On June 11, 2021, the IRS addressed the character of section 481(a) adjustments resulting from depreciation accounting method changes in IRS Legal Memo (ILM) 202123007. The IRS held that the section 481(a) adjustment retained its character as depreciation, and therefore affected the calculation of the section 163(j) interest deduction limitation.
Section 481(a) provides an adjustment for changes in method of accounting, computed as of the beginning of the year of the change. The section 481(a) adjustment for a change in method of accounting for depreciation generally represents the difference between the depreciation the taxpayer took on a piece of property and the depreciation the taxpayer would have taken had the taxpayer used the new method when it originally placed the property in service.
Section 163(j) limits the amount of business interest expense that certain taxpayers can deduct in the current taxable year for taxable years beginning after Dec. 31, 2017. Under section 163(j)(1), the deduction for business interest expense is limited to the sum of: (1) the taxpayer's business interest income for the taxable year; (2) 30% (50% for some years), of the taxpayer's adjusted taxable income (ATI) for the taxable year; and (3) the taxpayer's floor plan financing interest expense for the taxable year (the section 163(j) limitation). ATI is computed under federal tax rules, which Congress intended to approximate EBITDA (earnings before income tax, depreciation and amortization) for years beginning prior to Jan. 1, 2022, and to approximate EBIT (earnings before income tax) thereafter.
Under Reg. section 1.163(j)-1(b)(1)(i), for taxable years beginning before Jan. 1, 2022, when taxpayers calculate tentative taxable income to determine ATI, taxpayers add back any depreciation under sections 167 or 168, along with amortization and depletion (the Depreciation Add-Back). A similar subtraction from ATI is required under Reg. section 1.163(j)-1(b)(1)(ii) when taxpayers directly or indirectly sell or dispose of an asset that generated a Depreciation Add-Back under section 163(j).
Prior to the ILM, many taxpayers questioned whether a section 481(a) adjustment attributable to depreciable assets affects the depreciation Add-Back, and whether the answer would remain the same if the assets in question were placed in service prior to section 163(j)’s effective date. In the ILM, the IRS answers “yes” to these questions.
The taxpayer in the ILM filed a favorable depreciation accounting method change with an adjustment equal to a net negative ($100x) for the 2020 calendar year related to assets placed in service in 2017. The IRS concludes that the 100x amount is depreciation computed under section 168. Accordingly, the ILM concludes that the 100x amount is added to the taxpayer’s Depreciation Add-Back for 2020.
The ILM further notes that in situations where a taxpayer has an unfavorable net section 481(a) adjustment attributable to depreciation, the adjustment creates a subtraction from the taxpayer’s Depreciation Add-Back when computing ATI. If the taxpayer takes the section 481(a) adjustment ratably over four years, then the add back follows the same ratable treatment.
Method changes for depreciation can generate very large section 481(a) adjustments, which means they can significantly affect the section 163(j) interest deduction limitation. Taxpayers should consider section 481(a) adjustments for depreciation when calculating ATI, as the IRS will expect calculations to reflect these adjustments. The guidance also presents an opportunity for some taxpayers to review their depreciation methods and potentially improve their position with respect to the interest deduction limitation.