Correcting Depreciation Errors (Including Bonus Elections and Computations)

Overview

One of the common errors made on a tax return involves depreciation.  Depreciation errors can result from, among other things, a math error, a posting error, or an incorrect method.  Depreciation errors are corrected by either filing an amended return or filing a change in accounting method form.

Basic Principle

It is important to note that errors are errors and accounting methods are not errors.  Errors are corrected by amending returns.  Accounting methods are corrected by filing Form 3115.  An amended return can be filed to correct for depreciation method problems (wrong method or life) if the next year’s return has not yet been filed. 

Automatic Consent Procedure

The IRS’s automatic consent procedures for taxpayers who have adopted an impermissible method of accounting for depreciation (or amortization) and have either claimed no allowable depreciation, less depreciation than allowable, or more depreciation than allowable is provided in the guidance at Rev. Proc. 2015-13, 2015-13, 2015-5 IRB 419.

Note:  Rev. Proc. 2019-43, 2019-43, 2019-48 IRB 1107 has the latest list of automatic consent procedures.  While several revenue procedures have been issued that modify or add to that list, Rev. Proc. 2019-43 is the latest of the full listing.

Taxpayers who qualify under the automatic procedure are permitted to change to a method of accounting under which the allowable amount of depreciation is claimed. The unclaimed depreciation from years before the year of change is considered as a net negative adjustment in the year of change and are deducted in full on the return for the year of change.

The 2-year Rule

The use of an incorrect method of depreciation is considered the use of an incorrect accounting method.  Once an incorrect accounting method has been used for two years, Form 3115 is required to change accounting methods back to a correct method, or to begin taking depreciation. 

Note:   If no depreciation had been taken and only one year has passed the return may be corrected via amendment because the incorrect method had only been used for one year.

Amended Returns

A depreciation error that is not subject to the accounting method change filing requirements are to be corrected via an amended return in the following situations:

• The incorrect amount of depreciation was claimed due to a mathematical error made in any year;
• The incorrect amount of depreciation was claimed due to a posting error made in any year;
• An incorrect amount of depreciation was claimed on property placed in service in tax years ending before the statute of limitations expired (but not due to an established accounting method);
• The amount of expense method depreciation (I.R.C. §179) is being changed;
• An election is being made to apply the $2,500/$5,000 de minimis safe harbor rules (within its own time period requirements of return due date plus extension); and

Caution:  If the election out for bonus depreciation wasn’t made, the accounting method change provisions apply, and an amended return cannot be filed if two years have gone by. If only one year, the taxpayer has a choice of amending the return or proceeding under the rules governing a change in accounting method. But filing an amended return may not be an option for a partnership.  If the bonus election was made, a change to not make the election may only be made via a superseding return.

Amending returns will only correct depreciation errors that have occurred in the last three years. Errors that have occurred before that cannot be “caught up” on current or amended returns and will only be “caught up” when the asset is sold using a Form 3115 and Code 107. These errors must be from applying impermissible accounting methods. Accounting method issues are fixed by filing Form 3115.

Change in Accounting Method - Form 3115

IRS Form 3115, Change in Accounting Method, is used to correct depreciation if the correction relates to the misapplication of an accounting method. This includes the omission of depreciation.  When depreciation for an asset is inadvertently left off the return, the IRS treats the omission as the adoption of an incorrect method of accounting if the subsequent year’s return has been filed.  Thus, the correction of the omission may only be by the filing of Form 3115.  

Note:  When changing methods of accounting from not taking depreciation (incorrect method) to taking depreciation (correct method) use Code 7 on Form 3115 if the asset is still in use, code 107 if disposed.

Generally, Form 3115 must be attached to the taxpayer’s tax return for the year of change by the due date (including extensions). A copy must also be filed with the IRS no later than when the original Form 3115 is filed with the taxpayer’s return.  Rev. Proc. 2015-13  allows the use of one Form 3115 to correct mistakes on more than one asset.

When Form 3115 is required.  Depreciation changes that constitute a change in accounting method are:

• Changing from not taking depreciation to taking depreciation. (Because this is a change from an impermissible method to a permissible method, use Code 7 on Form 3115);
• Corrections in methods or conventions (use Code 7 on Form 3115);
• Changes from a permissible method to another permissible method (use Code 8 on Form 3115);

Note:  Generally, there is only one permissible recovery period.  If the taxpayer used the wrong recovery period.  If the taxpayer used the wrong recovery period, it is a change from impermissible to permissible.  For a taxpayer with multiple assets that need to be changed the Code is 200.

• Correcting depreciation on leasehold improvements from using the incorrect life of the lease term to the correct life of the asset (usually 15 or 39 years). (Use Code 199 on Form 3115.)

Note:  Rev. Proc. 2015-13 is also to be used to correct depreciation after an asset has been sold.

Rev. Proc. 2015-13 allows a taxpayer to recover depreciation deductions that have been mistakenly overlooked, for which, under the “allowed or allowable” rule the taxpayer had to reduce basis in the asset, effectively making the “allowed or allowable” penalty disappear. Code 107 on Form 3115 is to be used to “catch up” omitted depreciation on an asset when it is sold.

When Form 3115 is not required.  Depreciation changes that do not require Form 3115 because they are not considered changes in an accounting method include (and which may only be made on an amended return) are as follows:

• A change in computing depreciation because of a change in the use by the same taxpayer;
• Changes in placed-in-service dates;
• A change in useful lives;
• Making a late depreciation election or revoking a timely valid depreciation election.

Note:   A change from not claiming bonus depreciation to claiming bonus is a revocation of the election and is not an automatic accounting method change. This change requires IRS advance consent to change an election.

Procedural aspects.  Form 3115 is filed to correct the accounting method for depreciation., the total depreciation adjustment, an I.R.C. §481 adjustment, is deducted in full in the year of change if it is negative. If the adjustment is positive, it must be added in ratably over 4 years, except that if the adjustment is positive but less than $50,000 in total, the taxpayer may elect to add it in to income in full in the year of change.

Form 3115 may be filed at any time for any year.  If it is filed for an asset that was sold in a prior year, the taxpayer should use Code 7 on page one of Form 3115 if the taxpayer still owns the asset.  If the asset was sold during the year, the applicable Code is 107. 

Filing requirements.  Rev. Proc. 2015-13 requires that a signed copy of Form 3115 be filed to the IRS office. No advance approval is required to correct the error, as this is an automatic approval change in most cases. There is no user fee.

The original Form 3115 should be filed with the tax return for the year of change. The original must be filed by the due date of the return, plus extension. There is a 6-month automatic extension of the due date if the return was timely filed, and an amended return (with this change) is filed within 6 months.

When filing Form 3115, the additional statements listed below must be attached:

• A detailed description of the former and new methods of accounting;
• A statement describing the taxpayer’s business or income-producing activities;
• A statement of the facts and law supporting the new method of accounting, new classification of the item of property, and new asset class;
• A statement identifying the year in which the item of property was placed in service.

TCJA and Bonus Depreciation

The Tax Cuts and Jobs Act (TCJA) increased the additional first year bonus depreciation deduction from 50 to 100%.  In addition, the property eligible for bonus depreciation was expanded to include certain used depreciable property and certain film, television, or live theatrical productions.  Also, the placed-in-service date was extended to before January 1, 2027, and the date on which a specified plant is planted or grafted by the taxpayer was extended to before January 1, 2027.

The TCJA created three additional first year depreciation deduction elections:

• A taxpayer can elect not to deduct the additional first year depreciation for all qualified property that is in the same class of property and placed in service by the taxpayer in the same tax year;
• A taxpayer can elect to deduct 50-percent, instead of 100%, additional first year depreciation for all qualified property acquired after September 27, 2017, and placed in service by the taxpayer during its taxable year that includes September 28, 2017; and
• A taxpayer can elect to deduct additional first year depreciation for any specified plant that is planted after September 27, 2017, and before January 1, 2027, or grafted after and before those dates to a plant that has already been planted. If the taxpayer makes this election, the additional first year depreciation deduction is allowable for the specified plant in the taxable year in which that plant is planted or grafted.

Conclusion

Depreciation errors are not uncommon.  Fortunately, there are procedures that can be used to correct many of the mistakes that have been made.