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IRS ITG Audit Techniques Chapter 6.2

Chapter 6.2 – Change in Accounting Method

INTRODUCTION

A taxpayers may conduct a cost segregation study on used property and then recompute its depreciation deductions for prior years. Examiners need to be aware of the potential issues relating to these recomputations, including changes in accounting method. This chapter provides a brief overview of the applicable law in this area.

HISTORICAL SERVICE POSITION

In general, 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, or convention for the depreciable property. In any subsequent year after the placed-in-service year, a change in depreciation method, recovery period, 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 IRC § 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.

RECENT LITIGATION

In recent years, the historical position of the Service was challenged in several court cases. The Fifth Circuit, affirming the Tax Court, held that the reclassification of gas station properties as 15-year property for MACRS purposes was not a change in accounting method requiring the Secretary’s consent [Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), aff’g T.C. Memo. 2001-150, reh’g denied (March 31, 2003)]. The Circuit Court agreed with the Tax Court that the then-existing regulations were meant to allow taxpayers to make temporal changes in their depreciation schedules without the consent of the IRS. The Court also affirmed that Brookshire’s change in the classification of its gas station properties from straight-line depreciation of non-residential real estate to declining balance depreciation of 15-year property was not a change in Brookshire’s method of accounting under IRC § 446.

The decision of the Fifth Circuit in Brookshire conflicts with the opinion of the Tenth Circuit in Kurzet v. Commissioner, 222 F.3d 830, 842-845 (10th Cir. 2000). In Kurzet, the taxpayer sought to change the classification of a reservoir from nonresidential real property to 15-year property under § 168, thereby resulting in a change in recovery period from 31.5 years to 15 years. The taxpayer did not change the method of depreciation for the reservoir, which was the straight-line method of depreciation. Although the Tenth Circuit found “some persuasive value to the [taxpayer’s] argument that a change in recovery period under MACRS should be treated like a change in useful life,” the court concluded that the Commissioner’s interpretation of § 1.446-1(e)(2)(ii) as requiring a taxpayer to obtain permission for a change in recovery period is not “plainly erroneous” or “inconsistent” with § 1.446-1(e)(2)(ii).

In addition, the Tax Court in Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349, 410-411 (1981), held that a change in depreciation method resulting from a reclassification of depreciable property from section 1250 property to section 1245 property is a change in method of accounting. In reaching its decision, the court cited to §§ 1.167(e)-1 and 1.446-1(e)(2)(ii)(a), and explained “It is unquestioned that a change in the method of computing depreciation is a change in method of accounting.” Id. at 410. (But see, Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, which followed Brookshire by holding that a change in computing depreciation from the general depreciation system in § 168(a) (GDS) to the alternative depreciation system in § 168(g) (ADS) is not a change in method of accounting, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003), rev’g in part 2002-1 U.S.T.C. (CCH) ¶ 50,235 (D. Minn. 2001), which also followed Brookshire by holding that a change in classification under MACRS is not a change in method of accounting.)

NEW REGULATIONS

Clearly, this area of law has been unsettled in recent years, due to the conflicting court opinions. However, temporary regulations covering this issue have been promulgated. Treas. Reg. § 1.446-1T(e)(2)(ii)(d)(2)(i), effective for taxable years ending on or after December 30, 2003, provides that a change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset is a change in method of accounting. See Example 9 of Treas. Reg. § 1.446-1T(e)(2)(iii), which specifically relates to changes based on a cost segregation study. On January 28, 2004, Chief Counsel Notice CC-2004-007 was issued, setting forth Chief Counsel’s Change in Litigating Position on the application of § 446(e) to changes in computing depreciation. It provides, in relevant part:

The Service’s position continues to be that a change in computing depreciation under section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or ACRS generally is a change in method of accounting under section 446(e) for which the consent of the Commissioner of Internal Revenue is required. However, for depreciable or amortizable property placed in service by the taxpayer in taxable years ending before the effective date of Treas. Reg. § 1.446-1T(e)(2)(ii)(d), the Service will not assert that a change in computing depreciation under section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or ACRS for depreciable or amortizable property that is treated as a capital asset under the taxpayer’s present and proposed methods of accounting is a change in method of accounting under section 446(e). Consequently, 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 section 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 section 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 under new section 2.01 of the Appendix of Rev. Proc. 2002-9 for the current taxable year (provided the filing requirements of Rev. Proc. 2002-9 are met, and the taxpayer and the property are within the scope of Rev. Proc. 2002-9 and new section 2.01 of the Appendix of Rev. Proc. 2002-9).

Similarly, if, for example, the same cost segregation study determined that some of the taxpayer’s MACRS property that is reported as being placed-in-service by the taxpayer in 2002 was actually placed-in-service by the taxpayer in 2001, the Service will not litigate whether or not the change in computing depreciation resulting from this change in placed-in-service date is a change in method of accounting under section 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 under Rev. Proc. 97-27, 1997-1 C.B. 680, for the current taxable year (provided the filing and scope limitations of Rev. Proc. 97-27 are met). New sections 2.01, 2.02, and 2B of the Appendix of Rev. Proc. 2002-9 do not apply to a Form 3115 filed for taxable years ending on or after December 30, 2003, for a change in computing depreciation resulting from a change in placed-in-service date. This change in the Service’s litigating position does not apply to an adjustment in useful life under section 167 (other than under MACRS, section 1400I, section 1400L, or ACRS) if the useful life is not specifically assigned by the Internal Revenue Code, the regulations thereunder, or other guidance published in the Internal Revenue Bulletin, to any adjustment to correct an incorrect classification or characterization of depreciable property for which depreciation is determined under Treas. Reg. § 1.167(a)-11 (CLADR property), or to a change in computing depreciation or amortization due to a posting error, a mathematical error, a change in underlying facts (other than a change in the placed-in-service date), a change in use of property in the hands of the same taxpayer, the making of a late election, or a revocation of an election. These changes in depreciation or amortization are not a change in method of accounting. Accordingly, field personnel should consult with their local Chief Counsel attorneys when a taxpayer asserts that such a change is a change in method of accounting.

Similarly, 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 section 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.

LOOK-BACK STUDIES

Taxpayers may prepare cost segregation studies on existing assets and recompute depreciation for prior tax years based on the reallocated asset costs. In some cases, the taxpayer may file amended returns (claims) for the prior years and, in other cases, the taxpayer may simply deduct the additional depreciation from prior years on the first return filed after the study is complete. Neither of these actions is proper, given the Service position that changes to the recovery period resulting from the reclassification of assets constitutes a change in accounting method. However, see Notice CC-2004-007 (January 28, 2004), quoted on page 6.2-2 of this Appendix.

The correct procedure for a taxpayer to change its accounting method is the timely filing of Form 3115, Request for Change in Accounting Method. Pursuant to Revenue Procedure 2002-9, 2002-3 I.R.B. 327, a taxpayer may request automatic consent for the change. Revenue Procedure 2004-11 modifies Rev. Proc. 2002-9 and other revenue procedures to conform with § 1.446-1T(e)(2)(ii)(d) of the temporary Income Tax Regulations. Although Form 3115 is subject to National Office review, it is generally the responsibility of the examiner to verify the accuracy of the § 481(a) adjustment at the time of the examination. A Schedule M-1 adjustment may also be an indication of the taxpayer’s change in accounting method. The examiner should evaluate the need to review the study that formed the basis for the depreciation recomputations and the resultant change in accounting method.

If the years the assets were placed in service end before December 30, 2003, and are still open under statute, taxpayers may file amended returns to correct the depreciation deductions for those years. They may also file a Form 3115 as a “protective” measure. In either case, the issue would generally warrant examination.

Table 1 to this appendix provides a listing of revenue procedures that are most frequently used by taxpayers to implement accounting method changes based on cost segregation studies. Taxpayers generally argue that they are simply reclassifying property placed in service in prior years to “correct” class lives. This results in recovery period, depreciation method, and convention changes. 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, or Rev. Proc. 92-20, 1992-1 C.B. 685:

  • 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. 96-31, 1996-1 C.B. 714; Rev. Proc. 97-37, 1997-2 C.B. 455; Rev. Proc. 98-60, 1998-2 C.B. 761; Rev. Proc. 99-49, 1999-2 C.B. 725; Rev. Proc. 2002-9, 2002-1 C.B. 327; or Rev. Proc. 2004-11:

  • 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 AND CONCLUSIONS

It is the position of the Service that a change in recovery period is a change in accounting method. Accordingly, a taxpayer is required to obtain the consent of the Commissioner by filing a timely Form 3115. However, the issue regarding a change in accounting method with respect to the recomputation of depreciation (e.g., those based on cost segregation studies) is quite complex. Examiners should consult Notice CC-2004-007 (January 28, 2004) and Treas. Reg. § 1.446-1T(e), and contact the Change in Accounting Method Technical Advisors for ongoing developments in this area. Examiners should also contact Change in Accounting Method Technical Advisor Philip Whitworth 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 IRC § 481(a). Contact: Philip Whitworth (330) 253-7346

Table 1
Revenue Procedures Relative to Cost Segregation Studies

Depreciation Method Changes
(Re-classifications among class lives)

Revenue Procedure Year of Change Remarks
92-20 1996 & Prior Non-automatic; generally used when automatic change was not available
96-31 1996 Automatic; limited to not enough depreciation claimed by using an improper method of depreciation; one-year reporting of taxpayer favorable section 481(a)
97-27 1997-2000 Non-automatic; generally used when automatic change was not available; four-year reporting of taxpayer favorable or unfavorable section 481(a)
97-27 as modified by RP2002-19 2001 and subsequent Non-automatic; generally used when automatic change was not available; one-year reporting of taxpayer favorable section 481(a) & four year reporting of section 481(a)when Service favorable
97-37 1997 Automatic; limited to not enough depreciation claimed by using an improper method of depreciation ; compliance with section 2 of the Appendix necessary; four-year reporting of taxpayer favorable or unfavorable section 481(a)
98-60 1998*
* Transition rules for 1997		 Automatic; Available if not enough or too much depreciation was claimed by using an improper method of depreciation; compliance with section 2 of the Appendix necessary; four-year reporting of taxpayer favorable or unfavorable section 481(a)
99-49 1999-2000*
* Transition rules for 1998		 Automatic; Available if not enough or too much depreciation was claimed by using an improper method of depreciation; compliance with section 2 of the Appendix necessary; four-year reporting of taxpayer favorable or unfavorable section 481(a)
2002-9*

*modified by RP 2002-19 and

RP 2004-11

 2001 & subsequent Automatic; available if not enough or too much depreciation was claimed by using an improper method of depreciation; compliance with section 2 of the Appendix necessary; one-year reporting of taxpayer favorable section 481(a) & four-year reporting of Service favorable section 481(a) adjustment