Chapter I:10 Depreciation, Cost Recovery, Amortization, and Depletion Discussion Questions I:10-1 a. An automobile held for personal use is not eligible for depreciation or amortization.
b. Goodwill is a Sec. 197 intangible asset amortizable ratably over a 15-year period beginning with the month of acquisition.
c. Since the cost of the customer list represents a Sec. 197 intangible, its cost is amortizable on a ratable basis over a 15-year period beginning with the month of acquisition.
d. A patent is amortizable over its legal life of seventeen years since the cost of the patent has a definite and limited life. The patent does not qualify for 15-year amortization under Sec. 197 because it was not acquired in connection with a transaction that involves the acquisition of a trade or business or a substantial portion of a trade or business.
e. Land is not eligible for depreciation or amortization. f. A covenant not to compete is a Sec. 197 intangible amortizable ratably over a 15-year
period despite the fact that the period under the agreement may be different (e.g., five years). In such case no loss is recognized and the basis of retained Sec. 197 intangibles is increased by the unrecognized loss. pp. I:10-2 through I:10-4, I:10-17, and I:10-18. I:10-2 Depreciation deductions are not discretionary. The basis of property must be reduced by the amount of depreciation that should have been taken (allowable depreciation) even if no depreciation was claimed. The basis of the property must be reduced on a consistent basis by depreciation computed using one of several accounting methods provided under the tax law. If no method had previously been used, allowable is defined as the slowest possible method allowed by law (e.g., straight-line using the longest permissible recovery period). So, Rick could wind up recognizing a gain to the extent the asset is sold for more than its adjusted basis. p. I:10-3. I:10-3 The basis of property converted from personal-use to business or investment use is the lesser of the adjusted basis or the FMV of the property (at the date of conversion). The decline in value of $20,000 ($120,000 - $100,000) represents a nondeductible personal loss and is not depreciable. Therefore, the depreciable basis is $100,000 of which a portion must be allocated to land. This lower of cost or market rule is intended to prevent taxpayers from depreciating unrealized nondeductible personal losses. pp. I:10-3 and I:10-4.
I:10-4 a. Furniture Yes No 7 years Plumbing fixtures Yes No 7 years Land No No N/A Trademark No Yes 15 years Goodwill No Yes 15 years Automobile Yes No 5 years Heavy Truck Yes No 5 years Machinery Yes No 7 years Building used in manufacturing Yes No 39 years pp. I:10-5 and I:10-17 through I:10-19. I:10-5 a. Depreciation in 2011(Year 1) would be $7,145 ($50,000 x 0.1429). Depreciation in 2012 (Year 2) would be $12,245 ($50,000 x 0.2449). The percentages come from Table 1 (HY convention) in Appendix C.
b. Depreciation in 2011 (Year 1) would be as follows: Bonus depreciation ($50,000 x 100%) $50,000 No depreciation in 2012 as the machine is fully depreciated.
c. If Robert had elected Sec. 179 in 2011, he would have deducted the entire $50,000 as
taxpayers were permitted to expense up to $500,000 in 2011. Because he deducted the entire $50,000 in 2011, no depreciation is allowable in 2012.
pp. I:10-5 through I:10-7. I:10-6 a. Neither machine was placed in service in the fourth quarter, so the half-year convention (Table 1) applies. Depreciation on Machine C would be $81,453 ($570,000 x 0.1429), and depreciation on Machine D would be $10,000 ($50,000 x 0.20).
b. If Roberta elects Sec. 179, she can expense up to $500,000 in 2011. She can choose the assets on which she takes the Sec. 179 deduction. To maximize the depreciation deduction, assets with longer recovery lives generally should be selected first. So, Roberta can elect to expense $500,000 of Machine C. Thus, total depreciation for 2011 would be $520,003 [$500,000 + ($70,000 x 0.1429) + ($50,000 x 0.20)]. pp. I:10-5 through I:10-7.
Subject to Subject to Sec. 197 MACRS Depreciation Amortization b. Recovery Period
I:10-7 Yes, Depreciation for real estate is computed using tables that follow the mid-month convention, so depreciation is allowed in the year of disposal. The amount of depreciation is computed by taking one-half month for the month the asset is sold plus the number of full months held prior to sale, divided by 12 months. Thus, one-half of a month’s depreciation is allowed in the year of disposal regardless of the day of the month the disposal occurred. For example, if property is disposed of on October 30, the table percentage must be multiplied by the fraction 9.5/12 (nine full months plus one-half month for October). p. I:10-10. I:10-8 a. No. The salesman is incorrect. The maximum amount of depreciation, (Sec. 179 and regular MACRS) is limited to $3,060 in 2010 due to the Section 280F luxury auto limits. If Sec. 179 is not elected, the total depreciation deduction of $9,000 still would be greater than the maximum luxury car amount. Thus, the maximum depreciation deduction in the initial year is substantially less than claimed by the salesperson. As one may observe, Sec. 179 is not recommended for luxury automobiles. If Jose did not elect out of bonus depreciation, the limit would be $11,060.
b. The maximum depreciation deduction under Sec. 280F in the first year would be $1,836 ($3,060 limit x 0.60 business).
c. Jose could deduct the lease payments. However, he must reduce the deduction by a lease inclusion amount from tables published by the IRS. See Tables 13 and 14 of Appendix C. Jose is not eligible for the Sec. 179 deduction.
d. The salesman’s claims are a bit more correct in this case, but still overstated. Because the SUV has a GVWR of greater than 6,000 pounds, the ceiling limitations do not apply. However, the Sec. 179 deduction is limited to $25,000. So, in this case, Jose may claim a Sec. 179 deduction of $25,000 and a regular MACRS deduction of $4,000 [($45,000 - $25,000) x 0.20], for a total of $29,000 in 2010. While the 2004 Jobs Act reduced the Sec. 179 deduction to a maximum of $25,000, SUVs still may claim depreciation deductions far in excess of passenger automobiles that are subject to the ceiling limitation. pp. I:10-13 through I:10-16. I:10-9 a. Straight-line depreciation would be preferable to regular MACRS in this case to reduce depreciation deductions in current years. This would have the effect of increasing taxable income, which could be offset against the NOLs. The alternative depreciation system (ADS) employs the straight-line method of depreciation (versus 200% DB under MACRS) and a longer recovery period.
b. Straight-line (ADS) depreciation would be preferable to MACRS in this case because it will give Rhonda lower deductions and higher taxable income in the years when her marginal tax rate is low. MACRS would accelerate deductions into the low-rate years and reduce deductions in the high rate years, causing higher taxable income. pp. I:10-11. I:10-10 Section 179, allows for an ordinary deduction in the year placed in service of up to $500,000 (in 2010 - 2011) of the cost of tangible personal business property. Its primary advantage is the time value of the tax benefits that result from a larger depreciation deduction in the first year and the corresponding deferral of tax. pp. I:10-6 and I:10-7.
I:10-11 Qualified leasehold improvement property (QLIP) placed in service after December 31, 2005 and before January 1, 2012 could be depreciated over 15 years using the straight-line method. Prior to this provision, which was initiated by the Jobs Act of 2004 and extended by Tax Relief and Health Care Act of 2006, the Tax Extenders Act of 2008 and the Tax Relief Act of 2010, taxpayers depreciated QLIP over the nonresidential real property recovery period of 39 years. However, in 2012 the recovery period reverts to 39 years unless Congress extends the 15-year recovery period. pp. I:10-10 and I:10-11. I:10-12 a. The taxpayer may use MACRS for the business-use portion of the cost of both assets. Thus, he generally is entitled to claim depreciation on $25,600 of the auto’s cost ($32,000 x 0.80) and $4,000 of the computer’s cost. Both have a recovery period of five years. However, the maximum depreciation that may be deducted in 2010 on the auto is limited to $2,448 ($3,060 x 0.80) under the so-called “luxury car rules.”
b. If the taxpayer is an employee and the auto and computer are not required as a condition of employment, no depreciation is allowed.
c. If the business use percentage decreases to 50% or less in a subsequent year, the property is subject to depreciation recapture and the depreciation for all subsequent years is recomputed using the ADS. When the business use first falls to 50% or below, depreciation must be recaptured to the extent that MACRS depreciation exceeds the recomputed depreciation using the ADS. pp. I:10-12 through I:10-14. I:10-13 a. Qualified property for bonus depreciation includes (1) MACRS property with a recovery period of 20 years or less, (2) computer software (other than computer software that must be amortized under Sec. 197), or (3) qualified leasehold improvement property. The qualified property must have been placed in service by the taxpayer after September 8, 2010 and before January 1, 2012. The original use of the property must have begun with the taxpayer.
b. Sec. 179 depreciation is generally taken before any bonus depreciation. pp. I:10-7 and I:10-8.
I:10-14 No. Sarah may deduct the automobile lease payments made during the year. However, she must reduce the deduction by a “lease inclusion amount” (found in Table 13 of Appendix C). This reduction prevents Sarah from avoiding the luxury auto depreciation limits that apply to purchased vehicles. Sarah’s lease payment deduction is computed as follows: Lease payments ($600/month x 10 months) $6,000 Minus: Lease inclusion amount from Table 13 ($85 x 306/365) (71) Deductible lease payments in 2010 $5,929 p. I:10-16.
I:10-15 Intangible assets acquired in connection with the purchase of a trade or business are Sec. 197 intangibles, amortizable ratably over a 15-year period. Gain on disposition will be given Sec. 1231 treatment, but a loss on disposition is not deductible if other intangibles acquired in the same asset purchase are retained. Internally created intangibles and intangibles acquired by the purchase of an individual asset are subject to amortization only if they have both a definite and limited life (e.g., an internally created patent with a 17-year legal life). pp. I:10-17 and I:10-18. I:10-16 a. The internally created patent should be amortized over the legal life of 17 years, $2,000 ($34,000 ÷ 17 years) in the current year. Goodwill and going concern value, the covenant not to compete, licenses, and customer lists are Sec. 197 intangibles and are amortizable on a straight-line basis over 15 years, $20,000 in the current year ($300,000 ÷ 15 years).
b. The purchaser should attempt to allocate as much of the total purchase price as possible to inventory, because gross profit is reduced when inventory is sold. Next, allocate as much of the remaining purchase price as possible to the assets with the shortest recovery periods (e.g., the equipment and the Sec. 197 intangibles). The smallest amount possible should be allocated to the land because land is not depreciable. pp. I:10-17 through I:10-19 and I:10-24. I:10-17 Research and experimental expenditures are usually expensed in the current year because the taxpayer wants the immediate tax benefit. The deferral and amortization method would be advantageous if the taxpayer is in a low tax bracket or expects a net operating loss. pp. I:10-19 and I:10-20. I:10-18 Buyers generally prefer a liberal allocation of the purchase price to ordinary assets such as inventory because gross profit is reduced when the inventory is sold. Allocations to short-lived depreciable assets and Sec. 197 intangibles are preferred over allocations to land and other nondepreciable assets due to the tax benefits obtained from the depreciation and amortization. p. I:10-24. I:10-19 Cost depletion is the systematic allocation of the cost of a natural resource property over the property’s expected recoverable life. Cost depletion is similar to the units-of-production method of depreciation and is calculated by dividing the asset’s adjusted basis by the estimated recoverable units to arrive at a per-unit depletion amount. This per-unit amount is then multiplied by the number of units sold to determine the cost depletion deduction. Percentage depletion, on the other hand is computed by multiplying the percentage depletion rate times the gross income from the property. While there are limitations on percentage depletion based upon a taxpayer’s taxable income, percentage depletion may be taken in excess of the taxpayer’s basis in the property. Percentage depletion will generally provide larger deductions than cost depletion, especially when measured over the life of the property. pp. I:10-22 and I:10-23.
I:10-20 a. Assuming Simon wants to maximize his deductions in the initial year, he would elect expensing, because the total deduction is $25,000 ($15,000 percentage depletion + $10,000 IDC) if the IDC is expensed, but only $20,000 if the IDC is capitalized.
b. Intangible drilling costs (IDCs) are generally expensed because of the greater current tax benefit over capitalizing and deducting the costs in future periods. If percentage depletion is expected to be greater than cost depletion, it is more beneficial to deduct the IDCs. The capitalization and amortization of IDC merely increases the cost depletion amount and produces limited or no tax benefit. Expensing IDCs reduces gross income, thereby lowering taxable income. pp. I:10-23 and I:10-24. Issue Identification Questions I:10-21 The principal tax issue is whether depreciation may be started in the year of acquisition or in the year the automobile is placed into service. Other issues are the use of MACRS methods and whether the luxury auto limits apply. pp. I:10-3, I:10-13, and I:10-14. I:10-22 The following tax issues need to be addressed:
• The regular MACRS depreciation amounts each year • The luxury auto limitations on depreciation each year • The inclusion amount under tables published by the IRS for the initial year and subsequent
years if the automobile is leased. • The effect of depreciation recapture and the required use of the ADS when the use of the
auto falls to 50% or less. • Paula's increased marginal tax rate and the impact of her changed tax situation on the
decision. pp. I:10-13 through I:10-17. I:10-23 The principal tax issue is whether Sec. 197 amortization applies to the intangible assets and to what extent the purchase agreement will establish tax basis for the acquired properties. Generally, under Sec. 1060, an agreement between the purchasing and selling parties is binding unless the IRS determines the allocations are not appropriate. p. I:10-24. I:10-24 The principal issue is the applicability of the mid-quarter convention. The issue is complicated by the interaction of the Sec. 179 deduction and the 40% test. For purposes of the 40% mid-quarter convention test, the Sec. 179 deduction is subtracted from the cost of tangible personal property placed in service. If the CPA elects $200,000 on the March 1 purchase and $300,000 on the September 18 purchase, the mid-quarter convention will apply because more than 40% of tangible personal property was placed in service in the last quarter of the year [($140,000 -
$0) ÷ ($700,000 - $500,000) = 0.700]. pp. I:10-8 and I:10-9.
Problems I:10-25 a. Even though Sandy did not claim any depreciation in 2009 through 2011, she is required to reduce her basis for the amount of allowable depreciation. The adjusted basis of the machine is computed as follows:
2008: ($10,000 x 0.1429) $ 1,429 2009: ($10,000 x 0.2449) 2,449 2010: ($10,000 x 0.1749) 1,749 2011: ($10,000 x 0.1249 x 0.50) 625 Total allowable depreciation $ 6,252
Sandy may file amended returns for 2009 and 2010 to claim depreciation for those years. Her 2011 return should be corrected before she files it to claim depreciation for 2011. Note: If any of Sandy’s prior years are closed by the statute of limitations, she could get relief by requesting a change of accounting method under Rev. Proc. 2007-16. With this change, all prior allowable depreciation deductions missed (even for closed years) can be taken in the year of change as a Sec. 481 adjustment (see Chapter I:11 for changes in accounting methods).
b. Sandy recognizes a $2,252 gain upon the sale of the asset, computed as follows:
p. I:10-3, I:10-5, and I:10-6. I:10-26 a. The automobile's basis for depreciation is $6,000. When personal use property is converted to business-use, the property's basis for depreciation is the lesser of its adjusted basis or FMV on the date of conversion.
b. Depreciation for 2011 is $1,200 ($6,000 x 0.20) (Table 1, Appendix C.) Section 179 expensing is not available because the property was converted rather than purchased. pp. I:10-3, I:10-4, and I:10-7.
I:10-27 Small Corporation can depreciate only the truck, the machinery, and the building in 2011. The equipment was not placed into service until 2012, so no depreciation is allowable in 2011. Total depreciation in 2011 was $40,680, computed as follows:
a$100,000 x 0.00107 (Table 9, Year 1, 12th month) In 2012, Small depreciates the building and the equipment. The 40% test on the equipment
shows that it uses half-year MACRS depreciation because no tangible personal property placed in service in 2012 was placed in service in the last three months. Total depreciation in 2012 is $35,887, computed as follows:
2012
Equipment [$40,000 x 0.20) (Table 1, Year 1)] 8,000Building [$100,000 x 0.02564 (Table 9, Year 2, 12th month)] 2,564Total 2012 depreciation $10,564
pp. I:10-4 through I:10-10 I:10-28 a. Large Corporation can depreciate only the truck, machinery, and building in 2011. The 40% test was used to determine which convention (half-year or mid-quarter) applied for MACRS depreciation of the truck and the machinery. The 40% test showed that both assets use mid-quarter depreciation, because more than 40% of all tangible personal property placed in service in 2011 was placed in service in the last three months ($85,000 ÷ $121,000 = 70.2%). Total depreciation in 2011 is $15,935, computed as follows: Truck ($36,000 x 0.35 (Table 2, Year 1)] $12,600 Machinery ($85,000 x 0.0357 (Table 5, Year 1)] 3,035 Building ($280,000 x 0.00107 (Table 9, Year 2, 12th month)] 300 Total 2011 depreciation $15,935
b. Because the MACRS table percentages are full-year percentages, Large must adjust depreciation in the year of disposition. Adjusted bases for the machinery and the building are computed as follows:
Machinery Building Original cost $85,000 $280,000 Accumulated depreciation: 2011 (from above) $ 3,035 $ 300 2012 23,418a 7,179c 2013 2,091b 5,085d (28,544) (12,564) Adjusted Basis: $56,456 $267,436 a$85,000 x 0.2755 (Table 5, Year 2) b$85,000 x 0.1968 x 0.5/4 (Table 5, Year 3) c$280,000 x 0.02564 (Table 9, Year 2, 12th month) d$280,000 x 0.02564 x 8.5/12 (Table 9, Year 3, 12th month) pp. I:10-4 through I:10-10. I:10-29 a. Ted must use the 40% test to determine which convention (half-year or mid-quarter) applies for MACRS depreciation of the equipment and the machinery. The 40% test shows that both assets will use half-year depreciation because no more than 40% of all tangible personal property placed in service in 2011 was placed in service in the last three months ($200,000 ÷ $550,000 = 36.4%). Total depreciation in 2011 is $96,834, computed as follows:
Furniture [$350,000 x 0.1429 (Table 1, Year 1)] $50,015 Equipment [($200,000 x 0.20 (Table 1, Year 1)] 40,000 Building [$300,000 x 0.02273 (Table 7, Year 1, 5th month)] 6,819 Total 2011 depreciation $96,834
b. When Ted elects Sec. 179 and expenses the entire furniture cost and part of the equipment cost, the 40% test shows that the furniture and equipment use the mid-quarter convention because more than 40% of all the tangible personal property placed in service during 2011 (after Sec. 179 expensing) was placed in service in the last three months [($200,000 - $50,000) ÷ ($550,000 - $500,000)] = 100%. Total depreciation in 2011 is $509,319, computed as follows:
Furniture Equipment Building
Sec. 179 expensing $350,000 $150,000 n/a MACRS depreciation -0-a 2,500b $6,819c Total 2010 depreciation $350,000 $152,500 $6,819
aTed expenses the entire cost, leaving nothing for MACRS depreciation. b($200,000 - $150,000) x 0.05 (Table 5, Year 1) c$300,000 x 0.02273 (Table 7, Year 1, 5th month)
c. When Ted elects Sec. 179 and expenses all the equipment cost and only part of the furniture cost, the 40% test now shows that the furniture and equipment use the half-year convention because no tangible personal property placed in service during 2011 (after Sec. 179 expensing) was placed in service in the last three months [($200,000 - $200,000) ÷ ($550,000 - $500,000)] = 0%. Total depreciation in 2011 is $513,964, computed as follows:
Furniture Equipment Building
Sec. 179 expensing $300,000 $200,000 n/a MACRS depreciation 7,145a -0-b $6,819c Total 2010 depreciation $307,145 $200,000 $6,819
a($350,000 - $300,000) x 0.1429 (Table 1, Year 1) b Ted expenses the entire cost, leaving nothing for MACRS depreciation.
c$300,000 x 0.02273 (Table 7, Year 1, 5th month)
Thus, with these facts, Ted obtains more total depreciation in 2011 by expensing the entire equipment cost and using the half-year convention than he obtains by expensing the entire furniture, which results in the mid-quarter convention. This outcome occurs even though the equipment is 5-year property. In this case, the value of the half-year convention outweighs the detriment of expensing a large portion of 5-year property.
For a complete analysis, however, one also would have to compute the present value of the remaining depreciation deductions for each asset and determine which depreciation pattern results in the greater present value. If tax rates were not constant throughout the recovery period, to get a proper comparison, one would have to multiply the depreciation deductions by the applicable tax rate to obtain the present value of tax savings from each alternative.
Also, the outcome in this situation is particular to the given facts. Other facts can provide other outcomes. For example, in Problem I:10-33, the mid-quarter convention gives the better first-year result. Thus, the tax planner must analyze each particular situation before reaching a conclusion. pp. I:10-4 through I:10-10. I:10-30 a. Tish’s Sec. 179 deduction is $310,000. The maximum Sec. 179 expense ($500,000 in 2011) is first reduced dollar-for-dollar when the total cost of eligible property placed in service exceeds $2,000,000 (in 2011). Tish’s reduction is $100,000 ($2,100,000 - $2,000,000), so the maximum she could expense under Sec. 179 is $400,000 ($500,000 - $100,000). She cannot carry this $100,000 reduction over to other years. However, this amount remains as basis subject to MACRS depreciation. Next, Sec. 179 is limited to business taxable income before the Sec. 179 and 50% of SE deductions. In Tish’s case, this limitation is $310,000. Thus, her unused Sec. 179 expense of $90,000 ($400,000 - $310,000) carries over to 2012.
b. Tish’s total depreciation deduction in 2011 is $647,145, computed as follows: Machine Equipment Sec. 179 expense $310,000 $ -0- MACRS depreciation 7,145a 330,000b Total 2011 depreciation: $317,145 $330,000
a$50,000 x 0.1429 (Table 1, Year 1) b$1,650,000 x 0.20 (Table 1, Year 1)
Note: The $50,000 MACRS basis in footnote a above is determined as follows: $450,000 - $400,000 = $50,000, where the $400,000 includes the $310,000 Sec. 179 expense allowed in 2011 and the $90,000 Sec. 179 carryover to 2012. For MACRS depreciation, the machine’s basis must be reduced by the $90,000 disallowed because of the taxable income limitation as well as reduced by the $310,000 Sec. 179 expense allowed in 2011. This rule insures that taxpayers do not double-depreciate assets when they use the Sec. 179 carryover in subsequent years.
c. To use the $90,000 carryover in 2012, Tish must have sufficient business taxable income and also not have the dollar limitation next year be reduced below $90,000 because of the total cost limitation.
d. If Tish’s business taxable income were $525,000, the taxable income limitation on Sec. 179 would not apply. Tish would be able to expense $400,000 of the machine’s cost because the total cost limitation and resultant reduction still apply. The remaining $50,000 would be subject to MACRS depreciation. Thus, her total depreciation deduction in 2011 would be $737,145 computed as follows: Machine Equipment Sec. 179 expense $400,000 $ -0- MACRS depreciation 7,145a 330,000b Total 2011 depreciation: $407,145 $330,000
a$50,000 x 0.1429 (Table 1, Year 1) b$1,650,000 x 0.20 (Table 1, Year 1)
pp. I:10-4 through I:10-10. I:10-31 a. Depreciation for 2011 is computed as follows:
Automobile [$9,000 x 0.1152 x 1/2 (Table 1, Year 4)] $ 518 (Note that the luxury auto ceiling does not apply.)
Equipment [$20,000 x 0.1249 x 1/2 (Table 1, Year 4) 1,249 Building [$100,000 x 0.02564 x 11.5/12 (Table 9, Year 11, 4th month)] 2,457 Total depreciation for 2011 $4,224
b. Gain or loss on each asset sold in 2011 is computed as follows:
Automobile:
Sales price $ 1,200
Cost $ 9,000 Accum. depr. 2008 $1,800 2009 2,880 2010 1,728 2011 518 (6,926) (2,074) Loss on sale $ (874)
Equipment: Sales price $ 9,500 Cost $ 20,000 Accum. depr. 2008 2,858 2009 4,898 2010 3,498 2011 1,249 (12,503) (7,497) Gain on sale $ 2,003 Building: Sales price $240,000 Cost $100,000 Accum. depr. 2001 $ 1,819 2002-10 23,076 2011 2,457 (27,352) (72,648) Gain on sale $167,352
pp. I:10-4 through I:10-10. I:10-32 a. Thad’s 2011 depreciation deduction is computed as follows: Sec. 179 expense $500,000 MACRS depreciation ($2000 x 0.1429) 286 Total $500,286
b. Depreciation for the three years is as follows: 2011 (above) $500,286 2012 ($2000 x 0.2449) 490 2013 ($2000 x 0.1749 x 1/2) 175 Accumulated depreciation $500,951
Adjusted basis and loss on sale are computed as follows: Sale price $ 80,000 Adjusted basis: Cost $502,000 Accumulated depreciation (500,951) ( 1,049) Gain on sale $(78,951) pp. I:10-4 through I:10-10. I:10-33 a. If Rita allocates the entire $500,000 Sec. 179 expense to Asset A, the mid-quarter convention applies, as follows: Cost of property in 4th quarter (after Sec. 179) $505,000 ($505,000 - $0) Cost of all property (after Sec. 179) 1,105,000 ($1,605,000 - $500,000) Percentage of cost placed in service in 4th quarter 45.7% ($505,000 ÷ $1,105,000) Asset A: Sec. 179 expense $500,000 MACRS depreciation 150,000 [($1,100,000 - $500,000) x 0.25 (Table 2, Year 1)] Asset B: MACRS depreciation 18,029 [$505,000 x 0.0357] (Table 5, Year 1)
Total depreciation in 2011 $668,029
b. If Rita allocates the entire $500,000 Sec. 179 expense to Asset B, the half-year convention applies, as follows: Cost of property in 4th quarter (after Sec. 179) $ 5,000 ($505,000 - $500,000) Cost of all property (after Sec. 179) 1,105,000 ($1,605,000 - $500,000) Percentage of cost placed in service in 4th quarter 0.45% ($5,000 ÷ $1,105,000) Asset A MACRS depreciation $ 157,190 [$1,100,000 x 0.1429 (Table 1, Year 1)]
Asset B: Sec. 179 expense 500,000 MACRS depreciation 715 [($505,000 - $500,000) x .1429 (Table 1, Year 1)]
Total depreciation in 2011 $657,905
Thus, with these facts, Rita is slightly better off expensing Asset A and using the mid-quarter convention. This result occurs because a high percentage of the cost (after Sec. 179) occurs in the first
quarter, allowing that property to be depreciated at the higher (25%) mid-quarter percentage for property placed in service in the first quarter.
The outcome in this situation is particular to the given facts. Other facts can provide other outcomes. For example, in Problem I: 10-29, the half-year convention gives the better first-year result. Thus, the tax planner must analyze each particular situation before reaching a conclusion. pp. I:10-4 through I:10-10. I:10-34 a. All of Long Corporation’s assets are depreciated under the alternative depreciation system (ADS) using straight-line and the half-year convention. Depreciation for 2011 is computed as follows:
Equipment [$40,000 x 0.0714 (Table 11, Year 1)] $2,856 Truck [$30,000 x 0.20 x 1/2 (Table 11, Year 5)] 3,000 Furniture [$10,000 x 0.1429 (Table 11, Year 5)] 1,429 Automobile [$12,000 x 0.20 x 1/2 (Table 11, Year 4)] 1,200
(Note that the luxury auto ceiling does not apply.) Total depreciation for 2011 $8,485
b. Gain on each asset sold in 2011 is computed as follows:
Truck: Sales price $ 8,000 Cost $30,000 Accum. depr. 2007 $3,000 2008 6,000 2009 6,000 2010 6,000 2011 3,000 (24,000) (6,000) Gain on sale $ 2,000
Automobile: Sales price $10,000 Cost $12,000 Accum. depr. 2008 $1,200 2009 2,400 2010 2,400 2011 1,200 (7,200) (4,800) Gain on sale $ 5,200
pp. I:10-4 through I:10-10. I:10-35 Both assets are "listed property" and are subject to the special rules contained in Sec. 280F. The MACRS depreciation deductions are computed as follows:
Automobile: When business use is greater than 50% of total use, the taxpayer may use regular MACRS depreciation for the business-use portion of the asset's cost.
Cost $21,000 Times: MACRS rate (Table 1, 5-year recovery) 0.20 Regular MACRS depreciation $ 4,200 Times: Business-use percentage 0.60 2011 depreciation before the luxury auto ceiling limitation: $ 2,520 The luxury automobile limitation for 2011 is $3,060 (Table 6 in Appendix C). Because Trish’s
business-use percentage is 60%, the luxury limitation is $1,836 ($3,060 x 0.60). Trish must use the lower of the MACRS depreciation or the luxury car limit. Therefore, Trish’s depreciation on the automobile for 2011 is $1,836.
Computer: When business use is 50% or less of total use, the taxpayer must use the alternative depreciation system (ADS), which is five-year straight-line depreciation for automobiles and computers.
Cost $4,000 Times: Business-use percentage 0.40 Business portion $1,600 Times: rate from Table 11, Appendix C 0.10
2011 depreciation: $ 160
pp. I:10-12 and I:10-13. I:10-36 No depreciation is allowed for either the automobile or the computer. In addition to the 50% business use test, the employee’s asset use must be for the convenience of the employer and required as a condition of employment. Since that is not the case, Trish’s use is deemed to be personal rather than business. pp. I:10-12 and I:10-13. I:10-37 a. Tammy’s depreciation deductions for 2008-2011 are computed as follows:
2008:
Regular MACRS depreciation (100% business use): $20,000 x 0.20 = $4,000 Luxury limit (100% business use) = $2,960 Depreciation for 2008: 70% of the lesser of $4,000 or $2,960; $2,960 x 0.70 = $2,072
2009:
Regular MACRS depreciation (100% business use): $20,000 x 0.32 = $6,400 Luxury limit (100% business use): $4800 Depreciation for 2009: 70% of the lesser of $6,400 or $4,800; $4,800 x 0.70 = $3,360
2010:
ADS depreciation (100% business use): $20,000 x 0.20 = $4,000. Business use fell to 50% or below, so ADS is required.
Luxury limit (100% business use) = $2,850
Depreciation for 2010: 40% of the lesser of $4,000 or $2,850; $2,850 x 0.40 = $1,140
2011: ADS depreciation (100% business use): $20,000 x 0.20 = $4,000
Luxury limit (100% business use): $1,775
Depreciation for 2011: 35% of the lesser of $4,000 or $1,775; $1,775 x 0.35 = $621 Thus, depreciation deductions are:
2008 $2,072 2009 3,360 2010 1,140 2011 621
b. Depreciation recapture: When business-use percentage for listed property decreases to
50% or below, as it did in 2010, the property becomes subject to depreciation recapture. The alternative depreciation system must be used to recompute all prior year depreciation deductions. The excess depreciation is included in the taxpayer's gross income in the year in which the percentage falls to 50% or below. ADS depreciation for the prior years 2008 and 2009 is computed as follows:
Year ADS Depreciation (Table 11)
2008
2009
$1,400 ($20,000 cost x 0.10 x 0.70 business-use) $2,800 ($20,000 cost x 0.20 x 0.70 business-use)
Total recapture in 2010 is $1,232 ($5,432 MACRS depreciation for 2008 and 2009 - $4,200 ADS depreciation for 2008 and 2009). The $1,232 must be included in Tammy’s gross income in 2010. The recapture does not affect 2011 gross income. pp. I:10-5, I:10-12 through I:10-14. I:10-38 Depreciation deductions are computed as follows:
Year MACRS Deduction (Table 1)
(5- year recovery)
Ceiling Limit
(Table 6)
Allowed Deduction*
2010
Bonus depreciation: $64,000 x 50% = $32,000 MACRS depreciation: $64,000 - $32,000 = $32,000 x 0.20 = $6,400
Total depreciation in 2008 = $38,400
$10,960
$10,960
2011 $32,000 x 0.32 = $10,240 4,800 4,800
2012 $32,000 x 0.192 = $6,144 2,850 2,850 2013 $32,000 x 0.1152 = $3,686 1,775 1,775 2014 $32,000 x 0.1152 = $3,686 1,775 1,775 2015 $32,000 x 0.0576 = $1,843 1,775 1,775
*The allowed deduction is the lesser of (1) the regular MACRS deduction or (2) the ceiling amount.
Note: For subsequent years, a $1,775 (times business-use percentage) ceiling limitation applies until the automobile is fully depreciated. pp. I:10-13 through I:10-15. I:10-39 Depreciation deductions are computed as follows:
Year
MACRS Deduction (Table 1)
(5-year recovery)
Ceiling Limit
(Table 6)
Allowed Deduction*
2011 $36,000 x 0.20 = $7,200 $3,060 $3,060
2012 $36,000 x 0.32 = $11,520 $4,900 $4,900
2013 $36,000 x 0.192 = 6,912 $2,950 $2,950 *The allowed deduction is the lesser of (1) the regular MACRS deduction or (2) the ceiling amount.
Note: For subsequent years, a $1,775 (times business use percentage) ceiling limitation applies until the automobile is fully depreciated. pp. I:10-13 and I:10-14.
I:10-40 a. Depreciation for 2011-2016, and subsequent years is computed as follows:
MACRS depreciation: (until $25,200 (70% of cost) has been depreciated)
0 1,775 1,243 17,990 (19,765 - 1,775)
b. If the SUV has a GVWR of over 6,000 pounds, the luxury auto depreciation rules do not apply. These vehicles are permitted to expense up to $25,000 under Sec. 179. However, only $25,200 ($36,000 x 0.70) of the cost can be depreciated because personal-use assets are not depreciable. Therefore, 2011 depreciation will be:
c. When the taxpayer elects to use bonus depreciation, the maximum amount that can be deducted in 2011 for 100% business of a luxury automobile increases to $11,060. Because the taxpayer is using the automobile 70% for business, the taxpayer will be able to deduct $7,742 ($11,060 x 70%) in 2011. In 2012, the taxpayer will take the lesser of the MACRS deduction of $11,520 ($36,000 x .32) or the luxury automobile limit of $4,900. Because the limit of $4,900 is less, the taxpayer will be able to deduct $3,430 ($4,900 x 70%) in 2012.
pp. I:10-13 through I:10-16. I:10-41 a. 80% of the $7,200 ($600 x 12) lease payment, or $5,760, is deductible as a business expense in each of the two years.
b. Troy must reduce his annual lease payment deduction by $40 ($50 x 0.08) in 2010 and by $87 ($109 x 0.80) in 2011. (Table 13, Appendix C.)
c. Rental payments of $1,920 ($200 x 12 months x 80%) are deductible. No reduction is required because the FMV is below the minimum amount designated as a luxury auto. p. I:10-16. I:10-42 a. Vicki's assets would be recorded by Palm Corporation as follows:
Tangible assets: $400,000 Intangible assets: Covenant not to compete 50,000 Goodwill 70,000 Patents 30,000 Customer list 50,000 Total: $600,000
b. All except the tangible assets are Sec. 197 intangible assets and are amortized as follows:
• Covenant: $3,333 ($50,000 ÷ 15 years) even though the covenant is for a period of 5 years.
• Goodwill: $4,667 ($70,000 ÷ 15 years). • Patent: $2,000 ($30,000 ÷ 15 years) even though the remaining legal life is
only 12 years. • Customer list: $3,333 ($50,000 ÷ 15 years).
The tangible assets would be depreciated under the MACRS rules. pp. I:10-17 through I:10-19. I:10-43 The only expenditures that are deductible as research and experimental costs under Sec. 174 are materials and supplies for research laboratory, utilities and depreciation on research laboratory and equipment, and research costs subcontracted to a local university. Costs of acquiring another entity’s patent, market research surveys, and labor and supplies for quality control tests do not qualify. pp. I:10-19 and I:10-20.
I:10-44 a. If the expensing method is elected, Phoenix's deduction for R&E expenditures in 2011 is $170,000 [($40,000 + $80,000 + $30,000 + $20,000 depreciation ($100,000 x 0.20)] and in 2012 is $32,000 depreciation ($100,000 x 0.32).
b. If the deferral and amortization method is elected and the amortization period is 60 months, there would be no amortization allowed in 2011 and $34,000 [($170,000 ÷ 60) x 12] in 2012. The remaining equipment cost ($100,000 - $20,000) will be depreciated using MACRS beginning in 2012. pp. I:10-19 and I:10-20. I:10-45 Phillips Corporation can deduct the cost of computer software as follows:
• The cost of software included in the cost of the computer hardware may be depreciated with the hardware as long as the taxpayer consistently follows this treatment. Therefore, the total computer system would be considered 5-year property and the depreciation deduction would be ($15,000 x 0.20) = $3,000. The portion of the depreciation deduction attributable to the software would be $600 ($3,000 x 0.20) although it would not be separately stated.
• The bookkeeping software was acquired separately and would be depreciated over 36 months on a straight-line basis. Since the software was purchased on September 1, 2011, the deduction would be $640 ($5,760/36 months x 4 months).
• The computer software acquired in connection with a purchase of other assets would be considered a Sec. 197 intangible and amortized over 15 years. Therefore, the amortization deduction for 2011 would be $1,944 ($50,000/15 years x 7/12).
pp. I:10-20 and I:10-21. I:10-46 a. If the IDCs are expensed, the cost depletion amount is $40,000, computed as
follows:
Acquisition cost $200,000 Divided by: Estimated recoverable units 20,000 Cost depletion per unit $ 10 Times: Units sold 4,000 Depletion amount $ 40,000
b. If the IDCs are capitalized, the cost depletion amount is $44,000. The basis for cost
depletion purposes is $220,000. ($200,000 cost + $20,000 IDCs) Basis $220,000 Divided by: Estimated recoverable units 20,000 Cost depletion per unit $ 11 Times: Units sold 4,000 Depletion amount $ 44,000
c. The greater of cost depletion or percentage depletion, not to exceed 100% of taxable
income before depletion. Therefore, cost depletion of $44,000 is deducted if the IDCs
are capitalized, and $40,000 if the IDCs are expensed, because percentage depletion is only $25,000.
d. Assuming Tina has substantial gross income, the immediate expense method is
preferable because $20,000 of IDCs may be expensed in the initial year while also deducting $40,000 of cost depletion. Under the capitalization method, only $44,000 can be deducted. pp. I:10-21 through I:10-24.
I:10-47 a. If the IDCs are expensed the percentage depletion amount is $75,000 ($500,000 x
0.15). The limitation is $200,000 (taxable income before depletion) and, therefore, is not applicable.
b. If the IDCs are capitalized, the percentage depletion amount is still $75,000. Taxable income before depletion is $300,000 ($500,000 - $200,000) so, again, the limitation does not apply.
c. If the IDCs are expensed, the depletion deduction is $75,000 (the greater of $75,000 percentage depletion or $20,000 of cost depletion).
d. The percentage depletion method should be used because the taxpayer may deduct the $75,000 plus the $100,000 of IDCs in the current year. pp. I:10-21 through I:10-24.
Comprehensive Problem I:10-48 Interest income $ 275 Business income: Sales income ($8,000 u. @ $15/u.) $120,000 Service income 64,000 $184,000 Cost of sales 45,000(1) Gross profit 139,000 Expenses: Auto, gas, oil, etc. 3,800 Depreciation
16,122(2)
Interest on business loans 4,000 Lease expense 5,970 [(12 months x $500) = $6,000 - $30 lease inclusion amount] Taxes and licenses 3,300 Salaries 24,000 Utilities 2,800 59,992 $79,008 Gain on sale of 7-year equipment: Amount realized $ 12,000 Adjusted basis: Cost $ 30,000
Accumulated depreciation (24,645)(3) (5,355) 6,645 Total income 85,928
One-half SE tax [($79,008 x 0.9235 x 0.153) = $11,163 x 0.50] ( 5,582) Adjusted gross income: $80,346 Itemized deductions: Medical expenses [($4,500 - ($80,071 x 0.075)] $ 0 Real estate taxes 3,800 Home mortgage interest 9,000 Charitable contributions 600 ( 13,400) Personal exemptions ($3,650 x 2) ( 7,300) Taxable income: $59,646 Income tax per 2009 MFJ rate schedule $ 8,109 Self-employment tax ($79,013 x .9235 x .153) 11,163 Total tax 19,272 Estimated taxes paid ( 20,000) Overpayment (refund) $ (728) Detailed Computations
(1)Cost of goods sold: Beginning Inventory (4,000 u. @ $5/u.) $20,000 Purchase #1 (3,000 u. @ $6/u.) 18,000 Purchase #2 (4,000 u. @ $7/u.) 28,000 Ending Inventory (3,000 u. @ $7/u.) ( 21,000) COGS $45,000 (2) Depreciation for 2010: Equipment (7-year recovery) Table 1, Year 6: ($30,000 x 0.0892 x ½ year) $ 1,338 Old store building ($100,000 x .02564) Table 9, Year 11 2,564 New store building ($60,000 x .02033) Table 9, Year 1 1,220 Equipment (5-year recovery) expensed under Sec. 179 11,000
$16,122 (3)Accumulated depreciation on 7-year 2005 ($30,000 x 0.1429) $ 4,287 recovery equipment: 2006 ($30,000 x 0.2449) 7,347 2007 ($30,000 x 0.1749) 5,247 2008 ($30,000 x 0.1249) 3,747 2009 ($30,000 x 0.0893) 2,679 2010 ($30,000 x 0.0892 x ½ yr) 1,338 Total $24,645
Tax Strategy Problem I:10-49 Based on present value analysis, Stan would be better off purchasing the car. The difference in the two alternatives is relatively small. The analysis is presented below. Purchase the car: Stan will be able to deduct both interest and depreciation on the car. Luxury auto limits (Appendix C, Table 6) will apply. Deductible
Depreciation Deductible
Interest
Total Tax Savings @
28% PV of Tax Savings
@ 8% Year 2011 $ 3,060 $2,216 $ 5,276 $1,477 $1,368 2012 4,900 1,794 6,694 1,874 1,607 2013 2,950 1,337 4,287 1,200 953 2014 1,775 843 2,618 733 539 2015 1,775 305 2,080 582 396 Total $14,460 $6,495 $20,955 $5,866 $4,863 When Stan sells the car at the end of five years for $10,000, he would generate a loss of $5,540 [$10,000 - ($30,000 - $14,460)]. At a 28% tax rate, this loss would yield an additional financial benefit of $1,551 ($5,540 x 0.28 = $1,056; PV @ 8%, 5 years = $1,056). Finally, the $10,000 received from the sale of the car will be worth $6,806 (PV $10,000 @ 8% for 5 years). So, the present value of purchasing the car would be:
Cash outlay to purchase car (PV) ($30,000) Tax savings from deductions (PV) 4,863 Tax savings from loss on sale (PV) 1,056 Cash received from sale of car (PV) 6,806 Present value of purchasing the car: $(17,275)
Lease the car: Stan can deduct the lease payments, net of the lease inclusion amounts.* Present value of $450 monthly lease payment for 60 months at 8% per year (0.6667% per month):
($22,193)
Present value of tax benefits: Monthly lease payment $ 450
Payments per year x12 Annual lease payments $5,400
Annual lease inclusion amount ( 230)* Annual net lease deduction 5,170 Payments per year ÷12 Monthly deductible payment 431 Tax savings ($431 x .28) $ 121
PV of $119 @ 8% per year (0.6667% per month) for 60 months
Conclusion: Our analysis concludes that Stan would be better off leasing the car rather than purchasing it. Over a five-year period, Stan would save $1,050 ($17,275 - $16,225). Leasing is generally advantageous if a taxpayer uses the car primarily in business and wants to upgrade to a new car every 3-5 years. The purchase option could be better if Stan keeps the car for longer than five years.
Tax Form/Return Preparation Problems I:10-50 (See Instructor’s Resource Manual) I:10-51 (See Instructor’s Resource Manual) Case Study Problems I:10-52 The following points should be mentioned in the client memo.
1. The tangible assets should be recorded at their FMV of $400,000. Appraisals should be obtained to establish credibility for the individual asset allocations. It is preferable to allocate cost liberally to the inventory and depreciable assets. The sale of inventory results in an immediate tax benefit in the form of an increase in cost of goods sold, whereas allocations of cost to land affect only gain or loss upon a future sale.
2. It makes no difference for tax purposes whether the $600,000 excess amount is allocated to a covenant not to compete or to goodwill, because both types of assets are Sec. 197 intangibles and are amortizable over a 15-year period. Section 197 applies to intangible assets acquired in connection with a transaction that involves the acquisition of a trade or business. I:10-53 For 2009 and 2010 the corporation should have reported the value of the officer’s personal-use benefit to the IRS by including such amounts on the officer's Form W-2. SSTS No. 6 states that ... "A CPA shall advise the client promptly upon learning of an error in a previous return." The CPA, however, is not obligated to inform the IRS, nor may he do so without the client's permission. If the error is a material misstatement of tax liability, the CPA should consider whether to proceed in the preparation of the return for the current year. In this instance, the error has not been repeated in 2011 and affects only the officer’s personal return (although the corporation may be liable for penalties). Unless the amount is deemed to be a constructive dividend to the officer, the taxable income of the corporation is not affected. The CPA should advise the client as to potential penalty consequences. All reasonable steps should be taken to ensure that the error is not repeated. However, the primary responsibility for a true, correct, and complete return rests with the taxpayer, not the tax consultant or preparer.
Tax Research Problem I:10-54 Depreciation of works of art has been controversial. The IRS takes the position in Rev. Rul. 68-232, 1968-1 C.B. 79, that assets that automatically increase in value with age are not depreciable. In Associated Obstetricians and Gynecologists v. Comr., 46 TCM 613 (1983), affd. 762 F.2d. 38 (6th Cir. 1985), the court agreed with the IRS that pieces of artwork for their office had no useful life and were not subject to depreciation. Likewise, in Shauna C. Clinger, 60 TCM 598 (1990), the Tax Court held that artwork was not depreciable because it did not have a useful life. However, in two more recent cases, the requirement of a useful life has been diminished to some degree. In Simon v. Comr., 103 T.C. 247 (1994), affd. 95-2 USTC 50,552 (2d Cir. 1995) and Liddle v. Comr., 103 TC 285 (1994), affd. 95-2 USTC 50,488 (3d Cir. 1995), the taxpayers were allowed to depreciate violins because the taxpayer played the instruments as opposed to using them as passive objects displayed for admiration of their aesthetic qualities. In Timothy Couch’s situation, it appears that the artworks will not be eligible for depreciation. “What Would You Do In This Situation?” Solution Ch. I:10, p. I:10-26. Focused Marketing or Unethical Hustle?
Ruth Less' solicitation of your client, Widgets R Us, Inc., is clearly unethical under the
AICPA's Code of Professional Conduct. Rule 302 prohibits contingent fees by stating, "professional services shall not be offered or rendered under an arrangement whereby no fee will be charged unless a specified finding or result is attained, or where the fee is otherwise contingent upon the findings or results of such services. Thus, Ruth Less' fees being based solely on the amount of savings resulting from the R&E write-offs would constitute a contingent fee under the Code of Professional Conduct. Further, the solicitation by Ruth Less of your client may be a violation of Rule 502, which deals with false, misleading, or deceptive acts in advertising or solicitation.
While the arrangement as proposed by Ruth Less is clearly unethical, a slightly different approach would probably be acceptable and is done routinely in business today. Many CPA firms provide consulting services for clients who have another CPA do audit and general tax work. Thus, if Ruth Less was proposing an R&E study and not an attempt to take the client away from your firm, the R&E study would not be unethical. However, the fee structure would have to be modified to avoid contingent fee status.
Finally, if the claims of Ruth Less are valid (or even somewhat valid), your CPA firm should improve its update of tax laws because at present, you are not providing the necessary advice for your client to pay the minimum income tax allowable under the law.
