Sec. 481(a) adjustment affects business interest deduction calculation.

• Author: Yang, Zhonglu

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).

Background

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 sevenyear property placed in service in the 2017 tax year.

Analysis

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...