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In ILM 202123007, the IRS concluded that a taxpayer with a net negative IRC Section 481(a) adjustment resulting from a change to its accounting method for depreciating property must include the net negative 481(a) adjustment when calculating its adjusted taxable income (ATI) under IRC Section 163(j)(8).

Facts

A calendar-year taxpayer placed items of property in service in 2017. The taxpayer classified the property as seven-year property under IRC Section 168(e) and depreciated the property by using the general depreciation system of IRC Section 168(a).

During 2020, the taxpayer determined that the items of property should be classified as five-year property instead of seven-year property. The taxpayer filed Form 3115, "Application for Change in Accounting Method," to change its accounting method from an impermissible method to a permissible method of depreciating over a five-year recovery period for the tax year beginning January 1, 2020 and ending December 31, 2020 (the year of change). The accounting method change resulted in a net negative IRC Section 481(a) adjustment for the year of change. The taxpayer had made a timely election not to deduct additional first-year depreciation under IRC Section 168(k) for five-year and seven-year property placed in service in the 2017 tax year.

Analysis

IRC Section 163(j) limits the amount of business interest expense a taxpayer can deduct in the current tax year for tax years beginning after December 31, 2017. Specifically, "the amount allowed as a deduction for business interest expense is limited to the sum of: (1) the taxpayer's business interest income for the [tax] year; (2) 30%, or 50% where applicable, of the taxpayer's [ATI] for the [tax] year; and (3) the taxpayer's floor plan financing interest expense for the [tax] year ([IRC S]ection 163(j) limitation)."

IRC Section 163(j)(8) defines ATI as the taxpayer's taxable income calculated "without regard to certain items, including any deduction allowable for depreciation, amortization, or depletion for [tax] years beginning before January 1, 2022." Treas. Reg. Section 1.163(j)-1(b)(1) clarifies that ATI is the taxpayer's tentative taxable income for the tax year adjusted by certain items and includes a list of items the taxpayer must add or subtract from tentative taxable income to determine ATI.

To compute ATI in this situation so that it is "without regard to" depreciation, the IRS concluded the taxpayer must add the net negative IRC Section 481(a) adjustment to its tentative taxable income to determine ATI for tax year 2020. Therefore, the addback of the depreciation amount includes the net negative IRC Section 481(a) adjustment. If the accounting method change had resulted in a net positive IRC Section 481(a) adjustment, the IRS pointed out, the addback to tentative taxable income under IRC Section 163(j) would have been a negative amount equal to the net positive IRC Section 481(a) adjustment. If the taxpayer takes the net positive IRC Section 481(a) adjustment into account in calculating taxable income ratably over four tax years beginning with the year of change, the IRS clarified that the taxpayer should only add back the ratable portion of the net positive IRC Section 481(a) adjustment taken into account for the tax year. Additionally, the IRS noted that the addback of the depreciation amount, including the IRC Section 481(a) adjustment, for purposes of determining ATI is allowed only for tax years beginning before January 1, 2022.

Implications

This IRS memorandum is consistent with the general concept that an IRC Section 481(a) adjustment should retain the character of the underlying item that is subject to the accounting method change. Taxpayers should understand the impact, if any, that depreciation method changes have on their business interest deduction for the current tax year and future tax years. Under this IRS memorandum, a negative IRC Section 481(a) adjustment resulting from a depreciation method change should be added back as part of the IRC Section 163(j) ATI computation for tax years before 2022. The negative IRC Section 481(a) adjustment, however, will not be added back as part of the IRC Section 163(j) ATI computation in 2022 and future tax years because depreciation and amortization will no longer be added back as part of computing ATI in those tax years. This could have a favorable or unfavorable impact depending on the taxpayer's facts and overall tax posture.

Additionally, a taxpayer making a change to a less favorable depreciation method and generating a positive IRC Section 481(a) adjustment with a four-year spread will have a "negative" ATI addback (i.e., a decrease to ATI) in pre-2022 tax years for purposes of its IRC Section 163(j) ATI computation. With that said, to the extent the IRC Section 481(a) adjustment is spread into 2022 and future tax years (due to the four-year spread generally provided for positive IRC Section 481(a) adjustments), the adjustment will not factor into the IRC Section 163(j) computation for those tax years. As with a scenario in which a negative IRC Section 481(a) adjustment is generated, this could have a favorable or unfavorable impact depending on the taxpayer's facts and overall tax posture.

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