Tax Expenditures: Available Data Are Insufficient to Determine the Use and Impact of Indian Reservation Depreciation
Published: 2008-06-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Indians lag behind other Americans on many key economic indicators, such as median household income. To improve such conditions, Congress in 1993 created Indian reservation depreciation (IRD), a tax expenditure offering accelerated depreciation for property invested on Indian reservations. GAO was asked to (1) describe which taxpayers claimed IRD, (2) analyze the effect of IRD on the economic development of reservations, and (3) describe the tax benefits offered by IRD. GAO used the Internal Revenue Service's (IRS) Statistics of Income data to try to identify IRD users and measure IRD's effects; however, the data were unreliable for those purposes. GAO also calculated examples of potential IRD tax benefits for different property classes.
section_title: What GAO Found
paragraphs: Available data are insufficient to identify users of the Indian reservation depreciation (IRD) provision. Although IRD is to be calculated using unique recovery periods, this and other information that taxpayers report are not sufficient to infer from the tax returns which taxpayers are using IRD, in part because taxpayers appear to have reported IRD in combination with other depreciation on their tax forms. In some instances, taxpayers also appear to have made mistakes filling out Form 4562, listing recovery periods inconsistent with IRD when the deduction and basis amounts they reported suggest IRD was in fact used. Data are also insufficient to determine whether IRD increases economic development on Indian reservations. Taxpayers are not required to identify the reservation on which the depreciated property is located. This location data is critical for determining the effects of IRD on the economic development of reservations. Such a determination requires linking IRD investment to economic indicators on specific reservations and controlling for the influence of other economic trends, such as the growth of gaming facilities on these reservations. The lack of data on IRD also may affect how well the Internal Revenue Service (IRS) enforces IRD compliance with the tax law. IRS does not track compliance issues related to IRD and could fail to detect taxpayers who claim IRD deductions but do not in fact have property on a reservation. IRS officials said getting additional information could be costly to obtain, but auditors told us it would be useful. In fact, IRS collects data on some other tax expenditures that allow closer examination of compliance and use. For example, the low-income housing tax credit requires taxpayers to list the address for the property they are claiming, and New Markets Tax Credits users report identifying information for the Department of the Treasury. Tax benefits can accrue to taxpayers who use the IRD schedule because they can achieve higher depreciation deductions, in present value terms, than a taxpayer who claims a depreciation deduction under the usual schedule for the same type of property over the entire life of the property. For example, on a $50,000 property, the savings range from about 1 percent savings over the normal schedule to 22 percent savings, depending on the type of property depreciated. The greatest potential tax savings come from IRD claimed for property with the longest recovery periods. Additional bonus depreciation, when available, however, may decrease the incentive to use IRD.

section_title: Letter
paragraphs: Indians continue to experience economic distress and lag behind other  groups in the United States on key economic indicators, such as  employment and median household income, as they have for years in the  past. For example, according to the 2006 U.S. Census information,  American Indians’ median household income was about $15,000 less than  the median of all households in the United States. American Indians also  had the highest poverty rate of all Census ethnic categories, at 26.6  percent.
Among the programs that the federal government has initiated to assist  Indians and Indian reservations, Congress in 1993 adopted a special  depreciation deduction schedule for certain property used by businesses  on Indian reservations. This provision permits taxpayers to accelerate  their depreciation, i.e., to take a larger deduction for depreciation from  their business income earlier than they otherwise would be allowed, and is  featured in marketing materials by some tax preparers and Indian business  associations. Indian reservation depreciation (IRD) is considered a tax  expenditure, and as we reported in the past, many tax expenditures are  not regularly reviewed and may overlap other programs. With the nation’s  fiscal imbalance projected to grow as the 21st century progresses,  programs such as tax expenditures, including IRD, need to be periodically  reexamined to ensure they are achieving intended results.
Because of the continued economic challenges on some Indian  reservations, you asked us to study the effects IRD has had on  reservations’ economic development. The objectives of this report were to  describe (1) who uses the IRD and for what types of properties; (2) the  effect of this provision on the economic well being of Indian tribal  members; and (3) the tax benefits resulting from use of the accelerated  depreciation.
In attempting to describe the taxpayers who use IRD, we analyzed the  Internal Revenue Service’s (IRS) Statistics of Income Division (SOI) data  on depreciation for individuals, partnerships, and corporations. We tried  to identify IRD claimants and the amounts they claimed using this data. To  attempt to assess the economic effects of IRD, we had planned to use the  data from the first objective. Additionally, we reviewed the literature on  depreciation and economic development and interviewed officials from  IRS and the Department of the Interior’s Bureau of Indian Affairs (BIA).  However, we found that available data were not reliable for completing  these analyses. To describe the tax benefits afforded by IRD, we used IRS  instructions on depreciation under the Modified Accelerated Cost  Recovery System (MACRS) to determine what tax benefits, if any,  taxpayers might gain for claiming IRD compared to the standard  depreciation method. A more detailed description of our methodology  appears in appendix I.
We conducted this performance audit from March 2007 through June 2008,  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: According to the U.S. Census, 4.5 million people, or 2 percent of the total  U.S. population, reported that they were at least part Indian in 2007.  During the 2000 Census, about 36 percent of Indians lived on reservations.  The largest federal Indian reservation covers roughly 15 million acres and  the smallest reservation covers slightly more than 0.9 of an acre. Indian  tribes are sovereign governments that generally are exempt from federal  income taxation, but individual Indians are not exempt from income taxes.
Indians are among the most economically distressed groups in the United  States. The Census estimated in 2006 that 32 percent of American Indians  and Alaska Natives were unemployed. The Census also reported that the  median household income of American Indians and Alaska Natives was  $33,762, nearly $15,000 less than the median of all households in the  United States, and had the highest poverty rate of all Census ethnic  categories at 26.6 percent.
The federal government has more than 100 programs that can assist  Indians. Indian tribes also have used various strategies to stimulate  economic development on reservations, but our previous work has shown  that the prospects for economic growth may be limited. Tribes own  enterprises on reservations in a number of sectors, including gaming,  tourism, manufacturing, natural resources, and agriculture, and some  tribes may encourage private companies owned by nonmembers to locate  on their reservations. Still, many tribes lack some of the factors, including  accessibility to population centers and adequate physical infrastructure,  shown to be important for economic growth. Reservations located in rural  or remote locations have limited access to markets and may lack physical  infrastructure, such as roads, electricity, water, and suitable land for  building, making it difficult for many businesses to operate.
In 1993, Congress passed legislation enacting IRD, which acts as an  incentive for investing on Indian reservations. Depreciation is an annual  deduction from income that allows taxpayers to recover the cost or other  basis of certain property used in a business or other income-producing  activity over the useful life of the property. The deduction is calculated  on IRS Form 4562. According to IRS, MACRS is used to recover the basis  of most property placed in service after 1986. The General Depreciation  System (GDS) is one of the recovery systems permitted by MACRS. GDS  allows taxpayers to depreciate their property using specified amounts of  time—called recovery periods—which differ in length according to the  category—called a property class—that the property belongs. For  example, tractors and race horses are categorized as 3-year property.
Under IRD, taxpayers use shorter recovery periods than are otherwise  permitted under GDS. Table 1 shows the GDS schedule for property class  recovery periods and the corresponding IRD schedule.
Table 2 shows an example of the effects that IRD has on taxpayers’  depreciation deduction. According to the rules, the same method and  convention should be used when calculating the deduction for IRD and  GDS. To compare the difference in deduction between IRD and GDS most  simply, the example uses the straight line method and the half-year  convention to depreciate a property with a basis of $30,000 and falls in the  3-year property class. Under the rules for straight line depreciation,  taxpayers deduct the same amount in each year except for the year in  which the property was placed in service and the final year it was  depreciated. With the half-year convention, the portion of the year during  which the property is to be depreciated determines the amount deducted.  With the half-year convention, as shown in table 2, one-half of the amount  invested (called the basis) divided by the recovery period is deducted in  the first and final years.
IRD provides an incentive by permitting taxpayers to deduct a greater  proportion of the cost of the property earlier within the property’s  depreciable life. This deduction can reduce taxpayers’ tax liability, if any.  Reducing tax liability earlier acts as an incentive because of the time value  of money—having a lower tax payment today is worth more to the  taxpayer than having the lower payment in the future. IRD was designed to  reduce the after-tax cost of capital by exploiting this timing difference in  deductions and thereby make more funds available to the taxpayer for  additional investment on Indian reservations.
To qualify for IRD, property must be used predominately in the conduct of  an active trade or business on an Indian reservation. Some property,  however, does not qualify for IRD even if it is located or used on a  reservation, such as residential rental property, 25-year property, property  acquired from a related person, and property placed in service for  conducting or housing certain gaming facilities.
An additional first-year bonus depreciation deduction was allowed for  certain property—including MACRS property and any applicable IRD  property—placed in service after September 10, 2001, and before January  1, 2005. The bonus depreciation deduction was available for property  being depreciated using the IRD and GDS systems. For property acquired  after September 10, 2001, and before May 6, 2003, and placed in service  before January 1, 2005, a 30 percent rate applied. For property acquired  after May 5, 2003, and placed in service before January 1, 2005, a 50  percent rate applied. Essentially, bonus depreciation allowed taxpayers a  greater deduction in the first year in which property was placed in service.  For example, under 50 percent bonus depreciation in 2004, the initial basis  of a $50,000 property would have been reduced to $25,000, which the  taxpayer then would have continued to depreciate under IRS’s guidelines  for GDS or IRD.
section_title: Amount of IRD Use and Its Effect on Reservation Economic Development Cannot Be Determined with Available Data
paragraphs: In 2005, we reported that information on tax expenditures, such as IRD,  was needed to evaluate their effectiveness as a means of accomplishing  federal objectives and to ensure that they are achieving their intended  purpose. A wide variety of data could be useful for determining whether  IRD is stimulating economic development on Indian reservations, but  three essential pieces of information include which taxpayers claim IRD,  how much they invest in IRD properties, and on which reservations they  have placed IRD properties. The taxpayers’ identities and investment  amounts are needed for several reasons, including for analyses  determining whether and how much the IRD incentive is leading taxpayers  to change their investment behavior consistent with the provision’s  purpose. The IRD tax incentive, like other kinds of accelerated  depreciation, could boost economic development, in the first place, by  affecting business’ decisions about how much and where to invest. The  identity of IRD investors and the amounts they invest could be used to  determine whether the tax incentive increases the total amount of  taxpayers’ investment or induces IRD investors to shift investment onto  reservations from other locations, a shift that would be consistent with  IRD’s purpose. The identity of IRD claimants also could be used to  determine whether IRD overlaps other programs designed to assist Indians  in a way that affects the incentive to invest on Indian reservations. The  location of the IRD properties being placed into service is needed to assess  whether those investments are affecting the economic development of the  specific reservations on which the properties are placed.
However, available data cannot be used to identify IRD claimants because  of limitations in the manner in which IRS instructs taxpayers to report  depreciation and limitations on how IRS compiles tax return information.  Although IRD properties have unique recovery periods compared to other  depreciation recovery periods and Form 4562 does provide space for  taxpayers to report the recovery period, depreciation deduction, and basis  by property class, this information is insufficient to determine whether the  depreciation is IRD in all cases. Figure 1 shows how a taxpayer would  report the depreciation of a $30,000, 3-year property to IRS. The taxpayer  would report the basis, recovery period, method, convention, and  depreciation amount on Part III of the form.
The currently required information on Form 4562 is insufficient to identify  accurately all claimants of IRD or the amounts they invest in IRD property  in part because taxpayers are allowed to group properties on Form 4562.  Form 4562 on line 18 permits taxpayers to combine properties in the same  property class. If the properties within any given property class (lines 19a  to 19i in figure 1) are both IRD and GDS properties, however, IRD  claimants cannot be identified unless taxpayers indicate an IRD recovery  period on the form. The instructions provide no guidance for how  taxpayers should record recovery IRD periods if they are reporting both  IRD and GDS property. IRD users can be identified from Form 4562 when  they claim depreciation only for IRD property within any given property  class and enter the recovery period correctly on Form 4562. However,  even in this case, it is difficult to identify all users because IRS does not  transcribe recovery period data from paper-filed Forms 4562 and  electronically compile recovery periods into a database. Our data analysis  also shows reported depreciation deductions that could be explained by  taxpayers grouping IRD with non-IRD property.
Given these limitations, we attempted to use the basis and depreciation  amounts from Form 4562 (columns c and g in figure 1), which IRS does  compile and maintain in its SOI database, to infer the recovery period.  However, we found that the amount of depreciation and basis did not  uniquely determine which recovery period was used by the taxpayer and  thus did not identify all claimants of IRD. The reported depreciation and  basis were consistent with both the IRD and the GDS depreciation  recovery period for certain property classes when different methods and  conventions were used. Accordingly, although we could identify reliably a  portion of those who claimed IRD and the amounts they invested, we  could not do so for a possibly significant portion of those who claimed  IRD.
When we reviewed a non-representative sample of corporate SOI returns  to verify the reliability of our inference methodology, we also found that  taxpayers may not fill out the form correctly. For example, we saw several  instances where all other information on the Form 4562 pointed to the  taxpayer having used IRD, yet the taxpayer recorded a recovery period on  the Form 4562 that was not consistent with IRD. For example, the  taxpayer may have indicated that the property had a 3-year recovery  period and yet the depreciation amount claimed could have resulted from  the taxpayer depreciating the property over the 2-year recovery period  allowed by IRD. These taxpayers may have recorded that the property  with a 3-year recovery period simply because the name of the property  class is “3-year property.”
IRS does not collect the other essential information to assess the  effectiveness of IRD in promoting economic development on reservations.  IRD property location data—that is, which reservation the property has  been placed into service—are necessary to evaluate the impact of IRD on  economic development on Indian reservations. A common evaluation  approach would be to compare development in communities that receive  IRD investment to those that do not while controlling for other factors that  affect development. However, IRS does not require taxpayers to list where  property is placed in service. Not knowing which reservation the  investment is occurring means that it is impossible to link the property  invested through IRD to indicators of the reservation’s economic  performance. It also is impossible to distinguish between the effect on  economic growth of IRD investment and other kinds of investment that  may occur on reservations, such as the growth of gaming facilities.
IRS officials said that IRS did not compile information on the use of IRD or  require the location of IRD property to be reported because the  information was not needed for processing returns or for compliance  purposes. Collecting additional data on IRD also could take resources  from other priorities, such as combating tax avoidance schemes. IRS  officials said that although redesigning Form 4562 for reporting IRD  location information could be done, no system was in place to transcribe,  collect, and analyze the information from paper returns, and they said that  creating such a system could be costly. IRS officials said that IRS likely  would not collect additional Indian reservation depreciation information  unless doing so would result in enforcement actions that would be cost  efficient. Although IRS may incur costs to acquire the appropriate data,  these additional costs would be required to evaluate whether the provision  is accomplishing its legislative intent.
Obtaining data that identifies IRD claimants and the IRD amounts claimed  could be accomplished by requiring taxpayers to self-identify IRD use with  a check box on Form 4562 and file separate forms listing IRD property.  IRS would need to revise Form 4562 to include the check box, and space  appears to be available to do so. Thus the change would not require  redesigning forms. Segregating the IRD properties also appears unlikely to  impose significant additional costs on taxpayers since they already need to  separately identify the properties in their books and records to be able to  calculate and claim the correct depreciation amount. IRS officials also said  that large corporations often file spreadsheets as attachments to Form  4562 that show their depreciation calculations for individual properties.  However, to compile data on the forms that identify IRD claimants, IRS  officials told us that significant changes would need to be made in how  Form 4562 was processed, such as putting validation checks in place and  developing a system to segregate IRD Form 4562s from non-IRD Form  4562s, which would add considerable burden to forms processing. The  officials said that the benefit given the cost would be questionable.  Obtaining location data for IRD properties likely also would require some  change to tax forms. Form 4562 does not have sufficient space to add an  address field for each of the properties being depreciated using IRD. IRS  managers and officials in submissions processing and media and  publications did not provide a specific dollar amount on how much it  would cost to make the changes, but IRS managers said a new form would  be burdensome and involve substantial changes to the way IRS processes  forms, including many of the issues of form redesign already discussed,  plus changes to IRS’s system for processing tax forms.
Other tax forms require taxpayers to provide information analogous to  what is needed to assess the effectiveness of IRD. For example, Schedule  E requires those renting properties to list the location of each rental  property that they claim and the low income housing tax credit form  (Form 8609) also requires taxpayers to list the address of each claimed  property. A form also exists for claiming the Indian employment tax credit  (Form 8845), which the Joint Committee on Taxation (JCT) estimated had  less than $50 million in revenue loss for fiscal year 2008, far less than the  $300 million revenue loss estimate on IRD for the same year. An IRS  official said that information gathered on forms varies by the program for  such reasons as legislative requirements, IRS policy, compliance- enforcement needs, or the scope of the IRD provision’s use.
Some economic development programs that we have studied also have  more data for monitoring performance than IRD. For example, we were  able to analyze the New Markets Tax Credit (NMTC) partly because its  overseeing agency, the Community Development Financial Institutions  Fund, collected data on NMTC investors and on the location, type and size  of the investment. JCT’s most recent tax expenditure estimates for fiscal  year 2008 estimated revenue loss for NMTC to be about $900 million, $600  million more than the IRD estimate. In our 2004 report on the Economic  Development Administration (EDA) grants to Indian tribes, we were able  to analyze the results of grants because we had information on who the  recipients were and where the grants were being used from grant  applications. The grants to Indian tribes were much smaller than the  revenue losses estimated for IRD, totaling about $112 million from 1993 to  2002, or an average of about $11.2 million per year. But IRD is similar to  other programs we have studied in lacking adequate data for evaluation of  its effectiveness. For example, we said in our 2007 report that the  Empowerment Zone (EZ) and Enterprise Communities (EC) program,  which provides grants and tax benefits for certain impoverished urban  communities, lacks complete data on program tax benefits and the data it  has cannot be linked to individual communities. The JCT revenue loss  estimate for fiscal year 2008 for the EZ/EC provisions was $600 million.
Although having information on which taxpayers claimed IRD, how much  they invested, and where those investments were located would help in  assessing whether the IRD is leading to economic development on Indian  reservations, gauging the effect of economic development programs is  very complex. Often analyses of such programs cannot definitively show  how much a program has contributed to economic development.  Nevertheless, without these data on taxpayers’ use of IRD no valid  assessment can be made on the effect of the IRD provision.
The absence of data on IRD users could affect IRS’s ability to determine  IRD compliance. To enforce IRD, IRS officials said that IRS uses a  computer scoring model and other audit selection programs, such as  special projects where auditors focus on identifying and analyzing specific  audit issues. The model may be able to identify taxpayers who likely are  noncompliant overall in claiming depreciation deductions, but it could not  do so for IRD itself, because, as we found, it is impossible to accurately  identify each taxpayer who uses IRD with existing data. Also, even if  auditors were to detect a pattern of IRD noncompliance, a special  compliance project would have difficulty targeting returns with IRD for  review because taxpayers do not directly report its use on their tax  returns. IRS officials also told us that despite the limitations on  information reported on Form 4562, if a tax return was selected for audit,  experienced auditors should still be able to recognize use of IRD from the  property class, basis, and deduction amount reported on Form 4562. Based  on our analysis, auditors should be able to infer the use of IRD in some  cases, but not all. Of course, if the auditor reviews all of the support for  claimed depreciation expenses, the taxpayer should be able to provide  evidence from books and records supporting the proper claim of IRD.
Although an IRS manager said that IRS would not collect data when the  available data are sufficient to enforce IRD, some other IRS officials  involved with audits said that additional, more accurate information on  items taxpayers use to calculate their deductions would be helpful. In  particular, the officials said that an automated system that taxpayers could  use to calculate their depreciation deductions based on the property class  and basis would be helpful. The officials pointed to the spreadsheets that  some large taxpayers attach to their returns as an example of a format that  would provide more useful information.
In addition to the possible tax enforcement challenges caused by being  unable to identify IRD users, data specifically on IRD compliance  problems found during audits do not exist. For example, examination  databases that track audit issues do not single out information specifically  on IRD. Thus, there is no readily available way to determine patterns of  noncompliance, if any, by IRD claimants from IRS examination records.  We know from our previous work, however, that depreciation is a  prominent audit issue, at least for individuals. According to figures from  IRS’s National Research Program (NRP), depreciation was one of the four  most misreported items by individuals filing business tax returns in 2001,  with 42 percent of those returns containing a depreciation error. NRP did  not systematically compile information on how often those errors involved  IRD.
section_title: IRD Offers Greater Potential for Tax Savings Than Regular Depreciation, Especially for Long- Term Investments
paragraphs: A taxpayer who depreciates property under the IRD schedule will be able  to make larger deductions in the near term than under the GDS schedule  for the same property, and the advantage of using IRD grows as property- class recovery periods become longer. For example, figure 2 shows that  for a hypothetical $50,000 property in the 3-year property class, the  present value (PV) of the cumulative deduction under IRD is $577—or 1.2  percent—more than the deduction permitted under the GDS schedule. In  contrast, the PV-adjusted deduction for a 39-year property (nonresidential  real property class) is $6,786—or 21.7 percent—higher for IRD than the  same property under GDS.
The extent of the tax savings depends on how much more quickly the IRD  property is depreciated relative to GDS recovery periods and how much  more valuable to the taxpayer current deductions are relative to future  deductions. The incentive to use the IRD schedule for shorter-life property  classes is relatively small compared to longer-life property classes because  the PV of the depreciation deduction does not increase as much for  shorter property classes as it does for property classes with longer  recovery periods. Additionally, the incentive to use IRD will vary by the  discount rate, which is the interest rate used to determine the PV of a  future stream of receipts or outlays. The larger the discount rate, the  greater the difference in cumulative deduction amounts for each property  class and the greater incentive there would be to use IRD.
The availability of bonus depreciation, which narrowed the difference  between cumulative IRD and GDS tax deductions, also could have reduced  the incentive to use IRD. For example, a $50,000, 20-year property under  bonus depreciation had a cumulative tax deduction value that was $1,901  higher in present-value terms under IRD than GDS. In comparison, the  difference between the two methods without bonus depreciation for the  same property was $3,802, or double the amount with bonus depreciation.  Although IRD still retained a relative advantage in cumulative tax  deduction PV, the smaller differences could have led more taxpayers to  invest outside reservations, given that other factors besides tax savings  influence decisions on where to invest.
section_title: Conclusions
paragraphs: We found no way to determine reliably from available data which  taxpayers use IRD, how much IRD investment is made, or whether the  provision is having a positive effect on Indians. The analytical and  oversight problems stemming from the lack of IRD data echo concerns we  have expressed about tax expenditures in recent years. As we have said  previously, information on tax expenditures is needed to evaluate their  effectiveness, but inadequate or missing data can impede effectiveness  studies of tax expenditures. IRD is a case in point. Without additional data,  it is impossible to know whether IRD is succeeding in having its intended  impact. Furthermore, with more than 100 programs on Indian economic  development, the potential exists for IRD overlap with these programs. As  we found with the bonus depreciation provision described in this report,  overlap from other tax expenditures could interfere with IRD as an  incentive.
Gathering and analyzing data that identifies IRD users and the location of  IRD property likely would increase administrative costs—perhaps  substantially, according to IRS—for IRS, as additional forms and  processing procedures would be needed. However, precedents exist for  IRS collecting this kind of information on other tax provisions, such as  depreciation of rental property and the low-income housing tax credit. In  cases where the right data exist, economic analysis is possible, although  still challenging.
Our review also raises questions about IRS’s ability to ensure compliance  with the IRD provision, a potentially key shortcoming given that  depreciation is one of the most misreported items by individuals with  businesses. Without the ability for auditors to identify IRD users from tax  forms, noncompliant taxpayers could more easily go undetected.  Improved information and instructions on the recovery periods taxpayers  use to calculate their depreciation deductions on Form 4562—a concern  given the mistakes listing recovery periods we observed on taxpayers’  returns—could help IRS auditors better ensure compliance not only of  IRD but also of all depreciation deductions.
section_title: Matter for Congressional Consideration
paragraphs: Given the lack of information on IRD users and where property claimed  under IRD is placed in service, Congress should consider requiring IRS to  collect information identifying which taxpayers use IRD and the  reservation and/or address where they have placed the property into  service. In deliberating additional requirements, Congress should weigh  the need for more IRD information with the associated costs of collecting  and analyzing the information as well as the effects on IRS’s other  priorities.
section_title: Recommendation for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue change the  instructions on the directions for Form 4562 so that it is clear that  taxpayers depreciating IRD property should use different recovery  periods. The updated directions also should include an example of how to  fill out Form 4562 properly.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested written comments from the Commission of Internal Revenue  and received a letter from the IRS on June 16, 2008 (see app. III). The IRS  generally agreed with our findings. Its letter emphasized that compiling  data on IRD would add burden to IRS administration of its processing  functions and increase taxpayer burden. IRS also said it would review its  publications and instructions on depreciation and determine where  additional information about IRD would be beneficial.
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section_title: Appendix I: Scope and Methodology
paragraphs: In attempting to identify and describe Indian reservation depreciation  users, we analyzed data from IRS’s Statistics of Income (SOI) database on  the corporate tax return (Form 1120), individual return (Form 1040),  partnership return (Form 1065), and the depreciation form (Form 4562)  for tax years 1998 through 2004. IRD has a unique recovery period  schedule and Form 4562 provides space for taxpayers to report the  recovery period. However, IRS does not compile this recovery period  information electronically. Therefore, we used information on  depreciation deduction and basis by property class from Form 4562 to  construct an algorithm for identifying IRD claimants by comparing the  depreciation they are required to claim on Form 4562 to the amount that  they claimed using all available methods and conventions. To limit error  from false positives to an acceptable level, we intended to identify  taxpayers as claiming IRD if the calculated amount was within 1 percent of  the actual amount that they claimed on the form. Our goal was to produce  estimates that represented a reasonable lower bound on the size of the  program.
After repeated sensitivity tests and refinements of the algorithm, we  concluded that the information reported on Form 4562 is insufficient to  determine which taxpayers are claiming IRD. Our analysis of the IRS data  showed that, in many cases, the amount of basis and depreciation did not  uniquely determine which recovery period was used by the taxpayer. The  reported depreciation and basis were consistent with both the IRD and the  regular General Depreciation System (GDS) depreciation recovery period  for the property class even when different methods and conventions were  used. Therefore, the number of claimants and the amount invested with  IRD cannot be determined accurately and completely from IRS data.
To analyze the effects of IRD, we reviewed previous GAO work on  economic development, and tax expenditures, including our 2005 report  on tax expenditures in general, as well as our work on individual tax  expenditures, such as the new markets tax credit and the empowerment  zone and community enterprise program. We discussed our objectives  with officials from IRS, which has data on depreciation and the U.S.  Department of the Interior’s Bureau of Indian Affairs to discuss business  on reservations. We had planned to use the SOI data to conduct an  analysis of IRD investment as an initial step in analyzing how IRD affects  economic development on Indian reservations. However, we determined  that available information was not sufficient for this purpose because we  could not identify all claimants of IRD.
To show the potential tax advantages for taking accelerated Indian  reservation depreciation, we calculated regular depreciation and  accelerated depreciation for the following properties: 3-year, 5-year, 7- year, 10-year, 15-year, 20-year, and nonresidential real property. Further  calculations included 30 percent bonus depreciation and 50 percent bonus  depreciation for both regular depreciation and accelerated depreciation.  We chose a basis value of $50,000 to determine the present value for all the  types of depreciation. To determine the present value (PV) for all the types  of depreciation, we chose the half-year convention. For 3-year, 5-year, 7- year, and 10-year property, we chose the double-declining balance method  switching to straight line method in the optimal year.  For 15-year and 20- year property, we chose the 150 percent declining balance switching to  straight line method in the optimal year. Nonresidential real property was  depreciated with the straight line method and midmonth convention as  required by IRS. The discount rate for each property class was derived  from the Federal Reserve’s report of (July 7, 2007) inflation-adjusted  interest rates for U.S. Treasury debt instruments of corresponding  maturities.
We conducted this performance audit from March 2007 through June 2008,  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: General Depreciation System Property Classes and Indian Reservation Depreciation Recovery Schedules
paragraphs: The following is a list of the nine General Depreciation System (GDS)  property classes and the corresponding Indian reservation depreciation  (IRD) recovery period schedule, along with examples of the types of  property included in each class.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Kevin Daly, Assistant Director;  Eric Gorman; Tami Gurley; Cheryl Peterson; Jennifer Neer; and Anne  Stevens made key contributions to this report.
section_title: Glossary
paragraphs: A measure of an individual’s investment in property for tax purposes.
subsections: section_title: Convention
paragraphs: A method established under MACRS to determine the portion of the year  to depreciate property both in the year the property is placed in service  and in the year of disposition.
section_title: Depreciation
paragraphs: The annual deduction allowed to recover the cost of business or  investment property having a useful life substantially beyond the tax year.
section_title: Placed in service
paragraphs: A term that means property is ready and available for a specific use  whether in a trade or business, the production of income, a tax-exempt  activity, or a personal activity.
section_title: Present value (PV)
paragraphs: The discounted value of a payment or stream of payments to be received  or paid in the future, taking into consideration a specific interest or  discount rate.
section_title: Property class
paragraphs: A category for property under MACRS that generally determines the  depreciation method, recovery period, and convention.
section_title: Recovery period
paragraphs: The number of years over which the basis of an item of property is  recovered.
section_title: Straight line method
paragraphs: A way to figure depreciation for property that ratably deducts the same  amount for each year in the recovery period. The rate (in percentage  terms) is determined by dividing 1 by the number of years in the recovery  period.
section_title: Useful life
paragraphs: An estimate of how long an item of property can be expected to be usable  in trade or business or to produce income.