Depreciation and in a Realization Income Tax and the Business Interest Deduction

Author:Deborah A. Geier
Pages:376-407
 
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Chapter 13: Depreciation in a Realization
Income Tax and the Business Interest Deduction
In the early days of the income tax, before Messrs. Schanz, Haig, and Simons developed a tax-
specific meaning of the term “income,” you have learned that both Congress and the courts often
borrowed from other disciplines, such as financial accounting or trust accounting, in providing
content to the term. Indeed, an allowance for depreciation was likely imported into the income tax
reflexively from financial accounting, where depreciation is required to further the goal underlying
the “matching principle.”
In financial accounting (not tax accounting), the “matching principle” is a very important one,
and sometimes those steeped in a financial accounting background have trouble letting go of it
when they cross over the great divide into the tax realm.1 Indeed, even Tax Court Judge Laro in
the Simon case (Part C., below) fell into this trap when he wrote: “The primary purpose of
allocating depreciation to more than 1 year is to provide a more meaningful matching of the cost
of an income-producing asset with the income resulting therefrom; this meaningful match, in turn,
bolsters the accounting integrity for tax purposes of the taxpayer’s periodic income statements.”2
Notice his reference to “income statements,” which is a financial accounting document, as opposed
to tax returns. This quotation (with the exception of the reference to “tax purposes”) is consistent
with the following description of the role of depreciation in furthering the matching principle for
financial accounting purposes found at “Accounting-Simplified.com (the easy way to learn
accounting online, for free!).”
Depreciation results in a systematic charge of the cost of a fixed asset to the income
statement over several accounting periods spanning the asset's useful life during
which it is expected to generate economic benefits for the entity. Depreciation
ensures that the cost of fixed assets is not charged to the profit & loss at once but is
“matched” against economic benefits (revenue or cost savings) earned from the
asset’s use over several accounting periods.
[The] matching principle therefore results in the presentation of a more balanced
and consistent view of the financial performance of an organization than would
result from the use of cash basis of accounting.3
That last sentence illustrates the role of the matching principle in financial accounting: to
provide a more informative view of the economic health of a business over time to those interested
in its performance, such as shareholders of a corporation housing the business or a bank
contemplating making a loan to the business. That is to say, the role of the financial accountant is
only to provide helpful information to interested parties; no payment obligations (such as a tax)
depend on the computation of “income” for an “income statement.” Indeed, because of this goal,
a range of reasonable ways to account for costsusually referred to as “generally accepted
1 See generally Deborah A. Geier, The Myth of the Matching Principle as a Tax Value, 15 AM. J. TAX POLY 17 (1998)
(exploring how reflexively borrowing the matching principle from financial accounting for purposes of measuring
“income” for income tax purposes can undermine income tax values).
2 Simon v. Comm’r, 103 T.C. 247, 253 (1994).
3 http://accounting-simplified.com/financial/concepts-and-principles/matching.html.
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accounting principles” or GAAPcan be used by the accountant, depending on the individual
circumstances of the business. A “one size fits all” approach would be inappropriate if using
different rules for different businesses can actually boost the usefulness and reliability of the
resulting information for the consumer. But depreciation of some sort is common for all businesses
under GAAP.
Assume, for example, that Widget Company purchases in Year 5 a new factory building for
$10 million to replace its outdated one. In Year 7, Widget Company replaces an expensive widget-
making machine for $500,000. Widget Company has a steady stream of contracts and consistently
earns gross proceeds from sales of its widgets of $300,000 each year. If Widget Company, in
preparing its annual “income statement” for shareholders and lenders, shows “income” of
$300,000 in each of Years 3 and 4, a “loss” of $9.7 million in Year 5, “income” of $300,000 in
Year 6, and a $200,000 “loss” in Year 8, consumers of that information might assume that Widget
Company’s business is risky, suffering from roller coaster profits and losses, when in fact the
business has nice, steady sales. “Matching” the cost of the factory and equipment to the future
revenue expected to be earned by using the assets (which can vary from industry to industry or
even company to company under GAAP) provides a more accurate impression of the company’s
economic health over time to those who might rely on this information to make important
economic decisions, such as whether to invest in the company’s stock or whether to make a loan
to Widget Company.
In the income tax world, some might argue that depreciation is inconsistent with the realization
principle, as it allows a deduction for an asset’s cost before its disposition. Nevertheless, a
principled argument can be made that a realization-based income tax demands an allowance for
depreciation before disposition but only with respect to certain types of assets, described below in
Part A. But “matching” has nothing to do with this principled argument. Indeed, importing
financial accounting’s “matching principle” into the tax realm can do fundamental damage to
income tax values, inadvertently providing consumption tax treatment through the backdoor—an
irrelevant concern in financial accounting, where no payment obligation arises with respect to the
“income statement.” 4
A. Economic depreciation in a realization-based income tax
Recall from Chapter 2 that the capitalization principle defines the difference between an income
tax and a cash-flow consumption tax.
Under a cash-flow consumption tax, the cost of business or investment property would be fully
“expensed” (deducted) in the year of purchase, regardless of the expected useful life of the
property. Under an income tax, in contrast, the purchase of property with a useful life extending
substantially beyond the end of the taxable year is not a current “expense” (a current wealth
decrease) but rather a nondeductible capital expenditure because the taxpayer has not yet lost
wealth but rather has merely changed the form in which his wealth is held. The nondeduction of
the outlay, however, immediately creates basis, which can reduce the tax base in the future as that
wealth is lost if such loss occurs in an income-producing activity.
If our income tax abandoned the realization requirement in favor of a mark-to-market system,
4 See infra Chapter 21, Part B., for a more extended discussion of GAAP and the different goals and purposes of
financial accountin g and tax accounting.
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changes in property value would be taken into account as they occurred. The amount by which
property increased in value would be included in Gross Income year by year, with a concomitant
increase in basis to avoid taxing the same dollars twice to the same taxpayer in the future.
Similarly, the portion of basis reflecting a decrease in business or investment property value would
be deductible year by year, with a concomitant reduction in basis to avoid providing a double tax
benefit for the same dollars to the same taxpayer in the future. But we do have a realization
requirement, so you have learned that changes in value are ignored during the ownership period.
Nevertheless, a normative income tax with a realization requirement does allow deductions of
property basis in the form of “depreciation” (the term used for tangible property) or “amortization”
(the term used for intangible property) during the ownership period—before disposition of the
assetbut only if certain requirements are met. Why?
Economic depreciation or amortization is consistent with a realization-based income tax
to the extent that they are limited to deduction of final, irretrievable losses in value. Because
these losses in value are fi nal and irretrievable, they are “realized” in a nontrivial sen se, even
though the taxpayer continues to own the pro perty. Losses that are not final and irretrievable
should not be deducted in a realization-based income tax as a normative matter, which means
that some assets that are depreciable for financial accounting (information) purposes should
not be depreciable for income tax (wealth accessions and reductions) purposes.
Several ingredients combine to establish changes in the aggregate fair market value (FMV) of
an asset over time, such as changes in supply or demand for the asset or changes in interest rates
(if the asset is, for example, a debt instrument). Only one strand of value, however, can produce
final and irretrievable losses in an asset’s aggregate FMV, and that strand is the passage of time if
and only if that asset wastes away predictably over time from use in an income-producing activity.
Take, for example, a machine used in the manufacturing of widgets. As the widget-making
machine gets each year closer to the end of its income-producing life, one strand of its value is
permanently and irretrievably lost and cannot be restored with normal maintenance or with a shift
from one income-producing use to another income-producing use. In contrast, land used by a
farmer is not depreciable, even though it is used in an income-producing activity, because it does
not waste away in a predictable manner simply with the passage of time. If the land becomes
unsuitable for farming, it can be used for, say, real estate development. A building rented to tenants
or a factory building is depreciable, however, even if the building’s aggregate FMV is temporarily
rising, because buildings do—eventually—fall down, even with good maintenance. Just as time
passes with business use, and the building gets one year closer to the end of its useful life, that one
strand of value is permanently reduced, even if the building’s popular location means that its
overall FMV is temporarily rising, i.e., even if other strands contributing to the building’s overall
FMV are temporarily masking the permanent loss in this one strand of value.
As a normative matter, the analysis just described should inform the determination of both (1)
which assets are properly depreciable or amortizable and (2) the scheduling of those depreciation
and amortization deductions over time.
Let’s assume that (1) Tom purchases a widget-making machine for $10,000, (2) he expects to
earn a return from using this machine in his business sufficient to recover his original $10,000
investment plus a 4% profit, and (3) this machine has a useful life of 3 years in producing widgets
before it becomes worthless. Under such assumptions, Tom expects to earn about $3,609.49 in
gross receipts each year from use of the machine in his business.

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