1. Cost Recovery Deductions
Module 10
Cost Recovery Deductions * 1 1 1 1

2. Cost Recovery Topics Depreciation Amortization Depletion
Accelerated Cost Recovery System
Modified Accelerated Cost Recovery System
Amortization
Depletion
* “Depreciation” is a term usefully loosely in financial accounting to refer to cost recovery for all tangible assets. For tax purposes, it is less confusing to use the term to refer to cost recovery deductions for assets under § 167, i.e..., those assets placed in service prior to 1981.
* “ACRS” and “MACRS” refer to cost recovery for assets (1) placed in service after 1980 and before 1987 and (2) after 1986, respectively. 2 2 2 2

3. Economics of Cost Recovery
Expenditure benefits more than 1 tax year
§263 denies a current deduction
Cost recovery allows deduction over time
Tax policy issues
Marginal efficiency of capital affected by tax savings
Recovery periods
Recovery methods
* The advent of ACRS in 1981 represents a classic example of supply side economics that was designed to improve the marginal efficiency of capital. If the rate of return on business assets was increased (through more generous and faster depreciation methods), supply side economics would predict that businesses would produce more goods, hire more people, and place more money into the economy. These new workers would in turn demand more goods, and this increased demand would further increase the incentives to increase supply. 3 3 3 3

4. Cost Recovery Tax Savings
Assumptions
$10,000 asset
35% marginal tax rate
10% interest rate 4 4 4 4

5. Cost Recovery Tax Savings
Assumptions
$10,000 asset
35% marginal tax rate
10% interest rate 5 5 5 5

6. The Depreciation Allowance: Basic Requirements
Key Learning Objective
Basic requirement
Qualifying property
Placed in service
Depreciable basis 7 7 6 6

7. Qualifying Property Limited (Exhaustible) Useful Life
Qualifying Use of Property
Trade or Business
Income-Producing Activity
* Sometimes, a property may be used for both business and personal reasons. For example, a portion of a personal residence may be used as an office in the home. This portion of the cost of the residence would qualify for cost recovery deductions. However, when the taxpayer sells the property, the sales price must be allocated between the personal and business portions. This can have some negative consequences; for example, any gain on the sale of the business portion does not qualify for deferral under § 1034, which is discussed later in this text. 8 7 7 8

8. Placed in Service (PLIS)
PLIS when taxpayer can demonstrate
Readiness
Availability
Capacity to perform
Date PLIS can effect amount of cost recovery
Change in tax law
Affect modifying convention 9 8 8

9. Cost Recovery Basis Initial basis Subsequent changes in basis
Purchased property
Constructed property
Personal property converted to business use
Subsequent changes in basis
Capital improvements
Depreciation “allowed or allowable”
Return of capital
* If a taxpayer fails to take cost recovery deductions, the basis of the property is still reduced by hypothetical depreciation on the straight-line basis under the “allowed or allowable” principle. However, if a taxpayer begins using a particular method (e.g..., declining balance) and subsequently fails to take cost recovery deductions for a period of time, the basis is reduced by applying the cost recovery method originally elected by the taxpayer. 10 9 9 10

10. Compliance Query: Conversion from Personal to Business Use
Purchased home for $125,000
IF FMV = $112,000 at conversion
What is basis for depreciation?
IF FMV = $150,000 at conversion
* Remind students that a purely personal loss on personal property is never deductible, and if the taxpayer were allowed to use the original cost as the depreciable basis, then a personal loss would be deducted indirectly through depreciation deductions. 11 10 10 11

11. Solution to Compliance Query: Conversion from Personal Use
Get lower of basis or FMV
Basis if converted when FMV = $112,000
$112,000--lose decline in value during personal use
Basis if converted when FMV = $150,000
$125,000--no step up for unrealized appreciation
* Remind students that a purely personal loss on personal property is never deductible, and if the taxpayer were allowed to use the original cost as the depreciable basis, then a personal loss would be deducted indirectly through depreciation deductions. 11 10 10 11

12. MACRS--The Basic Rules
Key Learning Objectives
Class life
Depreciable basis
Recovery method
Modifying convention 12 12 11 11

13. Class Life = Recovery Period
Equipment
5 & 7 year classes
Most common
Tangible equipment
3 year class
Some animals & specialized equipment
10,15,20
Specialized uses
Real Estate
Residential year
Generally apartments & rental houses
Non-residential
39 year
In service after
31.5 year
In service before 14 13 12

14. Class Life Rev. Procs. 87-56 & 88-22
IRS provides information as to class life
Assets used in all businesses
Classes
Assets used in particular activities
Classes
Equipment with no class life given
Use 7 years
* Three points regarding class life:
1. Class lives are available only for Equipment, and can be traced
back to the old “guideline lives” of 1962, which represented
IRS estimates of useful lives.
2. One of the keys to classifying most Equipment is the 10-year
class life; assets with class lives of at least 10 years but less
than 16 years are in the 7-year category (under the original
ACRS rules, the 5-year ACRS class encompassed class
lives up to 16 years).
3. Most items of Equipment used by businesses fall in either
the 5- or 7-year MACRS classes. However, other classes can
be very important to selected taxpayers. For example, farmers
were distressed to learn that drainage tile was placed in the 20-
year MACRS class in 1986 (under ACRS, the tiles were 5-
year properties! 15 14 13 15

15. Research Query: MACRS Recovery Periods
This year Sea Drilling
Installed sidewalks around its office building
Purchased five floating drilling platforms for at-sea exploration.
See Rev. Proc in the OnPoint Service to determine recovery periods. 16 16 14 15

16. Solution--Research Query
Sidewalks -- MACRS life of 15 years
used in all business activities
listed in Class 00.3
Drilling platforms -- MACRS life of 5 years
used in specific activities
listed in Class 13.0
* It may prove beneficial in class to scan Rev. Proc and illustrate the two general classes of assets contained in this procedure. The Office of Depreciation Analysis is constantly conducting studies to determine (1) if more assets should be added to either the general asset classes or the industry classes, and (2) if the class lives for certain assets should be revised due to changing economic conditions. This group is under constant pressure from industry to revise downward class lives for assets used in particular businesses. 17 16 15 17

17. TaxPoint: Class 57.0-- 7 Gets You 5
Class 57.0 reads as follows:
Distributive Trades and Services: Includes assets used in wholesale and retail trade, and personal and professional services. Includes section 1245 assets used in marketing petroleum and petroleum products
If used in a “distributive trade or service,” an asset normally classified as 7-year property would get 5-year class life.
* Marketing is a big part of public accounting practice these days. One of the ways that a particular firm may convince potential clients to use their tax consulting services is to take an aggressive approach to tax planning. This is one way, by asserting that the company qualifies for 5-year recovery of assets normally thought of as belonging in the 7-year category. 18 17 16 18

18. Depreciable (Recovery) Basis
Salvage value always ignored
Equipment (equipment)
Reduction for §179 Election
Reduction for 50% of certain business credits
Realty
Exclusion of any land costs
Reduction for rehabilitation credits 19 19 17 18

19. MACRS Recovery Methods
200% declining balance
3,5,7,10 year classes of equipment
150% declining balance
15 and 20 year classes of equipment
Conversion to straight-line allowed
Straight-line
All realty
* Acquisitions of Equipment in the last 3 months of a taxpayer’s tax year should be carefully evaluated for (1) their effect on the acquisition year convention and (2) their effect on the possible phaseout of the $17,500 maximum § 179 immediate expensing election. 23 21 20 23

20. Modifying Convention Year of Acquisition
Equipment
General rule--half-year convention
Exception--mid-quarter convention IF
More than 40%
In service in last quarter
Realty
Mid-month convention
* A common mistake made by students is to include realty in the total assets used to test for the mid-quarter rule. Emphasize that only Equipment is included in this computation.
* Another common mistake is for students to use 20 19 18 20

21. The Four Quarters of Mid-Quarter
Applies to all assets according to quarter placed in service
* A common mistake made by students is to include realty in the total assets used to test for the mid-quarter rule. Emphasize that only Equipment is included in this computation.
* Another common mistake is for students to use 21 20 19 21

22. Compliance Query: Modifying Convention
A calendar year taxpayer places in service: 24 24 21 22

23. Solution to Compliance Query: Modifying Convention
First test for mid-quarter
The warehouse is ignored for the 40% test
4th quarter divided by all Equipment acquisitions
10,000 ÷ 260,000 = 3.8%
This is less than 40%
The half-year convention applies

24. Solution--Compliance Query Appropriate MACRS Deduction
Machine ($250,000 x .1429) $35,725
Computer ($10,000 x .20) ,000
Warehouse ($100,000 x )
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the TaxPoint disk. 25 25 22 23

25. Compliance Query: Modifying Convention
If we reverse the month of acquisition for the equipment that our calendar year taxpayer places in service, we get a different answer for the computer and equipment but not the building. 24 24 21 22

26. Solution to Compliance Query: Modifying Convention
First test for mid-quarter
The warehouse is ignored for the 40% test
4th quarter divided by all equipment acquisitions
250,000 ÷ 260,000 = 96.2%
This is more than 40%
The mid-quarter convention applies

27. The Four Quarters of Mid-Quarter
The computer was placed in service in March, so it is first quarter mid quarter 5-year property--35%.
The equipment is fourth quarter, mid quarter 7 year, so this table doesn’t apply. You will find 3.57% in the 7 year 4th quarter mid-quarter table on the disk.
* A common mistake made by students is to include realty in the total assets used to test for the mid-quarter rule. Emphasize that only Equipment is included in this computation.
* Another common mistake is for students to use 21 20 19 21

28. Solution--Compliance Query Appropriate MACRS Deduction
Machine ($250,000 x ) $8,925
Computer ($10,000 x .35) ,500
Warehouse ($100,000 x )
The mid-month convention applies to buildings.
Note that the tables other than five -year are on the TaxPoint disk. 25 25 22 23

29. Compliance Query: MACRS Deduction in Year 2, (no disposition)
Do not leave the column you started in!
Machine ($250,000 x ) $ 68,875
Computer ($10,000 x .26) $ 2,600
Warehouse ($100,000 x ) . . $ 2,564
Note that the tables other than five -year are on the TaxPoint disk. 25 25 22 23

30. Modifying Convention Year of Disposition
Applies to both equipment & realty
Use same convention as in year acquired
If mid-month, count the months, subtract 1/2 month, divide by 12
If mid-year, use 1/2
If mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4
* A common mistake made by students is to include realty in the total assets used to test for the mid-quarter rule. Emphasize that only Equipment is included in this computation.
* Another common mistake is for students to use 21 20 19 21

31. Compliance Query MACRS Deduction in Year 3, (sell in July)
Do not leave the column you started in!
Machine
($250,000 x x 2.5 ÷ 4) $30,750
Computer
($10,000 x x 2.5 ÷ 4) $975
Warehouse
($100,000 x x 6.5÷12) $1,389 25 25 22 23

32. Compliance Query: Once More, on Your Own
Mac Co. a calendar-year corporation
Placed in service in October
$250,000 of computers
only assets acquired that year
What is the recovery deduction for Year 1?
If Mac sells the computer in June, of Year 3 what is the year 3 recovery deduction? 28 28 25 26

33. Solution--Compliance Query: Once More, on Your Own.
Solution Year 1: 5 year/ mid-quarter property
$250,000 x .05 = $12,500
Solution Year 3: still 5 year/mid-quarter
$250,000 x x (1.5/4) = $21,375
Mid-quarter, count the quarters, subtract 1/2 quarter, divide by 4 29 26 27

34. MACRS - Special Elections
Key Learning Objectives
The requirements for the §179 election
The two straight-line recovery methods available under MACRS 30 30 27 28

35. §179 Immediate Expensing Election
Qualifying personal property
equipment used in an active trade or business
Year of acquisition only
$20,000 maximum annual election
$ for $ phaseout of $ 20,000 for acquisitions over $200,000
Can’t create a loss with §179 deduction 31 31 28 29

36. Tax Planning Query Make a §179 Election?
Minor Co. a calendar-year corporation
PLIS a $15,000 computer in April
(the only asset acquired that year).
Taxable income for the current year is $500 before considering MACRS recovery
Minor had profits of $120,000 in each of the preceding five years.
What factors should Minor consider in evaluating a §179 election? 32 32 29 30

37. Solution--Tax Planning Query. Make a §179 Election
Solution--Tax Planning Query Make a §179 Election? Key Factor--Expected profitability in future
Electing §179
Expense $15,000
Deduction limited to $500 (limited to taxable income)
$14,500 may be carried to the next year
Not Electing §179
MACRS deduction = $3,000 ($15,000 x .05)
creating an NOL
NOL may be carried back to the third prior tax year
Refund = $975
($2,500 x .39)
* If the company believes that this year’s low income was an aberration and should be at least $17,000 next year, then electing § 179 may make sense. The remaining $17,000 carryover would be deductible in the next year. However, if losses are a possibility, it may make more sense to forego § 179 and seek the benefits of an NOL carryback. 33 30 31 33

38. Tax Planning Query: Place In Service This Year or Next?
Meta Co. a calendar-year corporation
Put in service in February
$120,000 equipment (only acquisition to date)
Meta wants to acquire $83,000 of furniture
Should Meta placed the furniture in service
in December or January of the next tax year?
What factors should Meta consider in deciding when to buy the furniture? 34 34 31 32

39. Solution--Tax Planning Query Place In Service This Year or Next?
If placed in service in December
Total acquisitions = $203,000
Maximum §179 = 17,000. (20, )
Expensed property not used in test for mid-quarter
Could expense either equipment or furniture
If equipment, then mid-quarter
83,000 ÷ (203,000-17,000) = 44.6%
If furniture, then half year
(83,000-17,000) ÷ (203,000-17,000) = 35.5%
* Deferring the second acquisition to January may make sense in this case, since the § 179 deduction would be allowed in full each year. However, if other acquisitions are planned for the following year, the benefits of waiting are lessened. 35 33 32 35

40. Solution--Tax Planning Query Place In Service This Year or Next?
If placed in service in January of next year
Then for the current year
Maximum §179 is $ 20,000 (assumes 2000)
The half-year convention will apply
no acquisitions in fourth quarter
* Deferring the second acquisition to January may make sense in this case, since the § 179 deduction would be allowed in full each year. However, if other acquisitions are planned for the following year, the benefits of waiting are lessened. 36 34 33 36

41. MACRS Straight-Line Options
Acquisition year conventions apply
Must make election by class by year
Straight-line over the MACRS life
Straight-line over the class life
Alternative depreciation system (ADS)
Major exceptions to the class life rule:
Autos and computers (5 years)
equipment with no class life (12 years)
Realty (40 years)
* Straight-line options may make sense for startup businesses that expect little or no income in the early years. The delayed deductions of a portion of the cost may then be at higher tax brackets in future years (in the case of a corporation, the difference could be between a 15% rate now versus a 39% rate in the future). Of course, the time value of money should be considered in such decisions, in that MACRS will accelerate the recognition of tax savings if the company is profitable. 38 36 35 38

42. Compliance Query: Which MACRS Elections?
Melon Corp. a calendar-year corporation
PLIS a $29,000 machine in March (the only asset acquired this year)
The machine does not have a class live
Melon elects §179
What is the TOTAL cost recovery under
Regular MACRS recovery
Straight-line MACRS recovery
Alternative Depreciation System (ADS) 39 39 36 37

43. Solution--Compliance Query Which MACRS Elections?
§179 deduction = $20,000
Remaining basis = $ 9,000
No class live so MACRS = 7 and ADS = 12
MACRS = $1, ($9,000 x .1429)
MACRS SL = $ ($9,000 x 1/7 x .5)
ADS SL = $ ($9,000 x 1/12 x .5)
TOTAL deduction increased by $ 20,000 in each case 40 40 37 38

44. MACRS--Special Restrictions
Key Learning Objectives
The anti-churning rules
Restrictions applicable to listed properties
Including special limits on automobiles
MACRS computations for alternative minimum tax (AMT) purposes 41 41 38 39

45. Anti-churning Rules Prevent Perceived Abuse
Prevents using sales between related parties to change depreciation methods when tax law changes
If related party sale occurs, the transaction is ignored, old recovery method continues
* In general, MACRS provides less beneficial treatment for most assets than was available under ACRS. For that reason, the anti-churning rules do not apply if such procedures would result in a more generous cost recovery than MACRS. 42 40 39 42

46. Listed Property Rules: Personal Use Can Limit Recovery
Applies only to equipment
Subject to restriction if Qualified Business Use (QBU) < 50%
QBU generally limited to non-employee trade/business use
* It is doubtful if many (perhaps any?) taxpayer has willingly told the government that their computer, car, or other listed property was used less than 50% of the time in business. As a practical matter, these provisions may come into play during an IRS audit when the taxpayer is unable to document business usage. In such a case, the recapture rules would be invoked. 43 41 40 43

47. Listed Property Rules: Personal Use Can Limit Recovery
Straight line over CLASS LIFE used in any year QBU < 50%
Test must be applied each year
Recapture applies if MACRS used prior to failing the business usage test
* It is doubtful if many (perhaps any?) taxpayer has willingly told the government that their computer, car, or other listed property was used less than 50% of the time in business. As a practical matter, these provisions may come into play during an IRS audit when the taxpayer is unable to document business usage. In such a case, the recapture rules would be invoked. 43 41 40 43

48. Compliance Query: Change in QBU
Sue Adams , a calendar-year taxpayer
Placed in service in March
$10,000 computer
the only asset acquired this year
§179 NOT elected
For Year 1 QBU = 90%.
For Year 2 QBU = 40%.
What are Sue’s recovery deductions? 44 44 41 42

49. Solution--Compliance Query Change in QBU
Year 1
MACRS recovery = $1,800
($10,000 x .2 x .9)
($10000 ÷ 5 x 2 x .9)
Note ADS would have been $900
($10,000 ÷ 5 x .9)
Year 2
ADS straight-line recovery = $800 ($10,000 x 1/5 x .40).
$900 recaptured as additional income
This is the difference between MACRS Yr 1 (1800) & ADS Yr 1 (900)
* It is worth noting that the listed property rules do not work in reverse. For example, a taxpayer who reports property initially as listed property and subsequently meets the business usage test may not file amended returns and elect MACRS recovery. 45 42 43 45

50. Luxury Auto Rules--Everyone Bought a $15,300 Car in 1999
Limits for autos placed into service in 2000
First year $3, (15,300 x .20)
Second year $5, (15,300 x .32)
Third year $2,950
Remaining years $1,775
* The applicable limits for luxury autos are fixed in the year of acquisition, and are not affected by subsequent inflation increases in the limits for automobiles placed in service in later years.
* Although the lease value income inclusion tables are designed to reduce the tax value of leasing as compared to purchasing a business auto, the inclusion is relatively minor in most cases. Careful analysis of both options may reveal that leasing saves more tax dollars. 46 44 43 46

51. Luxury Auto Rules IBM follows them too!
Indexed annually for inflation
Limit is reduced by personal use
Limit applies to recovery and §179 election
Special rules for leased autos
* The applicable limits for luxury autos are fixed in the year of acquisition, and are not affected by subsequent inflation increases in the limits for automobiles placed in service in later years.
* Although the lease value income inclusion tables are designed to reduce the tax value of leasing as compared to purchasing a business auto, the inclusion is relatively minor in most cases. Careful analysis of both options may reveal that leasing saves more tax dollars. 46 45 44 47

52. Compliance Query: Recovering the Cost of Autos
Deck’s Realty, a calendar-year taxpayer
Placed in service in May, 1999
$40,000 auto (the only asset acquired that year)
QBU = 80%
What is the 1999 cost recovery deduction?
* If Deck instead leases the car, the income inclusion amount will be $202.40, or the $253 annual inclusion amount (per Rev. Proc. 95-9) times 80% business usage times 365/365 (assuming the auto was leased on January 1st and used for business the entire year).
* If Deck made $7,200 lease payments during 1995, 80% of the total, or $5,760 will be deductible as ordinary and necessary business expenses. Note that the deduction net of the income exclusion is still quite a bit larger than the limited MACRS recovery. (Of course, it is important to note that Deck is not acquiring the asset by leasing.) 47 46 45 48

53. Solution to Compliance Query: Recovering the Cost of Autos
Car is half year, five year property
MACRS and §179 are available
If this was not a car, without §179, the deduction would be
40,000 x .2 x .8 = 6,400
But auto rules limit deduction to
$2,448 (3,060 x .80)
* If Deck instead leases the car, the income inclusion amount will be $202.40, or the $253 annual inclusion amount (per Rev. Proc. 95-9) times 80% business usage times 365/365 (assuming the auto was leased on January 1st and used for business the entire year).
* If Deck made $7,200 lease payments during 1995, 80% of the total, or $5,760 will be deductible as ordinary and necessary business expenses. Note that the deduction net of the income exclusion is still quite a bit larger than the limited MACRS recovery. (Of course, it is important to note that Deck is not acquiring the asset by leasing.) 47 46 45 48

54. Alternative Minimum Tax Cost Recovery
Alternative Depreciation System (ADS)
Equipment--150% DB over class life
Realty--Straight-line over 40 years
ADS--150% & SL OK for regular tax
To slow down deduction
To reduce record keeping
Election on class by class,
year-by-year basis 50 51 48 49

55. TaxPoint: Possible Taxpayer Depreciation Records
Regular federal income tax
Alternative minimum tax
Earnings and profits determination
Adjusted current earnings determination
State income tax
Financial accounting records
Regulatory agency mandated methods
* To some extent, the problem of keeping multiple depreciation records is lessened by available cost recovery software packages. Most of these programs will compute cost recovery for all options. 51 50 49 52

56. Compliance Query Name That Method!
Technoid Corporation, 12/31 year end.
Put in service in May $20,000 of new equipment (the only asset acquired that year).
Technoid may choose one of 8 different methods of cost recovery for this equipment.
Can you name them? 52 53 50 51

57. Solution - Compliance Query Name That Method!
§179 election & normal MACRS
§179 election & straight-line MACRS
§179 election & ADS straight-line
§179 election & 150% ADS (AMT)
Normal MACRS recovery only
Straight-line MACRS recovery only
Straight-line ADS recovery only
150% ADS (AMT) recovery
* The use of 150% ADS may also meet “generally accepted accounting principles (GAAP)” for financial accounting purposes. Recall that ADS is generally based on the class life of the asset (and not the MACRS life), and this life is an approximation of the actual useful life of the asset (a requirement for GAAP). Accelerated depreciation is also consistent with GAAP. 53 52 51 54

58. Ace Co., a calendar-year taxpayer, Placed in service in 2000 the following assets. What is Ace’s maximum cost recovery deduction? 56 53 54

59. Solution to Concepts Review:
Step 1: Separate equipment and realty
Equipment--$202,000
Realty--$300,000
Step 2: Separate reality into
Residential (27.5 year recovery) ,000
Non-residential (39 year recovery) ,000
* This review problem emphasizes that the first two questions to be addressed are (1) is the Equipment subject to the mid-quarter convention and (2) is a § 179 election possible. 56 55 54 57

60. Solution to Concepts Review:
Step 3: Calculate §179 deduction
20,000-2,000 = 18,000
Before selecting consider impact on mid-quarter test (none in this problem)
Generally best to take from property with longest recovery period-- but no set rule
In next slide you will see that mid-quarter applies. Therefore largest deduction will come from expensing some of the 4th quarter, mid-quarter stuff.
* This review problem emphasizes that the first two questions to be addressed are (1) is the Equipment subject to the mid-quarter convention and (2) is a § 179 election possible. 56 55 54 57

61. Solution to Concepts Review:
Step 4: Determine modifying convention for equipment
Allocate equipment by quarter
2th Qtr -- $ 10,000
3th Qtr.-- $ 20,000
4th Qtr.--$172,000
MQ convention applies to equipment
172,000÷ 202,000 = 85.1%
* This review problem emphasizes that the first two questions to be addressed are (1) is the Equipment subject to the mid-quarter convention and (2) is a § 179 election possible. 56 55 54 57

62. Solution to Concepts Review:
Step 5: Stop to consider impact of listed property and luxury auto rules.
None in this problem.
Since cost of car is only $10,000, the first year will not exceed 3,060.

63. Solution to Concepts Review: Total Deduction $34,013
Warehouse
$100,000 x = 1,390
Rental Apartment
$200,000 x .0197) = 3,940
Auto
2nd qtr, MQ 5 year
$10,000 x .25 = 2,500
Equip
3rd qtr, MQ 7 year
($20,000 x .1071) = 2,142
Punch Machine
4th qtr, MQ 5 year
38,000 x .05) = 1,900
Drill Machine
4th qtr, MQ 7 year
30,000 x = 1,071
Cutting Machine
expense ,000
depreciate 86, ,070 57 58 55 56

64. Cost Recovery of Intangibles
Key Learning Objectives
General tax rules for amortization of intangibles
Special rules for §197 intangibles
Special provisions for research and experimentation expenses 58 59 56 57

65. Amortization--Cost Recovery for Intangible Assets
Need estimated useful or legal life
Straight-line recovery
Whole month convention used
Special 5-year recovery period
Organization & start-up costs
§197 purchased intangibles
Research & experimentation expenditures
* The estimated useful life is not necessarily the legal life of an intangible. Competitive pressures, technological changes, and other factors may point to a useful life of some intangibles, such as patents, as being substantially less than the legal life. 59 58 57 60

66. §197 Amortizing Goodwill Post 8/10/93 Acquisitions
Acquisitions of a business if purchase price includes intangibles
Goodwill
Going concern value
Other purchased intangibles (covenants not to compete, customer lists, workforce, etc...)
Amortize over 15 years
Amortization begins in month of acquisition
* Due to the large backlog of court cases involving goodwill and other intangibles, the IRS made a settlement offer in 1993 for all taxpayers. Taxpayers had a limited time to accept the offer, and anyone not accepting the offer had to take their chances in court. The settlement offer was quite complicated but was generous enough that a number of taxpayers accepted the offer (notwithstanding the precedent value of the Newark News Ledger court decision). 60 59 58 61

67. Compliance Query §197 Intangibles
As part of the acquisition of Bee Company, Ace Company paid $20,000 for Bee’s contractual agreement not to enter into a competing business for the next 10 years. What is Ace’s recovery period for the $20,000?
Solution--The agreement not to compete is a §197 intangible and must be amortized over 15 years. The contract is irrelevant. 61 62 59 60

68. Research and Experimentation Expenditures (R&E)
Definition--incident to product or process
Three tax options:
Expense immediately
Amortize over a period of not less than 5 years
Capitalize
Any tangible property must be capitalized and depreciated
Any R&E credit allowed reduces the deduction
* Most taxpayers choose to expense R&E immediately, due to the timing of the tax savings. This is also consistent with the financial accounting treatment of R&D under FASB 2 (although development costs are not eligible for tax purposes). 62 61 60 63

69. Compliance Query
Which of the following expenditures do not qualify as R&E?
Depreciation on research building
Wages of R&E employees
Consumer survey costs
Blueprints and drawings of product
Solution:
The consumer surveys are development costs and do not qualify. 63 64 61 62

70. Depletion Deductions Key Learning Concept
Requirements for the depletion deduction
Computations under the
Cost and
Percentage methods 64 65 62 63

71. Depletion--General Concepts
Cost recovery for natural resources
Allowed to anyone with an economic interest in the minerals or natural resource in place
Two methods of computing depletion:
Cost method
Percentage (statutory) method
Taxpayer may deduct the larger of the two methods 65 66 63 64

72. TaxPoint: Blood as a Mineral?
In the case of Margaret Green, 74 TC 1229, the taxpayer attempted to deplete the mineral content of her blood using statutory recovery.
She received commissions for donating her blood (a rare AB-type), and argued that she should be able to deplete her blood supply.
The Tax Court disagreed, stating that such minerals were not “natural deposits,” and eventual loss of ability to regenerate minerals was not relevant.
* It is interesting to note that the Court did allow the taxpayer to deduct the costs of special drugs, diet foods, and all travel expenses related to the blood donation. These were deemed “ordinary and necessary” expenses incurred in her “trade or business” of producing blood plasma. However, medical insurance premiums were held not to be deductible, as they were an inherently personal expenditure.
* For the year in question (1976), taxpayer donated 95 pints of blood and received $7,170 for the donations. 66 65 64 67

73. Cost Method of Depletion
Determine a depletion rate per unit
Undepleted cost/estimated remaining recoverable units
Multiply the rate times the number of units sold during the tax year
Total recovery may not exceed investment cost 67 68 65 66

74. Percentage Method of Depletion
Determine statutory (code) rate for particular resource
Multiply rate times the gross income from the property
Statutory depletion is further limited to:
50% of the taxable income from the property (100% of taxable income for oil properties)
65% of the taxpayer’s taxable income
Percentage depletion may exceed cost
* What if the taxpayer eligible for depletion is a corporation subject to the dividends received deduction? Which taxable income limit (depletion or dividends received) applies first?
* In Rev. Rul , the IRS insisted that the two limits should be computed at the same time with simultaneous equations!
* However, the Tax Court in Lastarmco, Inc., 79 TC 810, did not think much of this idea. The Court held that the deductions should be ranked, with the depletion limit being applied first. 68 67 66 69

75. Compliance Query
Sierra Co. paid $600,000 to lease land for mining uranium (22% rate).
Mine is estimated to contain 200,000 tons of ore.
This year, Sierra extracted 60,000 tons of ore and sold 40,000 tons for $20 per ton.
Sierra’s gross income for the year was $700,000 ($800,000 sales less a $100,000 royalty)
Expenses totaled $480,000.
What is Sierra’s depletion deduction ? 69 70 67 68

76. Solution--Compliance Query
Cost depletion:
$600,000/200,000 x 40,000 = $120,000
Percentage (statutory) depletion:
$700,000 x .22 = $154,000, limited to:
($700,000 - $480,000) x .50 = $110,000
Deduction is $120,000 (larger of the two)
* In many cases, the statutory (percentage) method yields the larger deduction. However, any percentage depletion taken beyond full cost recovery creates a tax preference item for purposes of the alternative minimum tax. 70 69 68 71

77. Research Query
M Company discovered that Sleasy had drilled a slant hole under their property and had stolen 50,000 barrels of oil.
M initiated a lawsuit to recover the value of the stolen oil.
Early Win, an attorney, agreed to represent M Company on a 1/3 contingency basis (receives 1/3 of the value if M wins, and nothing if M loses).
If Win wins the case, can he take a depletion deduction on his 1/3 of the proceeds? 71 72 69 70

78. Solution--Research Query
No, Win will not qualify for depletion. In a similar case, Parr v. Schofield (89 F Supp 98), the Court of Appeals for the 5th Circuit stated that such recoveries were not depletable gross income because the legal contract did not cause a transfer of an interest in the mineral property to the attorney.
(Federal Tax Coordinator, Para.N-2113)
* If the 1/3 interest had been transferred to the attorney prior to trial, then the amount may have qualified for depletion as a “economic interest” rather that merely an “economic advantage.” 72 71 70 73

79. Appendix--Pre-1981 Depreciation
Useful life
Salvage value
Maximum depreciation recovery methods:
Equipment
Realty
* As a practical matter, the only time these rules are encountered today is with depreciation on realty, which generally had useful lives of 30 to 50 years under pre-1981 law. 73 72 71 74

80. Appendix--Pre-1987 ACRS Equipment classes (3, 5, 10, and 15)
Realty classes (15, 18, and 19)
Acquisition year assumption
Maximum recovery rates:
Equipment
Realty
§179 expensing option
Straight-line options
* Once again, ACRS properties still subject to recovery are generally realty. In this respect, the effective dates of 15-, 18-, and 19-year properties are important. 74 73 72 75