Editor: Mark G. Cook, CPA, CGMA
In IRS Chief Counsel Advice (CCA) 202123007, the IRS advised that a net negative Sec. 481(a) adjustment resulting from a change in method of accounting for depreciation must be included in calculating adjusted taxable income (ATI) under Sec. 163(j)(8).
A calendar-year taxpayer placed items of property in service in 2017 as seven-year property under Sec. 168(e)(1) and depreciated the property under the general depreciation system of Sec. 168(a). During 2020, the taxpayer determined that these items of property should be classified as five-year property under Sec. 168(e)(1). Therefore, the taxpayer filed a Form 3115, Application for Change in Accounting Method, to change its method of depreciation from an impermissible method to a permissible method over a five-year recovery period under Sec. 168(c), beginning with the calendar tax year 2020 (year of change). The change in the accounting method for depreciation resulted in a $100x net negative Sec. 481(a) adjustment for the year of change. Also, the taxpayer made a timely election not to deduct the additional first-year depreciation under Sec. 168(k) for five-year and seven-year property placed in service in the 2017 tax year.
Regs. Sec. 1.446-1(e)(2)(ii)(d)(2)(i) indicates 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. Sec. 481(a) provides that in computing the taxpayer's taxable income for any tax year, adjustments shall be taken into account if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding tax year was computed.
Sec. 163(j) limits the amount of business interest expense a taxpayer can deduct in the current tax year for tax years beginning after Dec. 31, 2017, to the sum of: (1) the business interest income for the tax year; (2) 30% (50% where applicable) of the taxpayer's ATI for the tax year; and (3) the taxpayer's floor plan financing interest expense for the tax year (the Sec. 163(j) limitation).
Under Sec. 163(j)(8), ATI is the taxable income of the taxpayer computed without regard to certain items, including any deduction allowable for depreciation, amortization, or depletion for tax years beginning before Jan. 1, 2022. Regs. Sec. 1.163(j)-1(b)(1) further clarifies that ATI is the tentative taxable income of the taxpayer for the tax year adjusted by certain items including depreciation under Sec. 167 or 168; amortization of intangibles (e.g., under Sec. 167 or 197); other amortized expenditures (e.g., under Sec. 174(b)); and depletion under Sec. 611.
Based on the facts presented, the Chief Counsel's office considered the Sec. 481(a) adjustment as having the same character as the underlying item and concluded that the taxpayer must add back the net negative Sec. 481(a) adjustment of depreciation in determining ATI for the 2020 tax year.
However, if the accounting method change for depreciation had resulted in a net positive Sec. 481(a) adjustment, the Chief Counsel's office instructed that the addback to tentative taxable income under Sec. 163(j) would have been a negative amount equal to the net positive Sec. 481(a) adjustment. It is worth noting that if a taxpayer takes a net positive Sec. 481(a) adjustment into account in calculating taxable income ratably over four tax years beginning with the year of change, the taxpayer can add back only the ratable portion of the net positive Sec. 481(a) adjustment taken into account for the tax year. Also, the addback of the Sec. 481(a) adjustment for depreciation in determining ATI is allowed only for tax years beginning before Jan. 1, 2022. In other words, any remaining balance of a net positive Sec. 481(a) adjustment will not be included to determine ATI in tax years beginning in or after 2022.
Taxpayers must evaluate the potential impact of a Sec. 481(a) adjustment on their business interest deduction for current and future tax years. And tax planning for the business can be different depending on whether the accounting method change of depreciation results in a net negative or positive Sec. 481(a) adjustment, as well as to which tax years the adjustment applies. For example, if a taxpayer generates a net positive Sec. 481(a) adjustment with a four-year spread beyond tax year 2021, the negative ATI addback will not happen in 2022 and future tax years. Depending on the taxpayer's overall tax position, this may or may not provide a favorable tax impact to their business.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-623-0478 or email@example.com.
Contributors are members of SingerLewak LLP.