MACRS Reclassification Not Change in Accounting Method

IRC section 446(e) requires that a taxpayer secure IRS consent to change its method of accounting. Treasury regulations section 1.446-1(e)(2)(i) specifies that a taxpayer do this before computing its income under the new method. The rule also requires a taxpayer to file form 3115 with the IRS commissioner during the taxable year in which it wants to make the change. However, regulations section 1.446-1(e)(2)(ii)(b) says an adjustment in the useful life of a depreciable asset is not a change in accounting method.

Brookshire Brothers Holding Inc. operated grocery stores in Texas. The holding company and its subsidiaries filed a consolidated tax return. Brookshire used the modified accelerated cost recovery system (MACRS) for purposes of recovering the cost of the tangible assets used in its businesses. In 1991 Brookshire began constructing gas stations at its grocery store locations. It identified the stations as nonresidential real property, reporting depreciation on a straight-line basis over 311/2 years and then 39 years after the recovery period changed.

In response to the Industry Specialization Program Coordinated Issue Paper for Petroleum and Retail Industries (ISP), which the IRS issued effective March 1, 1995, Brookshire filed amended returns for 1993, 1994 and 1995. On these returns Brookshire reclassified the gas stations as 15-year property and recalculated the depreciation deduction using the 150%-declining-balance MACRS method, as specified in the ISP. The company continued this treatment on its 1996 and 1997 tax returns.

The IRS audited the 1996 and 1997 returns and issued a deficiency notice, asserting Brookshire had to reduce its MACRS deductions for those years because it had changed its accounting method without obtaining prior consent. Brookshire filed a petition in the Tax Court. The IRS argued the useful life exception was not applicable under MACRS. After the Tax Court ruled in Brookshire’s favor, the IRS appealed the decision to the Fifth Circuit Court of Appeals.

Result. For the taxpayer. The Fifth Circuit agreed with the Tax Court and determined that the kind of change Brookshire had made was the functional equivalent of a change in useful life—nothing more or less. Thus, the useful life exception in regulations section 1.446-1(e)(2)(ii)(b) exempted Brookshire from having to get permission to change an accounting method. Even if this exception had not applied, the court determined the accounting change had occurred in a closed year—1993—and the statute of limitations had run by the time the IRS questioned it.

Taxpayers have used the useful life exception in regulations section 1.446-1(e)(2)(ii)(b) for many years to avoid having to ask for a change of accounting method. It is reassuring the Fifth Circuit agrees that a reclassification of property under MACRS is nothing more than a change in useful life, which does not require a change in accounting method.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.