The IRS recently released a Chief Counsel legal memorandum (ILM 202123007) concluding that taxpayers who file any change in method of accounting for depreciation should consider the effect of the Section 481(a) adjustment on tentative taxable income (TTI) in the adjusted taxable income (ATI) computation to determine the business interest expense limitation under Section 163(j).
In the ILM, the taxpayer placed property in service in 2017 and depreciated the items as seven-year property under Section 168 using the general depreciation system. In 2020, the taxpayer determined that the items were five-year property and filed a Form 3115 to correct the recovery period. The change in method of accounting for depreciation resulted in net negative Section 481(a) adjustment for tax year 2020. The taxpayer timely elected not to deduct the additional first-year depreciation for property placed in service in the 2017 tax year.
To prevent omission or duplication of amounts affected by changes to methods of accounting for depreciation, taxpayers are required to compute a Section 481(a) adjustment. With respect to depreciation, a Section 481(a) adjustment reflects the difference between the amount of depreciation taken under the present method and the amount that that should have been taken under the proposed method as of the beginning of the year of change. The ILM addresses the impact of a Section 481(a) adjustment for depreciation on a taxpayer’s limitation of business interest pursuant to Section 163(j).
Generally, Section 163(j) limits the amount of business interest expense than can be deducted for taxable years beginning after Dec. 31, 2017. The amount allowed as a deduction for business interest expense is limited to the sum of:
- The taxpayer’s business interest income for the taxable year
- 30%, or 50% when applicable, of the taxpayer’s ATI for the taxable year
- The taxpayer’s floor plan financing interest expense for the taxable year
According to Section 163(j)(8), taxpayers compute ATI without regard to any depreciation, amortization, or depletion deductions for taxable years beginning before Jan. 1, 2022. As such, taxpayers add back any depreciation, amortization or depletion in computing ATI for those taxable years.
In the ILM, the IRS states that—in the current situation—the net negative Section 481(a) adjustment is the difference between the seven-year property and the five-year property treatment during the taxable years of 2017-2019. As such, the IRS concluded that the taxpayer’s ATI computation for 2020 should include an addback in the amount of the net negative Section 481(a) adjustment from the change in method of accounting.
The ILM reasons that because TTI is generally computed in the same manner as regular taxable income, and because depreciation is added back in the year incurred regardless of whether such amount has been capitalized, a Section 481(a) adjustment for depreciation should also result in an addback to ATI regardless of whether the Section 481(a) adjustment may, in part, relate to depreciation that took place prior to the application of Section 163(j).
The IRS applies a similar conclusion in the case of a net positive Section 481(a) adjustment for depreciation. A positive Section 481(a) adjustment spread ratably over multiple years results in a separate taxable income adjustment in each taxable year; however, different treatment may be applicable to ATI computations for tax years beginning after Jan. 1, 2022. For example, a taxpayer with a $200,000 net positive Section 481(a) adjustment taken ratably in $50,000 increments from 2020 to 2023, would only subtract $50,000 from TTI to arrive at ATI for 2020 and 2021, but not 2022 and 2023 (absent legislation to postpone the or repeal the scheduled change in Section 163(j)). Therefore, taxpayers who are subject to Section 163(j) and have a net positive Section 481(a) adjustment prior to 2022 will have additional tax implications to consider.
Taxpayers should also consider the impact of the Section 481(a) adjustment when a subsequent sale of the related asset occurs. Upon the sale of an asset, taxpayers are generally required under Treas. Reg. Sec. 1.163(j)-1(b)(ii)(C) to subtract the amount of the related depreciation taken in tax years beginning in 2018-2021 in arriving at ATI.
Some taxpayers may have inadvertently overlooked the opportunity to addback a negative Section 481(a) adjustment for depreciation when computing ATI. Those taxpayers may be afforded relief at the time of sale, as Treas. Reg. Sec. 1.163(j)-1(b)(1)(iv)(F) essentially limits the amount of depreciation subtracted at the time of sale to the benefit received from the initial depreciation addback. Thus, if no benefit was received, there should be no corresponding subtraction in the year of sale.
Taxpayers should consider the impact of any Section 481(a) adjustment for depreciation on their 163(j) calculation for the year in which the Section 481(a) adjustment occurs as well as the years in which a sale of those related assets take place.
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