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Cost Segregation ATG - Chapter 6.2 - Change in Accounting Method

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APPENDIX - Chapter 6.2 - Change In Accounting Method

INTRODUCTION

A taxpayer may conduct a cost segregation study on used property and then re-compute its depreciation deductions for prior years. The underlying incentive for preparing these studies for Federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions. Examiners need to be aware of the potential issues relating to these re-computations, including the need for taxpayers to notify the Service that it intends to make a change in accounting method for those items identified in the cost segregation study. This chapter provides a brief overview of the applicable law in this area.

HISTORICAL SERVICE POSITION

It has been the long-standing position of the Service that, in the year an asset is placed in service, an accounting method is adopted relative to the depreciation method, recovery period (but not useful life), or convention for the depreciable property. In any subsequent year after the placed-in-service year, a change in depreciation method, recovery period (but not useful life), or convention resulting from a reclassification of such property, results in a change in method of accounting. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file Form 3115, Application for Change in Accounting Method), and the adjustment to income is made pursuant to § 481(a). If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended returns or claims for adjustment, based on a cost segregation study performed after the original return was filed (for the placed-in-service year), should generally be disallowed on the basis that the taxpayer is attempting to make a retroactive method change. See § 446(e) and IRM 4.11.6.7.5.

The Service's historical position is that a change in computing depreciation under §§ 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or former § 168 (“ACRS”) generally is a change in method of accounting under § 446(e) for which the consent of the Commissioner of Internal Revenue is required. However, this position was successfully challenged by several taxpayers in litigation with respect to depreciable property subject to § 168 (MACRS property). See Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003); but contrast Kurzet v. Commissioner, 222 F.3d 830 (10th Cir. 2000) and Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1981). As a result of these decisions, there was inconsistent treatment of taxpayers with respect to whether a change in computing depreciation under § 168 is a change in method of accounting under § 446(e).

Final regulations under § 446(e), T.D. 9307, 71 F.R. 78066 (December 28, 2006), address the circumstances under which a change in calculating depreciation or amortization is a change in method of accounting under § 446(e). These regulations adopt, with modifications, temporary regulations published in the Federal Register on January 28, 2004. The final regulations provide that the following are changes in method of accounting under § 446(e):

  1. A change in the treatment of an asset from non-depreciable or non-amortizable to depreciable or amortizable, or vice versa, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(2);
  2. A correction to require depreciation in lieu of a deduction for the cost of depreciable or amortizable assets that had been consistently treated as an expense in the year of purchase, or vice versa, Treas. Reg. § 1.446‑1(e)(2)(ii)(d)(2);
  3. A change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset, Treas. Reg. § 1.446‑1(e)(2)(ii)(d)(2)(i); and
  4. A change to or from claiming the additional first year depreciation deduction provided by §§ 168(k), 1400L(b), or 1400N(b) under certain circumstances, Treas. Reg. 1.446-1(e)(2)(ii)(d)(2)(ii).

Treasury Regulation § 1.446-1(e)(2)(iii), Example 9, provides an illustration of a change in accounting method due to changes in depreciation method, recovery period and convention, all resulting from a cost segregation study.

The final regulations clarify that a change in depreciation due to a posting or mathematical error, or a change in underlying facts, is not an accounting method change because the rules in Treas. Reg. § 1.446-1(e)(2)(ii)(a) and (b) also apply to a depreciation change.

In addition, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(i) provides that an accounting method change does not include an adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under § 167 (other than under sections §§ 168, 1400I, 1400L, 1400N(d), or former § 168). This rule does not apply if a taxpayer is changing to or from a useful life (or recovery period or amortization period) that is specifically assigned by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

Treasury Regulation § 1.446-1(e)(2)(ii)(d)(3)(iii) provides that the making of a late depreciation or amortization election or the revocation of a timely valid depreciation or amortization election is not a change in method of accounting, except as otherwise expressly provided by the Code, regulations, or other guidance published in the Internal Revenue Bulletin.

Finally, Treas. Reg. § 1.446-1(e)(2)(ii)(d)(3)(v) provides that any change in the placed‑in-service date of a depreciable or amortizable asset is not treated as a change in accounting method.

The final regulations under § 446(e) only apply to a change in depreciation made by a taxpayer for a depreciable or amortizable asset placed in service by the taxpayer in a tax year ending on or after December 30, 2003, regardless of whether the change in depreciation is a change in method of accounting.

CHANGE IN LITIGATING POSITION

On January 28, 2004 the Associate Chief Counsel (P&SI) issued a Change in Litigating Position Notice (“Notice”) regarding the application of § 446(e) to changes in computing depreciation. See Notice CC-2004-007, as clarified by Notice CC-2004-024.

The Notice provides that the Service's position continues to be that a change in computing depreciation under §§ 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or ACRS, is a change in method of accounting under § 446(e) for which the consent of the Commissioner of Internal Revenue is required. However, for depreciable or amortizable property that is treated as a capital asset and placed in service in taxable years ending before December 30, 2003, the Service will no longer litigate the issue of whether such a change in computing depreciation is a change in method of accounting under § 446(e).

The effect of this Notice is that, if, for example, a taxpayer completes a cost segregation study in 2004 for its MACRS property placed in service in 2001 and, as a result, reclassifies that property from nonresidential real property to 15-year property under § 168(e), the Service will not assert that the change in computing depreciation resulting from this reclassification is a change in method of accounting under § 446(e) and, accordingly, the taxpayer may file amended federal tax returns for 2001 and any affected subsequent taxable year to effect this change in computing depreciation.  Alternatively, the taxpayer may treat this change in computing depreciation as a change in method of accounting and, thus, file a Form 3115 for the current taxable year.

A Service-initiated change in computing depreciation with respect to depreciable or amortizable property that is treated as a capital asset and placed in service in taxable years ending before December 30, 2003, should be treated in a manner consistent with a taxpayer amending its returns. Specifically, Examiners should compute the depreciation allowance for a full taxable year by applying the applicable depreciation rate (as determined using the revised depreciation method and revised recovery period) to the adjusted depreciable basis of the property for each year, beginning with the year of depreciation change, in accordance with Section 6 of Rev. Proc. 87-57, 1987-2 C.B. 687 (without a 481(a) adjustment). If a declining balance method is applicable for the depreciable asset for the taxable year for which a change in recovery period is made, see also Treas. Reg. § 1.167(b)-2(c) for determining the applicable depreciation rate. Recompilations should be performed for pending cases, and steps should be taken to ensure that succeeding years for which returns have been filed are treated consistently.

Examiners should refer to section 6 of Rev. Proc. 87-57 and Treas. Reg. § 1.167(b)-2(c) (if a declining balance method is applicable for the depreciable asset for the taxable year for which a change in recovery period is made). Specifically, Rev. Proc. 87-57 section 6.03 explains that the depreciation allowance for a full taxable year is computed by applying the applicable depreciation rate to the adjusted depreciable basis of the property for each year, beginning with the year of depreciation change. Section 6.04 states that the applicable depreciation rate for a declining balance method is determined by dividing the declining balance percentage (150 or 200) by the applicable recovery period and is constant for each year in which the declining balance is used (not yet switched to straight-line). See also Treas. Reg. § 1.167(b)-2(c) for determining the applicable depreciation rate. Section 6.05 states that the applicable depreciation rate for the straight-line method is determined by dividing 1 by the remaining recovery period at the beginning of the year.

In regards to optional depreciation tables, if a taxpayer used an optional depreciation table for the MACRS property before the depreciation change, continued use of the proper optional depreciation table requires modification of the applicable percentages. The depreciation allowances for the MACRS property for any 12-month taxable year beginning with the year of depreciation change are determined by choosing the optional depreciation table that corresponds to the depreciation system, depreciation method, recovery period, and convention that would have applied to the MACRS property in the placed-in-service year had that property been originally placed in service by the taxpayer with the revised depreciation method, revised recovery period, revised convention, and/or revised placed-in-service date, as applicable.  The applicable percentages for the MACRS property for any 12-month taxable year beginning with the year of depreciation change are modified by first determining the appropriate recovery year in the proper optional table. The appropriate recovery year for the year of depreciation change is the year that corresponds to the year of depreciation change. For example, if the recovery year for the year of depreciation change would have been Year 4 in the table that applied before the change in computing depreciation for the MACRS property, then the recovery year for the year of depreciation change is Year 4 in the proper optional table identified. Next, the annual depreciation rate (expressed as a decimal equivalent) for each recovery year is multiplied by a transaction coefficient. The transaction coefficient is the formula (1/ (1-x)) where x equals the sum of the annual depreciation rates from the proper table identified (expressed as a decimal equivalent) for the taxable years beginning with the placed-in-service year of the MACRS property through the taxable year immediately prior to the year of depreciation change. The product of the annual depreciation rate and the transaction coefficient is multiplied by the adjusted depreciable basis of the MACRS property as of the beginning of the year of depreciation change.

It should be noted that the change in the Service's litigating position does not apply to a change in the treatment of property from a non-capital asset (for example, inventory, materials and supplies) to a capital, depreciable or amortizable asset (or vice versa), or to a change from expensing the cost of depreciable or amortizable property to capitalizing and depreciating or amortizing such cost (or vice versa). These changes are a change in method of accounting under § 446(e). Accordingly, field personnel should consult with their local Chief Counsel attorneys when a taxpayer asserts that these changes are not a change in method of accounting.

PECO FOODS CASE

In Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-018, aff’d 522 Fed. Appx. 840 (11th Cir. 2013), the taxpayer purchased two poultry processing plants in applicable asset acquisitions under § 1060. As part of the acquisitions, Peco Foods entered into written agreements with the seller allocating the purchase price among the acquired assets. Peco Foods then hired an outside consulting firm to perform a cost segregation study on the plants and filed a Form 3115 with its return to change its accounting method and reclassify certain property from nonresidential real property to tangible property. Id. At *3. The IRS disputed these changes, arguing that the taxpayer could not modify the purchase price allocations and subdivide them into component assets in a manner at odds with those schedules. The Tax Court held that Peco Foods was bound by the clear and unambiguous terms of the original allocation schedules and could not deviate from its characterization of those assets. Id. at *4. Thus, the taxpayer was not allowed to change its method of accounting for the acquired assets pursuant to its cost segregation study. It is unclear whether the holding in Peco Foods would apply to acquisitions other than applicable asset acquisitions under § 1060.

TANGIBLE REGULATIONS – Treas. Reg. §§1.263(a)-1, -2, -3

As of the date of this document, the Service has finalized the “tangible regulations”. The impact of these regulations on cost segregation issues will be contained in a future update to this document.

REVENUE PROCEDURES INVOLVING METHOD CHANGES

In order to file a Form 3115 with the Service, a taxpayer needs to follow the procedures outlined in the applicable revenue procedure. Although taxpayers generally argue that they are simply reclassifying property placed in service in prior years to “correct” class lives, this reclassification results in recovery period, depreciation method and convention changes.

The most recently updated automatic consent procedures for taxpayers who have adopted an impermissible method of accounting for depreciation (or amortization) and have either claimed (1) no depreciation, (2) less than the allowable amount of depreciation, or (3) more than the allowable amount of depreciation, is provided in Rev. Proc. 2011-14, Appendix section 6 (which updates and supersedes Rev. Proc. 2008-52). As provided in Rev. Proc. 2011-14, Appendix section 6, the original Form 3115 must be attached to the taxpayer’s timely filed (including extension) original federal income tax return implementing the change in method of accounting for the year of change. A copy of the Form 3115 must be filed with the National Office no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with the federal income tax return for the year of change. For depreciation changes in Rev. Proc. 2011-14, Appendix sections 6.01, 6.02, 6.04 through 6.12, and 6.17 through 6.40, the copy of the Form 3115 must be filed with the IRS in Ogden, UT, instead of with the National Office. If the automatic consent procedures of Rev. Proc. 2011-14 do not apply to a taxpayer’s situation, the advance consent procedures in Rev. Proc. 97-27 should be followed.

The following is a list of the more common compliance issues involving accounting method changes:

1.  Compliance issues for non-automatic method changes made using Rev. Proc. 97-27, 1997-1 C.B. 680:

  • Was the accounting ruling letter properly applied?
  • Was the § 481(a) adjustment amount determined correctly?
  • Did the taxpayer change to a proper method of accounting?
  • Was a TAM obtained in a situation where an accounting ruling letter is to be modified or revoked (correcting the §481(a) adjustment amount is not a modification of the ruling letter)?

2.  Compliance issues for automatic method changes made using Rev. Proc. 2011-14, 2011-1 C.B. 330:

  • Was the change made within the scope of the procedure?
  • Was the change from an impermissible to a permissible method?
  • Were all the applicable provisions properly applied? 
  • Was the §481(a) adjustment amount determined correctly?

Was a change made to a proper method?

SUMMARY

A change in the recovery period is a change in accounting method and in order to make such a change, a taxpayer is required to obtain the consent of the Commissioner through the timely filing of a Form 3115. Pursuant to Rev. Proc. 2011-14, 2011-1 C.B. 330, a taxpayer may request automatic consent for the change. Although a Form 3115 is subject to National Office review, it is generally the responsibility of the Examiner to verify the propriety of the revised method of accounting for depreciation and the accuracy of the § 481(a) adjustment at the time of the examination. The Examiner should evaluate the need to review the cost segregation study that formed the basis for the depreciation recomputations and the resultant change in accounting method.

As discussed in CC Notice 2004-007, an Examiner cannot raise a depreciation change issue for an asset placed in service in a tax year ending before 12/30/2003 (effective date of T.D. 9105) as a change in accounting method (because the Service will not litigate that issue). A Service-initiated change in computing depreciation with respect to depreciable or amortizable property that is treated as a capital asset and placed in service in taxable years ending before 12/30/2003, should be treated in a manner consistent with a taxpayer amending its returns. Specifically, Examiners should compute the depreciation allowance for a full taxable year by applying the applicable depreciation rate (as determined using the revised depreciation method and revised recovery period) to the adjusted depreciable basis of the property for each year, beginning with the year of change, in accordance with Section 6 of Rev. Proc. 87-57, 1987-2 C.B. 687 (without a § 481(a) adjustment).

The issue regarding a change in accounting method with respect to the re-computation of depreciation (e.g., those based on cost segregation studies) is quite complex. Examiners should consult Notice CC-2004-007 and Treas. Reg. § 1.446-1(e) for further guidance. Examiners should also contact the Methods of Accounting & Timing Practice Network for assistance regarding ongoing developments in this area, as well as determining the taxpayer’s compliance with the proper procedures for changing the accounting method and computing the adjustment pursuant to § 481(a).

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Page Last Reviewed or Updated: 04-Nov-2016