For the past quarter century, Federal income tax depreciation has been fairly simple. The 1981 Act and its successors (notably the 1986 Act and the 1993 Act) eliminated the need to consider residual (i.e., salvage) value. Taxpayers also were relieved of the need to estimate useful lives, both for regular depreciation and for alternate minimum tax calculations. Depending on whether the property is realty, personal or intangible, only one averaging convention (e.g., treating all property placed in service during a period as if it were done one at the midpoint of the period) applies. The selection of accelerated methods also was simplified: For the most part, taxpayers have the choice between straight line and only one accelerated method.

Modified Accelerated Cost Recovery System

Modified accelerated cost recovery system (MACRS) generally must be used for depreciating tangible property. As one might expect, there are exceptions. Some exceptions are required, for example, under Secs. 168(f)(2) and 168(f)(3), MACRS does not apply to films, video tapes and sound recordings. Similarly, MACRS cannot be used for property defined in Sec 197(e)(4)(B), (C) or (D) (i.e., patents, copyrights and governmental licenses purchased separately instead of as part of the acquisition of a substantial portion of a trade or business).

Other exceptions to MACRS are optional. For example, Sec. 168(f)(1)(B) allows the election of deprecation methods not expressed in a term of years (other than the retirement-replacement-betterment method or similar method), so long as the method is “proper.” A classic example here is the standard mileage rate for business use of cars. Other allowable systems are the units of production method, the machine-hours method, the operating-days method and the income forecast method.

Traditional Income Forecast Method

Under the traditional income forecast method, the depreciable cost of an asset is reduced by expected residual value. Each year, this is multiplied by a fraction. The numerator is the net income from the asset for the tax year. The denominator is the total net income expected over the life of the asset. The result is the cost recovery for the year. This approach was substantially the same as GAAP. (For the most recent authoritative pronouncement of GAAP on this method, see the AICPA’s Statement of Position 00-2, Accounting for Producers or Distributors of Films.)

Income Forecast Method

Prior to the 1997 Act, the income forecast method was upheld for a variety of property types. The IRS itself approved the use of income forecast to depreciate television shows, movies, video tapes, sound recordings, copyrights, manuscripts and video game machines. Further, case law allowed its use for other kinds of property, such as rented consumer durables. See, e.g., ABC Rentals of San Antonio, 98-1 USTC Para. 50,340 (10th Cir).

This was useful in a wide variety of circumstances. Fittingly, the income forecast method more clearly reflects income for assets that generate unusually high portions of expected revenues in their early years of service. The same applies to assets which generate revenues based on “fads,” “fashions” or rapidly changing consumer “tastes.” Using the method usually also reduced book-tax differences, as well as federal-state, both a major headache for wildly successful young firms (such as “dot.com” companies or other high-tech concerns). Less nobly, the method also could be dragged out as an excuse to help negotiate reduced penalties where depreciation well in excess of MACRS, was claimed on a return being audited. Furthermore, the method could be abused by systematically pessimistic estimates of expected total revenue, which had the effect of inappropriately excessive cost recovery in early years.

Sec. 167(g)

Indeed, income forecast was such a good excuse that it violated Leightman’s corollary to Wosley’s Law: Whatever is too good to be true, isn’t or isn’t for long. In 1997, Sec. 167(g) was added to limit the use of the income forecast method (and any “similar” method). Codifying the IRS’ previous position, the method now only applies to “Disney assets.” These are entertainment media such as films, video tapes, sound recordings, copyrights, Broadway shows, books, patents and other property specified in IRS Regs., except when they are Sec. 197 assets (i.e., most intangibles obtained as part of the acquisition of a substantial portion of a trade or business).

Sec. 167(g) also codified details of the formulae to be used in determining cost recovery under the income forecast method. As noted above, each year the depreciable cost of an asset — reduced by expected residual value — is multiplied by a fraction. The numerator is the income from the asset for the tax year. The denominator is the total income expected over the life of the assets.

For the numerator, “income” is the actual net income derived from the asset as determined for Federal income tax purposes. Thus, a cash basis taxpayer normally would not include accrued revenues in the numerator. Further, to avoid the bane of tax accounting — simultaneous equations — income is net income before calculating depreciation.

The denominator is based on an 11-year life. For the first 10 tax years, the denominator is the sum of the total net income expected from the asset before the end of the tenth tax year after the year the asset is placed in service. For the eleventh year, any remaining tax basis is deductible.

Note that the denominator results from an estimate. Not surprisingly, this estimate must be based on evidence and can only consider conditions known as of the end of the applicable tax year: Hindsight may be 20-20, but must be ignored. In addition, per Rev. Rul. 72-28, 1978-1 C.B. 61, the denominator cannot be less than any extant non-recourse debt secured by the asset. Furthermore, estimated total income includes secondary uses. For example, for movies this includes both foreign and domestic revenues, as well as those from potential theatrical releases, television, DVDs and presumably podcasts, downloads and cell phone videos, as well as the exploitation of characters, designs, musical scores etc. This has the effect of lengthening the recovery period and raising the administrative costs of using the method.

Being based on estimates, the fraction can change from year to year. Subsequent events can change — after the fact — the amount allowable in prior years. Under Sec. 167(g)(2), a “look back” calculation is required in the third through tenth years. Taxpayers are required to file Form 8866 to show the result, which is a computation of additional interest owed if deductions effectively are reduced in prior years, or interest to be refunded if deductions effectively are increased. Because the statute of limitations is tolled for these calculations, those who play the audit lottery have more to lose; those who trade up to more astute tax advisors have more to gain:

Some relief from the effect of ever-changing estimates may be coming from the IRS. On May 31, 2002, the Service issued Proposed Regs. Sec. 1.167(n) covering the 1996 Act changes. These should be finalized by the end of this summer. They provide a special safe harbor for revising the denominator. Revised forecasted total income must be used if the amount used in the prior year is less than 90 percent or more than 110 percent of the revised number for the tax year. Similarly, the Proposed Regs. allow taxpayers to exclude amounts projected from the possible sale or other disposition of the asset from total income.

Conclusion

Although the Proposed Regs. also mandate very detailed calculations for re-computations under the look-back rules, the rules themselves are not substantively changed. Instead, the Proposed Regs. merely provide job security for tax accountants in the entertainment industry.

Dr. John E. Karayan, JD/PhD, is a professor of accounting in the College of Business at California State Polytechnic University, Pomona. Professor Karayan is a tax attorney with a "Big 8" CPA firm background who retired from professional practice to teach full time. While teaching, he remains active outside of academia as an expert witness on accounting issues in complex business litigation, and as a consultant to entrepreneurs. He has published articles in journals ranging from The Tax Adviser to the Marquette Sports Law Review as well as spoken before professional groups such as World Trade Institute, California Continuing Education of the Bar and California Society of CPAs. He is also a partner in the law firm of Bond Karayan.