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Pinkston v. Commissioner (T.C. Memo. 2020-44)

On April 13, 2020, the Tax Court issued a Memorandum Opinion in the case of Pinkston v. Commissioner (T.C. Memo. 2020-44). The issue properly before the court in Pinkston was whether the IRS appropriately “recaptured” depreciation deductions that the petitioners claimed on rental properties prior to the years at issue, as to which years the limitation period had expired.

Background

In 2003 and 2010, the petitioners acquired two rental properties in Hawaii (a beach-front home and a condo), for which they claimed depreciation deductions under the Modified Accelerated Cost Recovery System (MACRS) established by IRC § 168. The IRS examined the petitioners’ returns and adjusted the depreciation deductions downward by reallocating a larger portion of petitioners’ cost basis to non-depreciable land (for the property purchased in 2003) and by reclassifying most of the petitioners cost basis into a MACRS class with a much longer recovery period (for the property purchased in 2010).

For purposes of the dueling motions for summary judgment, the petitioners do not challenge the adjustments as they affect 2012; instead they challenge the IRS’s invocation of IRC § 481 (adjustments required by change in accounting method) to “recapture” depreciation deductions that petitioners claimed for years before 2012, as to which the limitations period on assessment has expired pursuant to IRC § 6501. The petitioners contend that IRC § 481 is inapplicable, insofar as the IRS’s adjustments to their reported depreciation do not constitute a change in method of accounting within the meaning of both IRC § 446 and IRC § 481.

Aloha, Audit

The petitioners reported their rental real estate activity on Form 1040’s Schedule E (Supplemental Income and Loss). The petitioners allocated the home’s cost basis between the land ($400,000) and the balance ($1.2m) to land improvements, and they took according depreciation deductions. For the condo, the petitioners were a bit more creative. The basis in the condo was $2.7m, $28,000 of which was allocate to land, $2m of which was allocate to distributive trades and services, $4,000 of which was allocable to information services, and $600,000 of which was allocable to residential rental property.

The IRS examined the 2012 return and significantly reduced the reported depreciation deductions by reallocating basis to other more “appropriate” categories, whose depreciation schedules were much less favorable to the petitioners. Because of the reallocation and resulting change in depreciation, the 2012 depreciation deduction was reduced from $500,000 to $80,000.

Notwithstanding the rather high and tight haircut that the IRS gave the petitioners’ Schedule E, the IRS was not quite done yet. They were in Hawaii, they figured, so they might as well make the most of it. The IRS further concluded that its basis reallocations constituted, for all intents and purposes, a change in the petitioners’ method of accounting.

The IRS, therefore, decided to poke the IRC § 481 volcano, determining additional adjustments to petitioners’ income for 2012 equal to the difference between (a) previously claimed depreciation on the two rental properties, less (b) the amounts that the IRS would have allowed (in those previous years) consistent with its reallocations for 2012. The petitioners were not well pleased, and, stewing over a bowl of pork-n-poi, they invoked Queen Liliʻuokalani and Dylan Thomas in equal measure, refusing to go gently into that (good) Hawaiian night.

The Practical Limits of IRC § 446(a)

Taxable income should be computed under the method of accounting used by the taxpayer to keep its books. IRC § 446(a). The IRS has the statutory discretion to change a taxpayer’s accounting method in certain circumstances. IRC § 446(b). If the method of accounting used by the taxpayer does not clearly reflect income, the IRS will change the method of accounting to a method that, in their not so humble opinion, more clearly reflects income. Id. A taxpayer may change its accounting method too, but like Oliver Twist, the taxpayer must beg forgiveness and permission from the IRS, whose consent is necessary for the change.

The IRS, not content with being the arbiter of doling out porridge to orphans, which in my metaphor means controlling accounting methods, wanted to be able to retroactively adjust the orphans’ porridge allotment. (Ok, admittedly, this is where the metaphor quickly goes downhill.) The IRS, talking to Congress one day in 1954 over a Schlitz, raised the question of how it might be able to stick it to a taxpayer whose methods of depreciation had been improper for years outside of the statute of limitations, a period that IRC § 446 could not reach. Congress finished his beer, patted the IRS on the shoulder, and said that it would make a few calls. And that, dear reader, is how IRC § 481 was born.

As the IRS noted above, IRC § 446 does not apply to retroactive adjustments to a taxpayer’s liability for a year preceding the year of change. Further, the period of limitations may prevent the IRS from examining prior years to make adjustments that directly relate to an accounting method change made for the current year. See IRC § 6501; Suzy’s Zoo v. Commissioner, 273 F.3d 875, 883 (9th Cir. 2001), aff’g 114 T.C. 1 (2000).

Principals of Consistency, Retroactive Adjustments, and Application to Years at Issue

The principal behind IRC § 481 is consistency. The IRS does not like change. There was the then-infamous Swingline to Bostich stapler schism of 1985 that still quietly reverberates in the corners of the IRS to this day. Nevertheless, to the victor go the spoils, and there are very few who were around during the Swingline embargo who remember the anger, fear, and palpable tension of those times.

Similarly, when the taxpayer computes income in Year 2 under a different accounting method than it used in Year 1, the IRS has an institutional flashback to the hostilities of 1985 and clutches at IRC § 481(a)(2) like a security blanket, because that section permits the IRS to take into accounts any adjustments determined to be necessary in Year 1 because of the change in accounting method in Year 2. Practically, this look-back prevents amounts from being counted twice or omitted completely.

Like the 1986 Treaty of the East Breakroom which formalized the stapler détente (to the satisfaction of no one, especially the loyalists), the courts have found that IRC § 481, in practice, leaves many questions unanswered. Indeed, the Fifth Circuit want so far as to refer to IRC § 481 as “codified confusion.” See Grogan v. United States, 475 F.2d 15, 16 (5th Cir. 1973). What courts have settled on, however, is that IRC § 481 permits the IRS to adjust the amount of tax due in a year that a taxpayer changes its method of accounting, whether the change is voluntary or foisted upon the taxpayer by the IRS like a piece of broccoli on a picky toddler. Suzy’s Zoo, 273 F.3d at 883.

Because the statute affects closed years, courts have permitted the IRS to allow adjustments in prior (even closed) years to affect adjustments in the year at issue. Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965); see Suzy’s Zoo, 273 F.3d at 884; Rankin v. Commissioner, 138 F.3d 1286, 1288 (9th Cir. 1998), aff’g T.C. Memo. 1996-350; Huffman v. Commissioner, 126 T.C. 322, 341 (2006), aff’d, 518 F.3d 357 (6th Cir. 2008). Notwithstanding the fact that IRC § 481 applies to prior years, Congress did not intend it to be “a means to correct errors of past years.” German v. Commissioner, T.C. Memo. 1993-59, aff’d, 46 F.3d 1141 (9th Cir. 1995).

Practically, this means that changes that the IRS makes to a taxpayer’s method of accounting in Year 5 may affect Years 1-4. If it does affect Years 1-4, adjustments may be made, even if the statute of limitations are closed on such years. If adjustments are made in Years 1-4, and such adjustments affect Year 5, then IRC § 481 permits additional adjustments in Year 5.

Looking back to the Tax Court’s opinion in Pinkston, the petitioners took large depreciation deductions during 2003-2011 using the same depreciation methods reflected on their 2012 returns. Thus, if the Tax Court sustained the IRS’s change in the petitioners’ accounting method and sustained his adjustments regarding the 2012, the IRS would have the chance to adjust the 2003-2011 return, which 2003-2011 adjustments would be reflected in additional adjustments to the 2012 return.

Heightened Scrutiny when IRS Invokes IRC § 481

Can a taxpayer ever sleep at night with the specter of IRC § 481 retroactively adjusting returns from years before “who let the dogs out” was an innocent, practical question? To pacify the worrywarts out there, the Tax Court assures that it very “carefully examines” each instance in which the IRS invokes IRC § 481. Further pushing the IRC § 418 bogeyman out of the dreams of taxpayers, the Tax Court “places a premium” on distinguishing between a permitted change in accounting method and an impermissible “correction of errors.” See Huffman, 126 T.C. at 341-42. Finally, if the Tax Court permits a change in accounting method, it is obligated to ensure that the IRC § 481 adjustment has been made to compensate only for that change. Rankin, 138 F.3d at 1288. Thus, the Tax Court makes clear that IRC § 481 does not give the IRS carte blanche to reach back to the Chumbawumba years.

The Symbiosis of IRC § 481 and IRC § 446

What the taxpayer and IRS must remember is that IRC § 481 has no teeth but for IRC § 466. Only when the taxpayer’s accounting method is changed in the year at issue by application of IRC § 466 may IRC § 481 then apply the new accounting method retroactively. German, T.C. Memo. 1993-59; Treas. Reg. § 1.481-1(a)(1); Treas. Reg. § 1.446-1(e).

Erroneous Treatment of “Material Item” Rising to Level of “Method of Accounting”

The Tax Court has adopted the position that the erroneous treatment of an item rises to the level of a “method of accounting” only if the item is consistently (albeit erroneously) treated for two or more years.” Thrasys, Inc. v. Commissioner, T.C. Memo. 2018-199, *12-*13. Thus, a “change in accounting” includes a change in the treatment/reporting of an item (if such change is carried out in more than one year) from a previously adopted treatment. See Treas. Reg. § 1.446-1(e)(2)(ii)(a).

Thus, the Tax Court looks to periods of inconsistent treatment for “material items,” which are items that involve timing of inclusion of the item in income or the timing of taking a deduction with respect to that item. See Treas. Reg. § 1.446-1(e)(2)(ii)(a). In other words, an item is “material” if it concerns when, as opposed to whether, taxable income is affected. See Primo Pants Co. v. Commissioner, 78 T.C. 705, 722 (1982).

When an accounting practice postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, like depreciation, it involves the proper time for reporting income. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989); see also Rankin, 138 F.3d at 1288 (noting that an item is “material” when it affects the timing of reporting income or deductions, as opposed to “how much income is reported, or whether a deduction would ever have been appropriate”). A change in method of accounting, however, does not include correction of mathematical or posting errors, or errors in the computation of tax liability.” Treas. Reg. § 1.446-1(e)(2)(ii)(b). Neither does a change in the method of accounting include a change in treatment resulting from a change in underlying facts. Id.

“Materiality” in Pinkston

Both sets of adjustments to petitioners’ depreciation methods involve “material items” under the general principles of the regulations, because the depreciation methods at issue involve the proper time for taking a depreciation deduction. See Treas. Reg. § 1.446-1(e)(2)(ii)(a). Similarly, the reallocation of basis from depreciable property to non-depreciable land affects timing of deductions, though a bit less directly.

Because under the petitioners’ method of accounting (that is, their adopted depreciation schedules) they would take large annual depreciation deductions very quickly, rather than under the IRS’s proposed method which would spread out the deductions over a longer period of depreciation, even though the change in accounting method affects the value of the deductions, it also affects the timing of the deductions, and this is enough to implicate IRC § 446 (and in turn IRC § 481).

The change in accounting methods would similarly affect the timing of reporting income. This is true because petitioners’ method postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime.” See Wayne Bolt & Nut Co., 93 T.C. at 510; see also Treas. Reg. § 1.446-1(e)(2)(ii)(a).

By changing petitioners’ treatment, the IRS has not altered their lifetime ability to recover the full cost of the beach house; it has changed the timing of when (and how) that cost recovery will occur. In determining whether an item postpones or accelerates the reporting of income, the courts have generally assumed that relevant future events (such as sale of the property) will ultimately occur. See, e.g., Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 799 (11th Cir. 1984).

Although the petitioners argue that the change in accounting method is inappropriate because they involve only a recharacterization of the rental properties, the Tax Court is not persuaded. The Tax Court notes that in some situations the IRS’s recharacterization of an item may determine whether the item is taxable or deductible, Underhill v. Commissioner, 45 T.C. 489, 496 (1966), the changes proposed by the IRS change both the characterization of the properties (from land to rental real estate, for example), the changes also change the timing of the cost recovery. Thus “it makes no difference” (for purposes of IRC § 446) whether the changes also implicate characterization. The Tax Court’s primary focus is on the change in timing. See, e.g., Sunoco, Inc. & Subs. v. Commissioner, T.C. Memo. 2004-29.

The Final Nail in the Petitioners’ Coffin is Material

Saving the best for last, the Tax Court observes that notwithstanding all of the prior justification and case law that it provided to support its ultimate holding that the IRS was well within its statutory rights to change the petitioners’ method of accounting under IRC § 446, the Treasury Regulations speak directly to the issue. In Treas. Reg. § 1.446-1(e)(2)(ii)(d), “changes involved in depreciable or amortizable assets” are changes to accounting methods.

Not to be outdone by its coyness, the Tax Court observes that the Treasury Regulations set out the general rule that a change in the depreciation or amortization method, period of recovery, or convention of a depreciable or amortizable asset constitutes a change in accounting method.

Way to bury the lead 17 pages into a 23-page opinion, Judge Vasquez. Geeze.

There is a limited exception, but it only applies to IRC § 167 property (property used in trade or business or held for the production of income). This may implicate rental properties, but in Pinkston, the petitioners depreciated the assets under the IRC § 168 (MACRS) method; therefore, the Tax Court did not find that the exception applied.

Original opinion: (T.C. Memo. 2020-44) Pinkston v. Commissioner

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