MACRS Correcting Past Depreciation
When it is discovered that a taxpayer has not been taking the correct amount of depreciation in a prior year, the prior years must be corrected because of the “allowed or allowable” rule. There are two possible procedures for making the correction: filing an amended return or filing for a change of accounting method. The limitations, pros and cons for each are discussed.
Amended Return
A taxpayer that claimed incorrect depreciation on a return may use a 1040X to correct the error ONLY IF:
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The statute of limitations is open for the year of the error
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The taxpayer is NOT changing from one permissible method of accounting to another permissible method of accounting.,
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The taxpayer has NOT adopted a method of accounting for the property.
Note
A taxpayer has adopted a method of accounting if an incorrect depreciation amount was deducted on the taxpayer’s return in two or more consecutive tax years for reasons other than a mathematical or posting error.
• The taxpayer is correcting math or posting errors that are not a change in accounting method. However, the corrections can only be made for open years.
Note
Generally, math or posting errors are not possible when using computer-processed returns.
Disadvantages of Using an Amended Return:
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If the depreciation was overstated, any additional tax liability would be immediately due (if a Form 3115 was used to make the change the tax can be spread over 4 years).
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If there is a tax due, interest will be assessed.
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You must file a separate 1040X for each year (while a Form 3115 corrects all years at issue).,
Form 3115
Generally the Form 3115 is used when a 1040X can’t be used or the statute of limitations has expired on the tax year to be changed. Form 3115 rather than Form 1040X is used in the following situations to make depreciation corrections (Pub 946):
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A change from an impermissible method of determining depreciation for depreciable property, if the impermissible method was used in two or more consecutively filed tax returns.
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A change in the treatment of an asset from non depreciable to depreciable or vice versa.
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A change in the depreciation method, period of recovery, or convention of a depreciable asset. However, a 1040X can be used to change the placed-in-service date of a depreciable asset.
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A change from not claiming to claiming the special allowance (bonus) depreciation if the election to not claim any special allowance hadn’t been made.
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A change from claiming 50% bonus depreciation to claiming a 100% bonus allowance for qualified property acquired and placed in service after September 27, 2017 (if the election under section 168(k)(10) to claim 50% bonus depreciation wasn’t made).
Changes of accounting method are only allowed if approved in advance by the IRS or if the change is one that IRS will approve automatically. Most changes of depreciation qualify for an automatic approval by the IRS if the required approval procedures are followed, e.g., Form 3115 is properly completed and filed. See Chapter 3.01 for the revenue procedures that include a list of automatic accounting method changes. Also refer to the table in the Form 3115 instructions. There is no user fee charged for automatic accounting method changes, but user fees do apply for those changes not granted automatically by the IRS.
Benefits of Using the Form 3115:
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Multiple years are corrected on one return for the year of adjustment. (Rev. Proc. 97-27, Rev. Proc. 2002-19 and Rev. Proc. 2007-67)
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Eliminates the statute of limitations issues for past returns (changes can be made without regard to the statute of limitations).
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If there is a negative Sec 481(a) adjustment it reduces the business’ income in the year of the adjustment which could result in a tax refund in the adjustment year.
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If there is a positive adjustment it increases the business’ income and results in an increase in tax for the year of adjustment.
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If the adjustment is less than $50,000, the taxpayer can elect to pay the tax in the year of the adjustment (de minimis election) (Rev Proc 2015-13, Sec 7.03(3)(c)).
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Otherwise add ¼ of the adjustment to the current year’s return and ¼ in each of the next three years, thus spreading the additional tax over four years.
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Potential Problem
If the taxpayer did not make the election to apply the new cap and repair regulations retroactively for tax years beginning on or after January 1, 2012, then the accounting method change (Form 3115) cannot be used to correct new-regs-related depreciation occurring prior to 2014. However, apparently a correction to pre-2014 depreciation could be made if the correction is unrelated to the changes in the repair regulations. Pub 946 does not make any mention of restricting pre-2014 corrections unrelated to the new regulations.Note: Some seminars strongly advocated filing the Form 3115 to adopt the new cap and repair regulations retroactively. If you did so, then all corrections to prior years related to the new regulations should have been made at that time and a Form 3115 cannot now be used to make a new-repair-regs correction for years prior to 2014. If you did not, then you automatically adopted the regulations prospectively and the chance to adopt the new regulations for years before 2014 has passed (Rev. Proc. 2015-20). Bottom Line:1. If the taxpayer did not retroactively adopt the new regulations, the taxpayer can still use the 3115 to correct pre-2014 depreciation unrelated to the new regulations.2. If the taxpayer did retroactively adopt the regulations, then the taxpayer cannot use the 3115 to correct pre-2014 depreciation errors.
Special Issues:
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Taxpayer Out of Business – The Sec 481(a) adjustment must be taken in the final year of the business or if a rental, the year of sale.
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Taxpayer Under Audit – Generally a taxpayer will not qualify for an automatic accounting method change while the taxpayer is under audit.
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Previous 3115 filings – The automatic accounting method change cannot be used if Form 3115 was used in the prior five years for the same type of change.
Completing Form 3115
When making an automatic change the instructions for the 3115 provide us with the following information:
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For automatic changes only Parts I, II, and IV need to be completed (skip Part III).
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For a depreciation change, only Schedule E of the 3115 (not to be confused with the 1040 Schedule E) must be completed; skip the other Form 3115 schedules.
Thus, when making depreciation or amortization corrections only Parts I, II, and IV and Schedule E need to be completed.
Designated Change Number(DCN)
The instructions for the Form 3115 include a great number of DCNs since the form has multiple uses. DCNs are entered at Part I, line 1a. For correcting depreciation for small businesses, the DCNs to use are:
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DCN 7 – Is used when changing from an impermissible method to a permissible method; commonly encountered impermissible methods include:
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Depreciation not claimed o , Incorrect asset life used
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Inheritance FMV basis adjustments not made
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No land value adjustment made to basis when determining depreciable basis
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DCN 107 – Same as DCN 7 except used when the property has already been disposed.
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DCN 8 – Is used when changing from one permissible method to another permissible method. Not normally encountered for small business., Used when switching from individual item accounting to multiple asset accounting.
Part I – in addition to entering the DCN number (see above), lines 2 and 3 must be completed.
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Line 2 – Generally check NO., Check YES if under audit.
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Line 3 – Check YES; you will be attaching a statement specifying the changes.
Part II –
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Line 4 - asks if the business entity ceased doing business in the adjustment year. Check YES if ceased doing business (should have entered DCN 107 on line 1a). Otherwise check NO (should have entered DCN 7 on line 1a). If this question is checked YES, a statement must be added and “see statement” entered on the line.
STATEMENT
Rev. Proc. 2015-14, Sec. 6.01 provides that the eligibility rule of Rev. Proc. 2015-13, Sec. 5.01(1)(d) does not apply to depreciation adjustments under DCN 7 or DCN 107.
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Line 5 – deals with corporate acquisition, check NO.
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Line 6a – asks if an affected return is under audit., Generally, check NO, but if under audit see the instructions for line 6a and complete 6b and 6c.
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Line 7a – generally, the answer to this question is YES, but if in doubt see the 3115 instructions for line 7a and 7b.
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Line 7b – if 7a was answered yes, check the appropriate box., Generally, check the box “not under exam;” otherwise see the 3115 instructions for line 7b.
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Lines - 8a and 10, check NO.
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Line 11a – generally check NO., But if the answer is yes, follow the instructions on lines 11b and 11c.
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Lines 12 and 13 – check NO.
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Lines 14 and 15 – enter “see attached statement”.
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Line 16 – skip.
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Lines 17 and 18 – check YES.
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Line 19a – enter N/A for not applicable.
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Line 19b – skip.
Part IV –
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Line 25 - check NO unless property disposed of (DCN 107 on line 1a) in which case check YES.
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Line 26 – enter the amount of the adjustment, either + or –. Note: an increase in the amount of depreciation would be a minus and a decrease would be a plus.
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The adjustment is the difference between the total depreciation actually deducted for the property and the total amount allowable prior to the year of change. If no depreciation was deducted, the adjustment is the total depreciation allowable prior to the year of change. A negative section 481(a) adjustment results in a decrease in taxable income. It is taken into account in the year of change and is reported on your business tax returns as “other expenses.” A positive section 481(a) adjustment results in an increase in taxable income.
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Line 27 – this is where you make the election to take the entire positive adjustment in the year of the adjustment as opposed to spreading it over 4 years. If the adjustment on line 26 is negative (i.e., more depreciation is allowed than was previously deducted), it will reduce the business’ income and could result in a refund. In this case, check the NO box. If the adjustment on line 26 is positive, the business’ income is increased and the taxpayer has the option, where the adjustment is an increase of less than $50,000, to report the entire amount in the year of the adjustment. To make that election check the YES box and check the $50,000 de minimis election. Otherwise check NO and the income will be spread over 4 years.
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Line 28 – generally check NO.
Schedule E –
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Line 1 – check NO
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Line 2 – is asking if the depreciation adjustment needs to be capitalized. Generally, check NO.
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Line 3 – generally check NO for real estate property., The YES box would be checked for elections under Sec 179 or electing out of bonus depreciation (Sec 168(k)).
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Line 4b – check YES or NO based upon whether the property was previously used as a primary residence.
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Line 4c - check NO.
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Lines 5, 6, 7 – prepare and include the appropriate statement.