Depreciation Correction Catch-Up Offers Significant Deductions
In certain situations, a taxpayer may be able to file amended returns and benefit from tax recovery plus interest. Under a blanket consent provided by Rev. Proc. 96-31, 1996-20 IRB 11, taxpayers now can correct certain erroneous depreciation methods that have provided less than the allowable depreciation. Unclaimed depreciation, for closed as well as open years, is restored through a Section 481(a) adjustment that reduces income in the year of change.
Generally, a change in the method of computing depreciation (or amortization) is a change in accounting method, according to Reg. 1.167(E)-1(a). Historically, a taxpayer whose depreciation method yielded less than the available depreciation had to obtain Internal Revenue Service (IRS) consent to correct its mistake. At the same time, the basis of the underdepreciated property was reduced by the unclaimed depreciation under Section 1016(a)(2).
Rev. Proc. 96-31 states that a change from not claiming the depreciation or amortization allowable to claiming the depreciation allowable is a change in accounting method requiring consent of the IRS commissioner. The revenue procedure provides automatic consent for a taxpayer to change the accounting method where it has claimed less depreciation or amortization than allowable and affords the taxpayer relief from filing under Rev. Proc. 92-20, which generally discusses changes in accounting method disclosures. The omitted depreciation from prior years will be taken into account in the year of change through a negative u481(a) adjustment (used in situations where a taxpayer has depreciated or amortized an asset too quickly). This is a significant, taxpayer-favorable concession on the part of the IRS.
Basic Operation of the Revenue Procedure
Generally, Rev. Proc. 96-31 applies to certain situations in which a taxpayer has inappropriately assigned longer lives to depreciable or amortizable assets than required. For example, the common misclassification retailers and wholesalers make of treating five-year property (Class 57.0 assets) as seven-year property would be covered by this revenue procedure. The revenue procedure applies to most depreciable property that has been "underdepreciated" and was held by the taxpayer at the beginning of the year of change. Types of property not covered by the revenue procedure include property that has been overdepreciated, depreciable tangible property that changes in use but continues to be owned by the same taxpayer, property held by a tax-exempt entity, and any property with respect to which a taxpayer is seeking to either make or revoke an election under the depreciation and amortization rules. In addition, the revenue procedure is not applicable to any change from deducting the cost or other basis of any property as an expense to capitalizing and depreciating such cost or basis. The procedure similarly does not apply to changes from one permissible method of depreciating property to another depreciation method.
The IRS national office has indicated informally that Rev. Proc. 96-31 applies to a change in asset classification that involves a change in characterization of property from real to personal in nature.
To qualify for the blanket consent to changing methods of depreciation, a taxpayer must change to a permissible method and complete and file a Form 3115 in accordance with the procedure. The form must be filed within the first 180 days of the year of change (including extensions) or the last day of a short tax year of less than 180 days, and a copy must be attached to the taxpayer's (timely) filed return for that year. The taxpayer should note clearly at the top of the Form 3115 "Automatic Method Change Under Revenue Procedure 96-31." The negative u481(a) adjustment, which is equal to the difference, between the total amount of depreciation/amortization previously taken and the total amount allowable for open and closed years prior to the year of change, will be picked up entirely in the year of change. No user fee is required, and the filing will not be acknowledged by the IRS. To effect the automatic change, a taxpayer must complete and file Form 3115 in duplicate. Rev. Proc. 96-31 applies only where there is a negative u481(a) adjustment (or only where a taxpayer has depreciated or amortized an asset too slowly).
While consent to the change under Rev. Proc. 96-31 is automatic, discussions with the IRS indicate that the Form 3115 filed under this revenue procedure will be screened by the IRS national office to ensure that taxpayers are using appropriate class lives for their assets. If the IRS disagrees with the proposed asset classification, the application will be rejected and the taxpayer will need to file a corrected application under either Rev. Proc. 96-31 or Rev. Proc. 92-20. In either case, the taxpayer has delayed the year of change and the corresponding tax benefit of making the change until the next tax year.
Pros and Cons
Rev. Proc. 96-31 provides an excellent opportunity to obtain improved cash flow. Because the IRS has indicated that a change in accounting method is permissible notwithstanding the allowed versus allowable issue under the basis adjustment rules of Section 1016, in certain situations a taxpayer may be able to file amended returns and benefit from tax recovery plus interest. The mixed blessing of this procedure is that taxpayers are not protected from audits using information from their filings under the procedure. Thus, if a taxpayer changes a depreciation method for an item under the procedure but has sold similar items in years that are still open, the IRS, using Form 3115 as a road map, could potentially increase the gain on sale income by the allowable but unclaimed depreciation.