Depreciation method changes.

• Author: O'Connell, Frank J., Jr.

Recent taxpayer-favorable decisions from the Fifth and Eight Circuits have created a conflict on whether a change in a depreciable asset's recovery period is an accounting-method change under Sec. 446, requiring IRS consent. In Brookshire Brothers Holding, Inc., 320 F3d 507 (5th Cir. 2003), and Roger O'Shaughnessy, 8th Cir., 6/13/03, the courts held that such changes were not accounting-method changes; however, three years earlier, in Kurzet, 222 F3d 830 (10th Cir. 2000), the Tenth Circuit had reached the opposite conclusion.

Reasoning

The Fifth and Eight Circuits relied heavily on the fact that a change to a depreciable asset's recovery period is analogous to a change in the asset's useful life under pre-modified accelerated cost recovery system (MACRS) law. They pointed to Kegs. Sec. 1.446-1(e)(2)(ii)(b), under which an accounting-method change does not include an adjustment to a depreciable asset's useful life.

In Kurzet, on the other hand, the Tenth Circuit deferred to the IRS as to how it interprets its own regulation. The fact that the Service amended the Sec. 446 regulations several times after Congress enacted MACRS without ever specifically stating that MACRS recovery-period changes did not require permission, indicated that such consent was required.

Changing Recovery Periods

A decision against the IRS is typically taxpayer-friendly. However, a closer look at the issues in Brookshire, Kurzet and O'Shaughnessy casts some doubt on that assumption. In at least one instance, Brookshire could create serious roadblocks for a taxpayer wanting to make a change.

Example 1: In 1997, X Co. (a passthrough entity with 10 individual owners), constructed a facility. It capitalized the entire cost as 39-year property for Federal depreciation purposes. In 2003, after conducting a cost-segregation study, X realizes that it should have classified 25% of the cost as five- or 15-year property. To effect recovery-period changes for the assets in question, it files Form 3115, Application for Change in Accounting Method, under Rev. Proc. 2002-9, for automatic consent to change the recovery periods, and takes the cumulative additional depreciation expense as a current-year deduction, under Sec. 481(a) and Rev. Proc. 2002-19.

Under the Brookshire methodology, a taxpayer would not have to file Form 3115, because a change in asset recovery periods is not an accounting-method change. In the example, X's mechanism for recovering the accelerated depreciation it...