changes.

* Under a lookback provision, the taxpayer pays or receives interest on an underpayment or overpayment due to errors in FTI.

The income forecast method allows taxpayers to depreciate property, such as movies and television films, on the basis of anticipated income. This article explains and illustrates the major elements of the proposed regulations, clarifying the application of income forecast depreciation under Sec. 167.

The income forecast method of depreciation was first allowed (1) in the early 1960s, when the IRS determined that traditional methods for recording depreciation on television films and similar property were inadequate. Currently, Sec. 167(g) authorizes use of income forecast depreciation for certain types of property. The Service issued proposed regulations (2) to provide more detailed guidance on the application of this method. This article explains and illustrates the major elements of the proposed rules.

Basic Rules

The income forecast method allows taxpayers to assign depreciation on the basis of anticipated income. In short, the depreciation deduction each year is the same proportion of a property's basis as the property's income for the year is to its forecasted total income (FTI). If it is determined in a later year that FTI was incorrectly computed in an earlier year, a lookback provision applies. Under this provision, the taxpayer must pay interest if the error caused depreciation deductions to accelerate; if it caused a delay, the taxpayer would be entitled to receive interest.

Under Prop. Regs. Sec. 1.167(n)-1(b)(1), the income forecast method is elected, for the most part, on a property-by-property basis. According to Prop. Regs. Sec. 1.167(n)-5(a), it is available for computing depreciation on copyrights, books, patents, motion picture films, videotapes, sound recordings and similar property. As a result of the wide variation in the amount and timing of income from such property, Treasury concluded that this method might better match income and expense than other depreciation methods.

Under Prop. Regs. Sec. 1.167(n)-4(a), income forecast depreciation for a year is computed by multiplying a property's depreciable or redetermined basis by a fraction, the numerator of which is current-year income and the denominator of which is FTI.

Example 1: B Corp. produced a short documentary film, spending $500,000 on the project in 2002 and $400,000 in 2003. The film was released in 2003, and generated $400,000 in income that year. Post-2003 income was estimated to be $1.6 million. The property's depreciable basis is $900,000 ($500,000 + $400,000); its FTI is $2 million ($400,000 + $1,600,000). B's 2003 income forecast depreciation deduction was $180,000 ($900,000 x ($400,000/$2,000,000)).

Example 2: The facts are the same as in Example 1, except that B's 2004 income is $500,000. As a result, its 2004 income forecast depreciation deduction is $225,000 ($900,000 x ($500,000/ $2,000,000)).

Depreciable Basis

A property's initial depreciable basis includes amounts paid or incurred as of the year it was placed in service. Prop. Regs. Sec. 1.167(n)-2(a)(2) requires basis to include amounts that satisfy the Sec. 461 "all events test," which requires that (1) all events have occurred to establish a liability, (2) the amount can be determined with reasonable accuracy and (3) economic performance has occurred. As a result, contingent payments are not includible in the initial basis, but, rather, in the year actually paid or incurred. For example, if an actor contracted to receive a percentage of a film's gross income in excess of a threshold, the cost has not yet been incurred and would not be included in basis, until the income exceeded that threshold.

"Out-year" costs are those paid or incurred after the year a property was placed in service. These costs are treated in one of two ways--either they are depreciated separately, or the basis of the original property is redetermined. However, if an out-year cost is significant and results in a major increase in FTI, it must be depreciated as a separate property under Prop. Kegs. Sec. 1.167(n)-5(c). Significant costs are the lesser of 5% of the property's depreciable basis or $100,000. Major increases in FTI are determined by comparing the new estimate of FTI to the most recent previous estimate. The proposed regulations do not indicate how much FTI has to increase to be deemed significant.

Basis Redetermination 

If an out-year cost related to income forecast property is not depreciated separately, then, under Prop. Regs. Sec. 1.167(n)-2(b), the property's basis has to be redetermined. The redetermined basis is the property's initial basis, plus the out-year cost required to be capitalized. The cost added to the initial basis is the basis redetermination amount. In years when there is a basis redetermination, an additional depreciation deduction is allowed. Under Prop. Regs. Sec. 1.167(n)-4(c), that deduction is the fraction of the redetermined amount that would have been deducted in prior years had the cost been included in the property's initial basis.

Example 3: The facts are the same as in Example 2, except in 2004, B spends an additional $40,000 (less than 5% of the property's depreciable basis) re-editing the film for home video use. At the end of 2004, B estimated that post-2004 income would be $1.1 million. The property's redetermined basis is $940,000 ($900,000 + $40,000), and its FTI remains at $2 million ($400,000 pre-2004 income + $500,000 2004 income + $1.1 million post 2004 income). B's total depreciation deduction for 2004 is $243,000 (2004 income forecast depreciation of $235,000 ($940,000 x ($500,000/$2,000,000)) plus 2004 additional depreciation of $8,000 ($40,000 x ($400,000/$2,000,000)).

The income forecast method does not provide for salvage value. Under Prop. Regs. Sec. 1.167(n)-4(d)(1), any unrecovered basis existing at the end of the tenth year after the property was placed in service is deducted in that year. In addition, any unrecovered basis is deductible in the year the income from the property ceases completely and permanently. According to Prop. Regs. Sec. 1.167(n)-5(c)(3), any cost incurred in a year following the year the original basis was recovered is treated as separate property. If significant new income is anticipated as a result of that cost, it is depreciated as new income forecast property. If there is little or no anticipated new income, the cost is deductible.

Current-Year Income

Under Prop. Regs. Sec. 1.167(n)-3(a), an income forecast property's current-year income includes, with one exception, all income earned (less distribution costs) in the current year. Income is computed in accordance with a taxpayer's regular accounting method. For a film or television show, such income includes that from all theatrical releases and syndications, sales and rentals of video tapes and DVDs and incidental income from the property (e.g., from exploitation of characters, designs or scores). When income is received in a year before the year the property was placed in service, such income is current-year income in the year the property is placed in service. However, according to Prop. Regs. Sec. 1.167(n)-3(d), current-year income never includes income from the sale or disposition of the property.

FTI

Under Prop. Regs. Sec. 1.167(n)-3(b), FTI is determined at the end of the year in which the income forecast property is placed in service; it is computed based on all the information available at that time. It includes the income for that year, plus income attributable from any prior year. It also includes all income estimated to be earned (by the taxpayer or by subsequent owners of the property) from the property in later tax years, up to and including the tenth year after the year the property was placed in service. Thus, a total of 11 years of actual or estimated income is included in FTI.

An inconsistency in the computation of depreciable basis and FTI will sometimes result in a mismatch of revenue and expenses. FTI includes all income expected to be earned from the property within an 11-year period; however, the depreciable basis would not include contingent costs incurred if the forecasted level of income is achieved. An obvious advantage of this provision is that it ensures that depreciation is not taken on a cost never actually incurred. While that result would seem to be relatively rare, the proposed rules offer the potential for frequent understatements of depreciation.

Revised FTI

According to Prop. Regs. Sec. 1.167(n)-4(b), a revised depreciation computation, using revised FTI, can be used in years after the year the property is placed in service when there is a change in the estimate of total income to be earned from the property. The revised computation is required in years in which the current estimate of revised FTI is either less than 90%, or more than 110% of the FTI (or revised FTI) used in the preceding year. The revised computation can also be elected in years in which it is not required. Once the revised calculation is used, it must continue to be applied in subsequent years.

Under Prop. Regs. Sec. 1.167(n)-3(c), revised FTI includes actual current- and prior-year income from the property, plus all the income estimated to be earned by it in later years, up to and including the tenth year after it was placed in service. The revised computation multiplies the property's unrecovered depreciable basis by a fraction, the numerator of which is current-year income and the denominator of which is current revised FTI, less current income from prior years.

Example 4: The facts are the same as in Example 2, except the film's long term prospects have improved such that post-2004 income is estimated to be $2 million. As a result, revised FTI is $2.9 million ($400,000 in 2003 + $500,000 in 2004 + $2,000,000 after 2004). Thus, B is required to use the revised depreciation computation, because revised FTI is more than 110% of the FTI used in 2003 ($2 million). The property's unrecovered basis is $720,000 ($900,000 2003 basis - $180,000 2003 depreciation). Using the revised computation method, the property's 2004 depreciation is $144,000 ($720,000 x ($500,000/($2,900,000 - $400,000))).

Income from the sale or disposition of property is never included in current-year income. Nonetheless, Prop. Regs. Sec. 1.167(n)-4(d)(3) provides that if the property is disposed of before the end of the tenth year after it was placed in service, income from the sale or disposition is included in the computation of revised FTI for the year of disposition. Revised FTI for that year will be the sum of the actual income computed for the years before disposition, actual income in the disposition year and actual income resulting from disposition.

The Lookback Method

Prop. Regs. Sec. 1.167(n)-6(a) requires that the lookback method be applied to income forecast property in recomputation years, including the third and tenth years following the year the property was placed in service. In addition, the year the property is disposed of, or ceases to generate income, is a recomputation year if it falls within 10 years following the year the property was placed in service. A de minimis rule, under Prop. Regs. Sec. 1.167(n)-6(e)(2), provides that the lookback rule will not be applied if FTI or revised FTI for each preceding year is more than 90% and less than 110% of revised FTI for the year being considered for recomputation. In addition, Prop. Regs. Sec. 1.167(n)-6(f) provides that the lookback method does not apply to property with an unadjusted basis of $100,000 or less.

The lookback method requires the following:

* Under Prop. Regs. Sec. 1.167-6(c)(1), the taxpayer recomputes depreciation for each year of the property's life in the year the lookback method is applied (the recomputation year). The recomputed depreciation is based on revised FTI as of the end of the recomputation year.

* Using the recomputed depreciation amounts, Prop. Regs. Sec. 1.167(n)-6(d) provides that the taxpayer computes revised taxable income for each year. Based on these amounts, a hypothetical tax liability is computed for each affected year. The hypothetical tax takes into consideration all provisions that normally affect tax liability, including alternative minimum tax, tax credits, carrybacks and carryforwards.

* Taking the difference between each year's actual and hypothetical tax computations, the taxpayer computes a hypothetical underpayment or overpayment. When the lookback method is being applied for a second time, any hypothetical tax liabilities are treated as actual tax liabilities in the current calculations.

* Prop. Regs. Sec. 1.167(n)-6(d)(2)(ii) provides that the taxpayer computes interest on each hypothetical underpayment and overpayment using the prescribed rate under Sec. 460(b)(7), compounded daily: Interest begins to run on the due date of the original return for the affected year and ends on the earlier of the return's due date for the recomputation year or the date the return is filed and the tax is paid in full.

* The taxpayer combines interest computed on underpayments and overpayments and nets them against one other to determine a net amount due or payable.

The Simplified Lookback Method

A simplified lookback method is provided in Prop. Regs. Sec. 1.167(n)-6(d)(3), which is required for passthrough entities (S corporations, etc.) not closely held. (3) Under the simplified method for each prior year, depreciation amounts are recomputed and compared with the previously reported depreciation amounts to determine any change in the depreciation allowance. If the entity owns multiple properties, the change in depreciation allowance for each property is computed separately; all the changes are combined to arrive at a net change for the entity for the year.

The hypothetical underpayment or overpayment for each year is computed by applying the applicable tax rate to the change in the depreciation allowance. This is the highest regular corporate income tax rate, unless individuals hold more than 50% of the entity (either directly or through passthrough entities). In such case, the applicable rate is the highest regular individual income tax rate. Interest on hypothetical underpayments and overpayments is computed, combined and netted in the same manner as under the regular lookback method; the net amount is either paid to or by the taxpayer.

Interest Paid or Received

Interest is addressed in Prop. Regs. Sec. 1.167(n)-6(g). If the taxpayer has to pay interest, the net amount received is includible in income. If the taxpayer has to pay interest, it is first considered an interest expense resulting from an underpayment. Thus, any such interest attributable to an individual (either directly or through passthrough entities) is treated as personal interest and is nondeductible. In addition, the net interest paid is treated as an income tax, and if not paid timely, is subject to underpayment penalties.

Conclusion

Under the proposed regulations, the income forecast method of depreciation continues to offer taxpayers a way to achieve a reasonable match between revenues and expenses. The lookback method provides appropriate safeguards to ensure that the overall tax results are not totally dependent on the quality of the forecast of future income.

(1) Rev. Rul. 60-358, 1960-2 CB 68.

(2) REG 103823-99 (5/31/02).

(3) For this purpose, "closely held" means ownership of 50% or more of the beneficial interest by five or fewer persons; see Prop. Regs. Sec. 1. 167(n)-6(d)(3).

Wayne M. Schell, Ph.D., CPA 

Associate Professor

Christopher Newport University 

Newport News, VA

For more information about this article, contact Dr. Schell at [e-mail]