INSIGHTS AND RESOURCES

IRS memo endorses using depreciation method change in ATI calculation

TAX ALERT  | 

Authored by RSM US LLP


On June 11, 2021, the IRS addressed the character of section 481(a) adjustments resulting from depreciation accounting method changes in IRS Legal Memo (ILM) 202123007. The IRS held that the section 481(a) adjustment retained its character as depreciation, and therefore affected the calculation of the section 163(j) interest deduction limitation.

Background

Section 481(a) provides an adjustment for changes in method of accounting, computed as of the beginning of the year of the change. The section 481(a) adjustment for a change in method of accounting for depreciation generally represents the difference between the depreciation the taxpayer took on a piece of property and the depreciation the taxpayer would have taken had the taxpayer used the new method when it originally placed the property in service.

Section 163(j) limits the amount of business interest expense that certain taxpayers can deduct in the current taxable year for taxable years beginning after Dec. 31, 2017. Under section 163(j)(1), the deduction for business interest expense is limited to the sum of: (1) the taxpayer's business interest income for the taxable year; (2) 30% (50% for some years), of the taxpayer's adjusted taxable income (ATI) for the taxable year; and (3) the taxpayer's floor plan financing interest expense for the taxable year (the section 163(j) limitation). ATI is computed under federal tax rules, which Congress intended to approximate EBITDA (earnings before income tax, depreciation and amortization) for years beginning prior to Jan. 1, 2022, and to approximate EBIT (earnings before income tax) thereafter. 

Under Reg. section 1.163(j)-1(b)(1)(i), for taxable years beginning before Jan. 1, 2022, when taxpayers calculate tentative taxable income to determine ATI, taxpayers add back any depreciation under sections 167 or 168, along with amortization and depletion (the Depreciation Add-Back). A similar subtraction from ATI is required under Reg. section 1.163(j)-1(b)(1)(ii) when taxpayers directly or indirectly sell or dispose of an asset that generated a Depreciation Add-Back under section 163(j).  

Prior to the ILM, many taxpayers questioned whether a section 481(a) adjustment attributable to depreciable assets affects the depreciation Add-Back, and whether the answer would remain the same if the assets in question were placed in service prior to section 163(j)’s effective date. In the ILM, the IRS answers “yes” to these questions. 

ILM 202123007

The taxpayer in the ILM filed a favorable depreciation accounting method change with an adjustment equal to a net negative ($100x) for the 2020 calendar year related to assets placed in service in 2017. The IRS concludes that the 100x amount is depreciation computed under section 168. Accordingly, the ILM concludes that the 100x amount is added to the taxpayer’s Depreciation Add-Back for 2020. 

The ILM further notes that in situations where a taxpayer has an unfavorable net section 481(a) adjustment attributable to depreciation, the adjustment creates a subtraction from the taxpayer’s Depreciation Add-Back when computing ATI. If the taxpayer takes the section 481(a) adjustment ratably over four years, then the add back follows the same ratable treatment. 

Takeaways

Method changes for depreciation can generate very large section 481(a) adjustments, which means they can significantly affect the section 163(j) interest deduction limitation. Taxpayers should consider section 481(a) adjustments for depreciation when calculating ATI, as the IRS will expect calculations to reflect these adjustments. The guidance also presents an opportunity for some taxpayers to review their depreciation methods and potentially improve their position with respect to the interest deduction limitation.

Let's Talk!

Call us at +1 213.873.1700, email us at solutions@vasquezcpa.com or fill out the form below and we'll contact you to discuss your specific situation.

  • Topic Name:
  • Should be Empty:

This article was written by Tracy Watkins, Stefan Gottschalk, John Charin and originally appeared on 2021-06-15.
2021 RSM US LLP. All rights reserved.
https://rsmus.com/what-we-do/services/tax/federal-tax/tax-accounting-services/irs-memo-endorses-using-depreciation-method-change-in-ati-calcul.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

​Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.

Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.

For more information on how ​Vasquez & Company LLP can assist you, please call +1 213.873.1700.

Subscribe to receive important updates from our Insights and Resources.

  • Should be Empty: