IRS ITG Audit Techniques Chapter 6.3
Chapter 6.3 – Depreciation Overview
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In order to compute depreciation using proper class lives and recovery periods, assets must be assigned to the proper asset classes. Cost segregation studies generally produce listings or groups of assets, based on asset classes under ACRS (Accelerated Cost Recovery System) or MACRS (Modified Accelerated Cost Recovery System). This chapter provides a summary of the applicable authorities and available guidelines for classifying property into its appropriate class.
HISTORICAL BACKGROUND – A BRIEF RECAP
- Pre-ACRS/ MACRS Depreciation Methods – Prior to 1981
Prior to the enactment of ACRS in 1981, depreciation deductions were generally calculated by applying the appropriate depreciation method to the basis, useful life, and salvage value of the asset. Taxpayers were permitted to use component depreciation, whereby assets were segregated into separate components with different useful lives, which were depreciated separately. Alternatively, taxpayers could elect to use the Asset Depreciation Range (ADR) system for computing depreciation deductions. Property was generally classified as either § 1245 or § 1250 property, based on the rules governing Investment Tax Credit (ITC), pursuant to Code § 48 and the regulations thereunder.
- ACRS /MACRS Depreciation Methods – Post-1980
Following the enactment of the ACRS depreciation system in 1981, component depreciation was specifically prohibited. The Service position has been that this prohibition continued under the MACRS depreciation system, enacted in 1986. Generally, ACRS is effective for property placed in use between 1981 and 1986, and MACRS is effective for property placed in use after 1986.
- Hospital Corporation of America, Inc. v. Commissioner, 109 T.C. 21 (1997) (“HCA”)
In HCA, the Tax Court concluded that the taxpayer was permitted to apply ITC principles to classify property as either § 1245 property or § 1250 property for purposes of determining asset classes and recovery periods under ACRS and MACRS. In effect, the HCA decision has reinstated a form of component depreciation.
- Action on Decision (AOD) Number CC-1999-008
In Action on Decision (AOD) Number CC-1999-008, the Service acquiesced to the application of ITC principles in the HCA case. However, the Service did not acquiescence to the particular results in this case (i.e., the Service did not agree with the classification of specific assets as qualifying § 1245 property).
- Use of Cost Segregation Studies to Compute Depreciation Deductions
Based on these developments, the use of cost segregation studies by taxpayers to accelerate depreciation deductions is expected to increase. The assignment of assets to the appropriate asset class is critical in determining the proper recovery period and, accordingly, the amount of depreciation.
GUIDELINES FOR THE CLASSIFICATION OF ASSETS – MACRS
- MACRS Rules – IRC § 168
Code § 168(e) specifies the classification of property for purposes of computing the cost recovery allowance provided by MACRS. Property is classified according to class life as determined in Revenue Procedure 87-56, 1987-2 C.B. 674, unless statutorily classified otherwise in § 168. There are no other exceptions. (Refer to the more detailed discussion of Rev. Proc. 87-56 on page 6.3-3, Item 4).
- Asset Guideline Class
Code § 168(i)(1) establishes the class life for assets, as defined in Code § 167(m) which, in turn, refers to Regulations § 1.167(a)-11 for rules regarding the classification of property under the class life system. Reg. § 1.167(a)-11(b)(4)(iii)(b) states that the selection of the appropriate asset guideline class is based on the business activity in which the asset is primarily used.
- General Depreciation System (GDS) and Alternative Depreciation System (ADS)
Under MACRS, taxpayers must generally use the General Depreciation System (GDS), unless specifically required by law to use the Alternative Depreciation System (ADS), or unless the taxpayer elects to use ADS. (Refer to IRC §§ 167 and 168, as well as IRS Publication 946, How to Depreciate Property, for additional details and explanations.)
A. GDS (General Depreciation System)
The GDS system contains nine property classes, based on the recovery period of an asset (3, 5, 7, 10, 15, 20, 25, 27.5, or 39 years). The taxpayer may generally utilize the 200% declining balance method, 150% declining balance method, or straight-line method for computing depreciation for most GDS property. However, 27.5-year property (residential rental property) and 39-year property (non-residential real property) must be depreciated using straight-line depreciation.
B. ADS (Alternative Depreciation System)
The ADS system must be used for the following property:
- Listed property used 50 % or less for business;
- Tangible property used predominantly outside the U.S. during the year;
- Tax-Exempt use property;
- Tax-Exempt bond financed property; and
- Property used predominantly in a farming business and placed in service in any tax year during which an election has been made not to apply the uniform capitalization rules to certain farming costs.
The use of ADS may also be elected for any property eligible for depreciation under GDS. The recovery periods under ADS are generally longer than the recovery periods under GDS, and straight-line methods must be used.
- Revenue Procedure 87-56, 1987-2 C.B. 674
Revenue Procedure 87-56 contains the “Table Of Class Lives And Recovery Periods,” which is reproduced as “Table B” in IRS Publication 946, “How to Depreciate Property.” This table provides guidance as to the classification of assets and for the determination of the proper recovery period.
- IRS 6 Publication 946, “How to Depreciate Property”
Publication 946 explains how to compute depreciation deductions. Appendix B in the publication reproduces the “Table Of Class Lives And Recovery Periods” from Rev. Proc. 87-56, which provides guidance for classifying an asset according to the business activity in which the asset is primarily used. The publication divides the table into two sections (Tables B-1 and B-2). Both tables must be consulted in determining the correct recovery period for specific assets. Table B-1, Specific Depreciable Assets Used In All Business Activities, Except As Noted, generally lists assets used in all business activities. Table B-2, Depreciable Assets Used In The Following Activities, lists assets used in certain activities, as described therein.
- How to Use Table B (Publication 946)
In general, if the property is described in Table B-1, the recovery period shown in that table is the recovery period for the asset. However, if the property is specifically listed in Table B-2 under the type of activity in which the asset is used, the recovery period listed under the activity in Table B-2 should be used. Further direction on the use of these tables is explained below.
(a) Table B-1, Specific Depreciable Assets Used In All Business Activities, Except As Noted
First, check Table B-1 to see if it contains a description of the asset in question. If the subject asset is described in Table B-1, then check Table B-2 to find the activity to which the property relates or in which it is being used. If the activity is described in Table B-2, read the text (if any) under the title to determine if the property is specifically included in the asset class listed in Table B-2. If it is, then use the recovery period shown in the appropriate column of Table B-2 following the description of that activity. If the activity to which the property relates is not described in Table B-2, then use the recovery period shown in the appropriate column following the description of the property in Table B-1. Also, if the activity is described in Table B-2, but the property either is not specifically included in or is specifically excluded from that asset class, then use the recovery period shown in the appropriate column following the description of the property in Table B-1.
(b) Table B-2, Depreciable Assets Used in the Following Activities
If the asset is not listed in Table B-1, then check Table B-2 to find the activity to which the property relates or in which the property is primarily being used, and use the recovery period shown in the appropriate column following the asset description.
(c) Property not in either table
If the property is not listed in Table B-1 and the activity to which it relates is not included in Table B-2, then check the end of Table B-2 to find “Certain Property for which Recovery periods Assigned (Personal Property/Section 1245 Real Property With No Class Life).” Property in this category generally has a recovery period of 7 years for GDS or 12 years for ADS. For residential rental property, and nonresidential real property, see Appendix A in Publication 946.
- Examples (from Publication 946, Appendix B)
The following examples appear in Appendix B of Publication 946, and illustrate the use of these tables for determining the proper asset recovery period.
(a) Example 1
Richard Green is a paper manufacturer. During the year, he made substantial improv 0fe6 ements to the land on which his paper plant is located. He checks Table B-1 and finds land improvements under Asset Class 00.3. He then checks Table B-2 and finds his activity, paper manufacturing, under Asset Class 26.1, Manufacturer of Pulp and Paper.
If Richard had looked only at Table B-1, he would have incorrectly selected Asset Class 00.3, Land Improvements, and incorrectly used a recovery period of 15 years for GDS or 20 years for ADS. However, Richard uses the recovery period under Asset Class 26.1, because it specifically includes land improvements. The land improvements have a 13-year class life and a 7-year recovery period for GDS. If he elects to use ADS, the recovery period is 13 years.
[Note: It is presumed in this example that the subject land improvements are directly associated with the factory site or production process, in the likeness of effluent ponds or canals necessitated by the production process, or parking lots utilized by employees directly involved with the production process. Those land improvements that are more closely associated with non-production activities, such as administrative or retail activities of the taxpayer, would fall into Asset Class 00.3 and have a 15-year recovery period under GDS. See Revenue Ruling 2003-81, 2003-2 C.B. 126, discussed in section 9 of this chapter.]
(b) Example 2
Sam Plower produces rubber products. During the year, he made substantial improvements to the land on which his rubber plants are located. He checks Table B-1 and finds land improvements under Asset Class 00.3. He then checks Table B-2 and finds his activity, producing rubber products, under Asset Class 30.1, Manufacture of Rubber Products. Reading the headlines and descriptions under Asset Class 30.1, Sam finds that it does not include land improvements. Therefore, Sam uses the recovery period under Asset Class 00.3. The land improvements have a 20-year class life and a 15-year recovery period for GDS. If he elects to use ADS, the recovery period is 20 years.
(c) Example 3
Pam Martin owns a retail-clothing store. During the year, she purchased a desk and a cash register for use in her business. She checks Table B-1 and finds office furniture under Asset Class 00.11. Cash registers are not specifically listed in any of the asset classes in Table B-1. She then checks Table B-2 and finds her activity, retail store, under Asset Class 57.0, Distributive Trades, and which includes assets used in wholesale and retail trade. This description for this asset class does not specifically list office furniture or a cash register.
She looks back at Table B-1 and uses Asset Class 00.11 for the desk, since it constitutes office furniture. The desk has a 10-year class life and a 7- year recovery period for GDS. If she elects to use ADS, the recovery period is 10 years. For the cash register, Pam uses Asset Class 57.0, because cash registers are not specifically listed in Table B-1 but are assets used in retail business. Accordingly, the cash register has a 9-year class life and a 5-year recovery period for GDS. If she elects to use the ADS method, the recovery period is 9 years.
- General Rules for Classifying Assets
In most cases, a single industry asset guideline class will cover all the production machinery and equipment that is typically used in that particular industry. Asset Guideline Classes 1.1 through 80.0 (Table B-2) list depreciable assets used in specific, primary business activities (the “activity” category).
Specific depreciable assets used in and common to all business activities (the “asset” category) cross all industry lines and are covered by Asset Guideline Classes 00.11 through 00.4 (Table B-1). For most taxpayers, three or four asset class guidelines will encompass all of their depreciable assets, such as autos, computers, and furniture & fixtures. The rule is that these classes (from Table B-1) must be applied first 04fd to determine the asset classification before applying and determining the primary business asset class (the “activity” category).
The exception to this rule is that certain activity categories, such as those described in Asset Classes 48.11 and 57.1, specify the assets that are section 1245 or section 1250 property. Other activity classes, such as Asset Class 28.0, include all land improvements, which takes priority over the asset category, such as Asset Class 00.3. [Note: As in Example 1 on page 6.3-5, only those land improvements associated with the plant site or production process, such as effluent ponds and canals, should be included in Asset Class 28.0. General land improvements, such as parking lots, should be included in Asset Class 00.3.]
- Application of Asset Classification Rules
Asset classification pursuant to the rules in Rev. Proc. 87-56 is not always a straight-forward determination, particularly where the taxpayer is involved in a number of related business activities. The proper steps to follow in assigning assets to the appropriate asset or activity or class may be summarized as follows:
1. Ascertain and fully understand the primary business activity of the taxpayer.
2. Determine the specific function and use of the assets in the taxpayer’s business.
3. Apply the clear and plain language contained in the asset guideline classes of Rev. Proc. 87-56 with respect to the assets in question.
The application of these steps may be illustrated by the analysis used in a sampling of court cases, private letter rulings, and revenue rulings, which are summarized below. The analysis in each citation is based on a strict reading of Rev. Proc. 87-56, including historical reference to original asset and activity class descriptions from which later classes have been derived. Note that, for those instances in which a taxpayer was permitted to use an asset class that was different from its primary business activity, the taxpayer was able to demonstrate that it did, in fact, have a separate trade or business for that property item.
Revenue Ruling 77-476, 1977-2 C.B. 5
Conclusion: The primary business activity of the taxpayer determines the appropriate activity class.
Analysis: An oil pipeline owned by an electric utility company and used to transport oil between the companyâ€™s dock and its inland generating facility is “public utility property” (Asset Guideline Class 49.13, Electric Utility Steam Production Plant). Since the taxpayer is not in the trade or business of transporting oil by pipeline, the pipeline should not be classified as “pipeline transportation property” (Asset Guideline Class 46.0, Pipeline Transportation).
Revenue Ruling 80-127, 1980-1 C.B. 53
Conclusion: Assets specifically excluded from a certain activity class must be classified in the appropriate asset class.
Analysis: The taxpayer leases shipping containers to a shipping company. The containers are designed to transport cargo over the road on trailers and by water on cargo ships and should be classified in Asset Guideline Class 00.27, which includes “trailer-mounted containers.” Activity Guideline Class 44.0, Water Transportation, which describes assets used in the commercial and contract carrying of freight by water, specifically excludes assets included in classes with a 00.2 prefix. (Note: the result would be the same if the shipping company owned the containers.)
Private Letter Ruling 9101003 (Sept. 25, 1990)
Conclusion: Property is classified according to the primary business activity of the taxpayer, even though the activity in which such property is primarily used is insubstantial in relation to all the taxpayer’s activities. In determining the primary business activity included in a current activity class, it is helpful and appropriate to analyze the historic business activities included in the classes from which it is derived.
Analysis: The taxpayer’s business activities include the acquisition, processing, and sale of various types of scrap materials. Asset Guideline Class 57.0, Distributive Trades and Services, includes assets used in wholesale and retail trade. The description for this class includes no further detail. However, the predecessor to Asset Guideline Class 57.0 included Asset Guideline Class 50.0, Wholesale and Retail Trade, which included assets used in the acquisition and processing of goods at both the wholesale and retail level. The description for Asset Guideline Class 50.0 also specifically referenced the brokerage of scrap metal and various pre-sale processing activities.
Private Letter Rulings 9502001, 9502002, and 9502003 (June 30, 1994)
Conclusion: Property is included in the asset class in which the property is primarily used, even if it is used in more than one activity or the activity is not specifically defined.
Analysis: The taxpayer uses a factory trawler to harvest and process various species of fish. There is no specific Asset Guideline Class for the fishing industry. Asset Guideline Class 20.4 covers the Manufacture of Other Food and Kindred Products, but does not specifically list water vessels. However, Asset Guideline Class 00.28 includes Vessels, Barges, Tugs, and Similar Water Transportation. Accordingly, the trawler is a specific asset described in Asset Guideline Class 00.28, which includes all water vessels without regard to the business activity.
Private Letter Ruling 9548003 (July 31, 1995)
Conclusion: Assets engaged in more than one activity must be classified to the activity in which they are primarily used.
Analysis: The taxpayer is a public utility company supplying electric and gas utility service. Through a number of subsidiaries, the taxpayer also owns and operates several natural gas gathering systems, processing plants, and pipeline systems. Most of the pipelines are not connected to the taxpayerâ€™s processing plants; thus, the taxpayer is engaged in two separate business activities. The gathering pipelines are appropriately included in Asset Class 46.0 (Pipeline Transportation), while the processing plants are included in Asset Class 49.23 (Natural Gas Production Plant).
Duke Energy Natural Gas Corporation v. Commissioner, 109 T.C. 416 (1997), rev’d, 172 F.3d 1255 (10th Cir. 1999), nonacq., 1999-2 C.B. xvi.
Conclusion: The class life of an asset is based on the asset’s primary use in relationship to the classes in question.
Analysis: The taxpayer was a natural gas corporation. At issue was the classification of its natural gas gathering systems as either assets used in the production of gas or assets used in the transportation of gas. It was determined that the plain language of the asset descriptions supported the contention that the gathering systems constituted assets used in the taxpayer’s production of natural gas.
Saginaw Bay Pipeline Co., et al v. United States, 124 F. Supp. 2d 465 (E.D. Mich. 2001), rev’d and rem’d, 2003 FED App. 0259P (6th Cir.) (No. 01-2599)
Conclusion: The proper asset class is determined by the use of the property rather than the activity of the owner of the property.
Analysis: The 6th Circuit held that, because the taxpayer’s underground natural gas pipelines were used primarily by natural gas producers and functioned as gathering pipelines in the natural gas production process, the taxpayer’s underground natural gas pipelines are includible in Asset Class 13.2. The 6th Circuit reached this result, even though the taxpayer was not a producer of natural gas (that is, not engaged in the activity described in Asset Class 13.2).Â
Clajon Gas Co. LP, et al v. Commissioner, 119 T.C. 197 (2002), rev’d, 2004 U.S. App. LEXIS 284 (8th Cir. Mo. Jan. 12, 2004)
Conclusion: Classification of property as to the proper asset class is based on the use of the property in a manner as described in an asset class.
Analysis: The taxpayer was not a natural gas producer and the taxpayer used the gathering lines to transport gas. At issue was the classification of taxpayer’s gathering lines as either assets includible in Asset Class 13.2 (Exploration for and Production of Petroleum and Natural Gas Deposits), which has a MACRS recovery period of 7 years, or Asset Class 46.0 (Pipeline Transportation), which has a MACRS recovery period of 15 years. The 8th Circuit determined that Clajon primarily used the gathering system in a manner consistent with the description of Asset Class 13.2 (i.e., as gathering pipelines). The descriptive language of the asset class does not require that the producer be the owner of the gathering system assets. The result is that there is no distinction between the gathering system assets of producers and nonproducers, for purposes of depreciation deductions.
Revenue Ruling 2003-81, 2003-2 C.B. 126
Conclusion: An asset included in both an asset category and an activity category is placed in the asset category, unless it is specifically excluded from the asset category or specifically included in the activity category. [Reference is to Norwest Corporation & Subsidiaries v. Commissioner, 111 T.C. 105 (1998).]
Analysis: The taxpayer was engaged in the business activity of producing and selling electricity generated from steam, which is described in activity class 49.13, Electric Utility Steam Production Plant.
A workbench used to repair machinery and equipment damaged during the production of electricity was classified in activity class 49.13, because it was used in the activity described in that class and not specifically included in another asset class.
A bookcase used to hold training manuals and operation protocols was classified in asset class 00.11 (even though it was used in connection with the taxpayer’s business activity of producing electricity) because it is not specifically excluded from asset class 00.11 or specifically included in asset class 49.13.
Parking Lot A, located outside the plant facility and used by employees at the plant, was classified in asset class 49.13, because that asset class specifically includes land improvements that are related to assets used in the production of electricity from steam. Although asset class 00.3, Land Improvements, also includes parking lots, it specifically excludes land improvements that are explicitly included in any other asset class.
Parking Lot B, located 100 miles away from the plant and adjacent to the corporate headquarters, was classified in asset class 00.3. This parking lot was used by employees at the headquarters office and was not related to the activity of producing the electricity. Therefore, it did not constitute a land improvement related to assets used in the production of electricity from steam and the proper classification was in the asset category, rather than the activity category.