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Appeals court expands availability of income forecast depreciation.

The Tenth Circuit has ruled in ABC Rentals of San Antonio, Inc., 9/27/96, rev'g and rem'g TC Memo 1994-601, that the income forecast method of depreciation can be used to depreciate tangible property Although the case applies to "rent-to-own" inventory, the ruling has much broader potential application. At issue is Sec. 168(f)(1), which provides that modified accelerated cost recovery system (MACRS) depreciation does not apply to "any property" if the taxpayer timely elects out of MACRS with respect to such property and the property is "properly depreciated" under any method of depreciation not expressed in a term of years. The Tax Court held that this provision is limited to an asset of an artistic or creative nature whose useful life depends on its popularity, as Opposed to physical wear and tear. Examples of assets traditionally allowed to be depreciated under the income forecast method include films, video cassettes, books and video games.

The Tenth Circuit held, however, that Sec. 168(f)(1) applies by its terms to "any property" "properly depreciated" under a non-time-sensitive system. Contrary to the Tax Court's narrow application of Sec. 168(f)(1), the Court of Appeals stated that Sec. 168(f)(1)'s "legislative history suggests that Congress intended to permit taxpayers to exclude 'moss properly' from the ACRS and MACRS under section 168(f)(1)."

The court then interpreted the phrase "properly depreciated." It held that the taxpayer did not have to show that MACRS would not be an appropriate method; the taxpayer only needs to show that the method elected was a reasonable and consistent one. ABC Rentals kept detailed records of its fixed assets and could document projected rental income for its assets. Significantly, the IRS conceded that the income forecast method was the most economically accurate for the rent-to-own industry. (Rent-to-own companies typically rent out assets under terms giving the lessee the option to receive title at little or no cost at the end of the lease.) Accordingly, the income forecast method is an allowable method of depreciating such assets.

The appellate judges disagreed among themselves as to the proper calculation of the income forecast depreciation. The majority held that, under Sec. 167(b)(4) and (c) (as they existed prior to 1990), the income forecast method could not result in a deduction in the first year greater than that which would have been allowable under the double-declining balance method and that the property being depreciated must have a three-year-or-greater useful life. The dissent, noting that Sec. 168(f)(1) does not refer to Sec. 167(b)(4) and (c), believed that those two limitations did not apply. (The provisions of Sec. 167(b)(4) and (c) were repealed in 1990.) The case was sent back to the Tax Court to determine whether ABC Rentals' assets met the three-year test. Surprisingly, there appear to be no regulations on this issue. Prop. Regs. Sec. 1.168-4(b) allows non time-sensitive depreciation if it "was a recognized method within the particular industry for the type of property in question." This regulation, which adds a requirement not in the statute, did not appear to be an issue in the case.

ABC Rentals is significant for several reasons. First, the alternative minimum tax adjustment for depreciation, often significant for capital-intensive businesses, does not apply when depreciation for regular tax purposes is not computed under MACRS (Sec. 56(a)(1)(B)). Second, since Sec. 168(f)(1) specifically refers to the units of production method of depreciation, the case should apply to property properly depreciated under that method as well. Third, since most depreciation adjustments for state income tax purposes are based on the difference between depreciation under MACRS and Sec. 167, a non-MACRS method of Federal depreciation is more likely to generate a larger state depreciation deduction. Finally, since most taxpayers no longer include depreciation details in their Federal tax returns, perhaps ABC Rentals can be relied on as substantial authority to avoid any accuracy-related penalty under Sec. 6662. If so, a disclosure statement would not be required by taxpayers adopting the income forecast method, even if such method is disallowed on audit.

Unlike MACRS, the basis eligible for depreciation under Sec. 167 must be reduced by salvage value (Regs. Sec. 1.167(b)-0). Thus, a potential beneficiary of the ABC Rentals holding would be a business that can accurately measure income to be derived from a fixed asset, with an income stream over a period substantially less than the asset's MACRS life and the salvage value of the asset not material. Under Regs. Sec. 1.167(c), there is no formal election required to use the income forecast method. It is sufficient to merely make the depreciation calculation using that method. However, to elect out of MACRS, an election under Regs. Sec. 1.168-5(e) must be made in the year in which the property being depreciated is first placed in service.

The Small Business Job Protection Act of 1996 made several modifications to the way depreciation is calculated under the income forecast method. However, the new act did not change the result in ABC Rentals. In fact, the House Committee Report authorizes non-time-sensitive depreciation for movies or "any other property if the taxpayer elects to exclude such property from MACRS." Similar to Sec. 168(f)(1), new Sec. 167(g) (Depreciation Under Income Forecast Method) applies if depreciation is allowable with respect to"any property." (The new law generally applies to assets placed in service after Sept. 13, 1995.)
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Author:Goldberg, Michael J.
Publication:The Tax Adviser
Date:Feb 1, 1997
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