Opinion ID: 545550
Heading Depth: 2
Heading Rank: 1

Heading: Reasonableness of Depreciation Allowances

Text: 8 Section 167(a) of the Internal Revenue Code allows a deduction for a reasonable allowance for exhaustion [and] wear and tear of property used in the taxpayer's trade or business. Section 167(b) authorizes the use of three widely recognized depreciation methods: straight line, declining balance (commonly referred to as double declining balance), and sum of the years-digits. In addition, section 167(b)(4) allows the use of 9 any other consistent method productive of an annual allowance which, when added to all allowances for the period commencing with the taxpayer's use of the property and including the taxable year, does not, during the first two-thirds of the useful life of the property, exceed the total of such allowances which would have been used had such allowances been computed under the method described in paragraph (2) [the double declining balance method] (emphasis added). 10 Carland relies upon section 167(b)(4) for its use of the income forecast method in this case. 11 We need not address the Commissioner's argument that the income forecast method is never an appropriate method for depreciating assets subject to normal wear and tear. 5 In this case it is plain that Carland's use of the income forecast method consistently resulted in unreasonable depreciation allowances which exceeded those permitted by section 167(b)(4). Thus, the Tax Court did not err in rejecting Carland's use of the income forecast method and in disallowing Carland's depreciation computations. 12 As the Tax Court recognized, the fundamental defect in Carland's depreciation method is that it erroneously assumes that the useful life of leased equipment is in all cases approximately equal to the primary term of the lease. This assumption might well have been correct if Carland had engaged in a regular practice of regaining possession of equipment and retiring it at the end of the primary lease term. However, the facts clearly show that Carland did not do this. Carland leased a large portion of its equipment for the full 8-year period covering both the primary and renewal periods. 6 In many instances Carland leased equipment for periods well beyond 8 years. Thus, there was very little correlation between the relatively short primary lease periods and the actual service lives of the leased assets. Carland's use of the income forecast method was unreasonable because it artificially shortened the cost recovery period of Carland's assets, enabling Carland to accelerate depreciation beyond what section 167(b)(4) allows. 13 Carland's unreasonable acceleration of depreciation can be demonstrated by applying the test of section 167(b)(4) to a unit of rolling stock, even assuming that the rolling stock had an 8-year useful life as Carland contends. 7 Computed under the double declining balance formula, the annual depreciation allowances for a $10,000 unit of rolling stock with an 8-year useful life and no salvage value would be as follows:As this table shows, the accumulated allowances that would have resulted from applying the double declining balance formula over the the first two thirds of the asset's useful life (5.33 years) would have been equal to 76 to 82 percent of cost. By contrast, Carland's method of tying depreciation to rental income enabled it to recover over 95 percent of the asset's cost over the same length of time. When the § 167(b)(4) test is applied to other asset classes similar results appear. Therefore, the Tax Court was correct in concluding that Carland's use of income forecast method was improper. 8 14 Carland argues, however, that it is entitled to use the elective class life system (known as the Class Life Accelerated Depreciation Range or CLADR) authorized by section 167(m) in applying the reasonableness test of section 167(b)(4). Carland has submitted a comparison sheet purportedly showing that the depreciation it claims for certain types of equipment 9 is less than the amount that would have resulted from using CLADR class lives, which are shorter than the actual useful lives found by the Tax Court. Therefore, Carland urges, depreciation deductions taken for these particular assets should be deemed allowable under section 167. 15 The Tax Court rejected this argument on the ground that Carland had not made the election required by section 167(m), and we agree with that conclusion. Carland's argument is essentially that a taxpayer who fails to make a timely election of the CLADR system should nevertheless be entitled to benefit from that system by showing that its depreciation method produces allowances that do not exceed those that would have resulted from that system. This, however, would render section 167(m)'s election requirement meaningless. Congress authorized the CLADR system at least in part to avoid the very kind of dispute about useful lives that exists in this case. See H.R.Rep. No. 533, 92d Cong., 1st Sess., reprinted in 1971 U.S.Code Cong. & Admin.News 1825, 1847. Because Carland failed to elect into the CLADR system it must base its depreciation method on reasonable estimates of actual useful lives; these actual useful lives must also be used in applying the § 167(b)(4) test. Accordingly, the Tax Court did not err in refusing to evaluate the reasonableness of Carland's depreciation method using the CLADR.