October 31, 2017 Optimized Depreciation Expensing With 481(a) Reviews

Manufacturers typically under-depreciate their fixed assets and needlessly pay more in federal income tax than necessary.

THE ISSUE

Every year, Manufacturers incur costs that add to their F/A lists by dozens, if not hundreds, of line items. At the same time, depreciation incentives are introduced, morph, and sunset. The current federal depreciation guidelines create a system so complex that most taxpayers default to a conservative approach; causing manufacturers to pay higher taxes than necessary each year.

Common Causes of Missed Depreciation:

Face-Value Classification: Applying a MACRS Class Life to an asset based solely on the line item general description. This often results in 1245 Personal Property getting mixed in and classified as 1250 Real Property (ie. “Electrical Work”).

Repair/Replace/Retire: Temporary Repair Regulations were enacted prior to the Final Repair Regulations, which was followed a few months later by the “Final-Final” Repair Regulations in 2015. If an asset is repaired, the repair gets its own line item, then the underlying asset’s basis is reduced by the repair cost. If an asset is replaced, the original asset should be retired and the undepreciated balance of the asset expensed, but it is commonly left on the books to depreciate.

Bonus Depreciation Confusion: The complicated history of bonus depreciation includes sunrise/sunset dates that do not necessarily begin on January 1 and end on December 31. Further, Bonus Depreciation has been extended, retired, and resurrected 8 times in 16 years. Bonus Depreciation (BD) has changed from 100% to 50%, back to 100% and back down to 50%. BD is currently slated to be reduced to 40% and then to 30% before a 2020 sunset. The tenuous relationship of BD to Section 179 expensing further complicates the matter. Yikes!

Acquired Chaos: Growth by Acquisition. Acquiring the F/A schedule of an acquired company can create an opportunity to fix the depreciation traps.

What are the Qualifications to Qualify as Qualified?: Amazingly, this is an actual, and grammatically correct, question. Recently defined Property Types, including Qualified Improvements and Qualified Leasehold Improvements impact the treatment of Real Property and the ability to take BD, Section 179, etc.

THE SOLUTION

The process of reviewing tax fixed assets for missed depreciation was first outlined in Revenue Procedure 97-27, which allows for the correction, under MACRS, of previously mis-classified tax lives for any depreciable Fixed Asset, going back to 1987. Refinements were made in subsequent Rev. Procs (97-37; 99-49; 02-09; 02-19; 03-29; 03-50; 04-03; 04-11; 05-43) and has been extended to include depreciation strategies beyond the standard MACRS Class Lives to include: Qualified Improvements, Qualified Leaseholds, Bonus Depreciation, Repair Regulations and Asset Retirement.

An outside review of a Manufacturer’s F/A List can help taxpayers get the most out of their depreciation. The service has been around for 20 years and has gone by many names (Fixed Asset Review, Depreciation Review) but is currently called a “481(a) Review.” The premise is straight-forward: identify mis-categorized fixed assets under MACRS. Revise the asset’s taxable life. Apply as-of-in-service incentives. Recalculate the new accelerated depreciation. The result is a 481(a) Adjustment; a function of Form 3115: Request for Automatic Change. The adjustment, or catch-up, is taken in the year of filing and all past tax years remain closed.

Though the premise (identify, revise, recalculate) seems simple, in reality, the practice can be unwieldy.   Each Line Item/Asset has its own in-service date, a cost to purchase equipment, acquire or build a facility, cost of plant changes to accommodate equipment, repairs, installation, removal and replacement. Each asset demands individual treatment and a unique depreciation strategy. Every Line Item poses a series of questions (What is the cost for? Is this a summary number?, etc.) After answering the questions the reviewer develops a depreciation strategy: Bonus Eligibility. Qualified Improvement Property. Personal Property. Real Property.  In an F/A List that may number in the thousands, a review may identify hundreds of assets to be revised.

THE BENEFITS

Serpentine? Yes, but the benefits are extraordinary. Taxpayers may see a current year additional depreciation increase that can reach into the millions of dollars. More than twenty years of research and experience has shown that even diligent taxpayers typically under-depreciate tax fixed assets by as much as 20% to 35% each year.   The results of a 481(a) Review for a Manufacturer will most often provide catch-up depreciation in the millions of dollars for the current year of filing. Multiply the depreciation catch-up by your combined tax rate and you will see that the tax savings are also in the millions of dollars.

About the authors:
John Kevil and Orion Kevil helm Kevil & Kevil, LLC a consulting firm, based in Oak Brook, Illinois, specializing in Fixed Asset Depreciation and Cost Allocation.

John, a licensed Architect, has provided these services for Big Four Accounting firms.  Orion has been with K&K since 2001 and has an additional specialty in Historic Preservation Tax Credits. John attended University of Illinois-Chicago.  Orion attended Northwestern University.

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