Revisiting Tax Depreciation Through Changes in Accounting Methods

While accounting methods and changes thereof may sound like financial reporting/bookkeeping concepts, tax reporting provisions and regulations incorporate these constructs as well. Whether a taxpayer uses the cash or accrual method of accounting or a specific method of depreciation for a fixed asset, or chooses to capitalize or deduct certain expenditures, all result in accounting methods being established. These accounting methods sometimes need to be changed by a taxpayer, whether voluntarily (because of an earlier error or current business decision change) or involuntarily (resulting from an audit).

The tax law provides a mechanism for requesting and implementing changes in accounting methods. The ultimate effect of a change in accounting method is either an increase or decrease to a taxpayer’s income in the year of change (and subsequent years in certain circumstances). Certain depreciation methods are included as accounting methods that may be corrected through this process.

The current COVID-19 pandemic has resulted in negative economic impacts for many taxpayers. The utilization of an accounting method change has the opportunity to provide some taxpayers much needed immediate tax and cash flow benefits. Specifically, as noted later in this alert, recent changes implemented by the CARES Act that accelerate the depreciation of certain assets create an opportunity for a change in accounting method.  

Overview of Changes in Accounting Methods

Adoption of an Accounting Method

The first year a taxpayer files an income tax return, a taxpayer may adopt any permissible method of accounting. With limited exceptions, once an accounting method is adopted, the taxpayer cannot file an amended return to change the accounting method. Rather, a taxpayer must obtain the consent of the Commissioner of the Internal Revenue Service before changing from an adopted method of accounting. It should be noted that an impermissible accounting method generally needs to be used on two consecutive tax returns before the consent of the Commissioner is required. Therefore, an amended return is permitted to correct an impermissible method that was used on only one tax return.

Types of Accounting Methods and Changes Thereof

A wide variety of accounting methods are included in the Internal Revenue Code and the underlying treasury regulations. Certain depreciation and amortization attributes, cash vs. accrual accounting, capitalization of expenditures, and long-term contracts are examples of some common accounting methods. Certain method changes are considered automatic and do not require user fees. Conversely, non-automatic changes require user fees as well as explicit approval through an accounting method change ruling letter (consent agreement) prior to implementing a method change.

General Steps to Apply for a Change in Accounting Method

Where a taxpayer pursues a change in accounting method, treasury regulations require Form 3115, Application for Change in Accounting Method, to be filed. The form includes a series of questions that address the type of change and underlying requirements. An analysis of the changes to taxable income is also required to be included, and the net taxable income effect (called an IRC Sec. 481(a) adjustment because of the code section that allows for such adjustment) is reported in a manner determined by whether there is a positive or negative income adjustment as follows:

It should be noted that the adjustment is calculated without regard to the statute of limitations. Therefore, a taxpayer is able to recalculate depreciation on assets acquired in a tax year that is closed under the statute of limitations. For example, a taxpayer could have acquired a depreciable asset in 2010, but used the wrong depreciable recovery period for tax years 2010 through 2018 while calculating depreciation. In 2019, the taxpayer decides to file for a change in accounting method to correct the depreciation. Although the statute of limitations for several tax years starting with 2010 have already expired, a change in accounting method still allows the taxpayer to include the adjusted depreciation for those years when calculating the IRC Sec. 481(a) adjustment. These adjustments can therefore have significant unexpected positive (or negative) implications to entities as well as to pass-through investors.

Audit Protection

A taxpayer who undertakes an accounting method change generally receives audit protection. Audit protection means that the IRS will not require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change. The following example assumes a taxpayer qualifies for audit protection. If a taxpayer has been using an impermissible method of accounting for depreciation for several years and in 2019 files Form 3115 to obtain a change in accounting method, the IRS would not be able to propose an adjustment relating to the changed depreciation of an earlier year. It should be noted that audit protection does not apply for all accounting method changes.

Special rules apply to requests for a change in accounting method where a taxpayer is under examination. While a taxpayer may voluntarily request a change in accounting method at any time, a taxpayer will not secure audit protection while under examination unless it meets one of six exceptions provided by the IRS. For example, one of the exceptions is that the request is filed between July 15 and October 10, the issue is not an issue under consideration, and the taxpayer has been under examination for at least the past twelve months.  Different rules apply to short tax years and also to controlled foreign corporations.  A taxpayer under examination that files an accounting method change outside of this window and is unable to secure audit protection will be required to pick up the positive IRC Sec. 481(a) adjustment over a two-year period.

Change in Accounting Method for Depreciation

Depreciation Attributes Considered Accounting Methods

Depreciation errors are generally corrected by the filing of an amended tax return or through the request of a change in accounting method. If an impermissible method of depreciation has been reported for at least two consecutive years, then a change in accounting method would be required to correct any errors. However, for changes from an impermissible to a permissible method of depreciation where depreciation has only been reported on one tax return, the two-year rule is waived and therefore a taxpayer can either amend a prior year tax return or request a change in accounting method. Some of the accounting method changes for depreciation are the following:

1. A change in depreciation method under IRC Sec. 168(b), period of recovery under IRC Sec. 168(c), or convention under IRC Sec. 168(d);
2. A change from not claiming to claiming bonus depreciation under IRC Sec. 168(k) provided the taxpayer did not make the election out of bonus depreciation;
3. A change from claiming to not claiming bonus depreciation under IRC Sec. 168(k) for an asset that does not qualify for bonus depreciation, including an asset that is included in a class of property for which the taxpayer elected not to claim bonus depreciation;
4. A change in the treatment of an asset from nondepreciable to depreciable, or vice versa; and
5. A correction to require depreciation in lieu of a deduction for the cost of depreciable assets that had been consistently treated as an expense in the year of purchase, or vice versa.

Depreciation Attributes NOT Considered Accounting Methods

Certain types of changes to depreciation are not accounting method changes. Generally, these include changes in the use of an asset by a taxpayer (i.e., business use changes to personal use), changes in the placed-in-service date of assets, and late elections. Furthermore, corrections because of mathematical, calculation, or posting errors are not considered to be accounting method changes.

Various elections relating to depreciation exist that allow taxpayers to choose between depreciation options. For example, taxpayers are able to elect out of bonus depreciation for qualified property. These elections must be timely filed by the due date of a taxpayer’s tax return. Any attempt to make such elections after the due date would be considered late elections. Late elections are a significant item to note since, while changing to or from bonus depreciation can be an accounting method change if the original reporting was incorrect, late elections out of bonus depreciation have historically not been subject to the accounting method change rules. Any late attempts to elect out of bonus depreciation need to follow the private letter ruling requirements as well as any other relevant treasury guidance. However, see discussion below regarding late elections and the CARES Act.

Relevance for Annual Tax Compliance Process

The ability to apply for a change in accounting method is an important tool that must be considered in the annual tax compliance process. When errors are identified in depreciation from prior years, it is important to analyze the positive or negative impacts on taxable income and then pursue a strategy to correct either via amended tax returns or an application for a change in accounting method.

As discussed above, audit protection is provided in certain instances when a change in accounting method is applied for. In contrast, waiting for the IRS to discover an error upon examination can lead to less depreciation and therefore increased taxable income, and also penalties and interest assessed on prior year tax returns.

The option to file a Form 3115 is helpful from an administrative perspective since taxpayers do not have to file additional amended tax returns. If a taxpayer used an impermissible depreciation method for two groups of assets, one group for several years and one group for just one year, the two-year rule would require a Form 3115 for the first group of assets and an amended return for the second group of assets. The ability to file one Form 3115 for both groups of assets provides a significant administrative benefit. Furthermore, as mentioned above, positive income adjustments are generally reported over a four-year period thereby reducing the immediate tax and cash flow impacts to taxpayers.

The “allowed or allowable” rule for depreciation is key to consider when evaluating the existence of an impermissible accounting method for depreciation. The adjusted tax basis of an asset which is used for gain/loss calculations upon disposition includes an adjustment for depreciation that was allowed or allowable. This means that if the depreciation allowable under the law was greater than the depreciation actually deducted on tax returns, the greater amount will be used to reduce the basis even though the depreciation was not previously deducted. Therefore, it is important to ensure that the correct amount of depreciation was taken historically and, if not, pursue corrective actions.

Depreciation and the CARES Act

The CARES Act enacted in response to the ongoing COVID-19 pandemic includes significant changes to the treatment of qualified improvement property (“QIP”). QIP was previously not eligible for bonus depreciation in 2018 and 2019 but, due to a retroactive change, is now eligible. Furthermore, the recovery period for QIP has changed from 39 years to 15 years. (See Changes to Qualified Improvement Property Under the CARES Act.)

The IRS has recently provided guidance that allows taxpayers to make late depreciation elections, or to revoke or withdraw certain depreciation elections for the 2018, 2019 or 2020 tax years. (See IRS Issues Guidance for Taxpayers Adjusting Depreciation on Qualified Improvement Property.)

As discussed in those alerts, the option to request a change in accounting method to implement revised depreciation for QIP could be of significant importance. Certain taxpayers may prefer not to amend prior year tax returns, especially partnerships with a significant number of investors that would be affected. A change in accounting method could be a preferred option in these circumstances.

Next Steps

Taxpayers and tax advisors both have a vested interest in continually considering historical and current depreciation methods. When errors do arise, the ability to file for a change in accounting method using Form 3115 is paramount due to negative consequences that may occur under the allowed or allowable rule. Furthermore, the impacts of an IRC Sec. 481(a) adjustment are favorable for taxpayers due to the mechanism by which they are reported in taxable income. As mentioned, negative adjustments are currently reported in full so therefore tax and cash flow benefits may be available. On the contrary, positive IRC Sec. 481(a) adjustments are taken into account over four years so the negative impact on cash flow is spread out.

As discussed above, multiple options may be available for a taxpayer to correct depreciation for the 2018 and 2019 tax years resulting from changes in the CARES Act. These include filing amended tax returns as well as filing Form 3115 for a change in accounting method. Changes to the depreciation of QIP resulting from the CARES Act have created the opportunity to provide significant tax and cash flow benefits to taxpayers and therefore a careful review by taxpayers of these changes is warranted.

Due to the complex nature of tax depreciation rules, consultation with tax professionals is strongly recommended when undertaking a fixed asset and tax depreciation analysis.