The ACE depreciation adjustment - coping with "simplification." (adjusted current earnings)by Gaffney, Dennis J.
In computing alternative minimum taxable income (AMTI) for tax years beginning after 1986 and prior to 1990, one-half of the amount by which the corporation's pre-tax book income exceeded AMTI, determined without regard to the "book income adjustment" and any NOLs, was added to the otherwise computed AMTI. TRA 86 provided that for tax years beginning after 1989, the corporate book income adjustment would be replaced with an adjustment based on adjusted current earnings (ACE). Hence, most corporate taxpayers must compute ACE for tax years beginning after 1989. In general, AMTI is increased by 75% of the amount by which ACE exceeds AMTI, determined without regard to the ACE adjustment and any NOLs.
The Revenue Reconciliation Act of 1989 (RRA 89) subsequently made a number of significant changes to corporate AMT. One purpose of RRA 89 modifications was to "simplify the ACE computation." This article examines the changes in the computation of ACE depreciation and provides examples of required computations. It also deals with portions of the proposed regulations under Sec. 56 issued in May 1990. The computations presented in this article suggest that ACE depreciation adjustments may be larger than many taxpayers have anticipated. Indeed, the magnitude of the adjustment for five-year ACRS property in the last year of its regular tax depreciation life can be staggering (see Example 3). The ACE depreciation adjustments may generate unexpected AMT liabilities, and corporate taxpayers are well advised to review their estimated tax payments to avoid significant interest and underpayment penalties.
While one purpose of RRA 89 was to simplify the ACE computation, the post-RRA 89 ACE depreciation adjustment is nonetheless complex. For example:
* For most corporate taxpayers, depreciable property must be subdivided into five groups for ACE calculation purposes.
* The ACE computation is virtually unaffected by MACRS realty. But the computation is significantly affected by ACRS realty.
* For depreciable property other than realty, one calculation is required for ACRS property but another, and possibly two, are required for MACRS property.
* All corporate MACRS property has four bases when calculating the corporate tax liability.
* Most corporate ACRS property has three bases when calculating the corporate tax liability.
The complexity remaining after RRA 89 is illustrated in a series of examples using relatively simple facts.
ACE DEFINITION AND
Secs. 56(g)(1) and (2) provide for an ACE adjustment in computing AMTI in tax years beginning after 1989. 1 Prop. Reg. Sec. 1.56(g)- (1)(a)(5)(i) contains the following definition:
"Pre-adjustment AMTI is the AMTI of the taxpayer for the taxable year, determined under Sec. 55(b)(2), but without the adjustment for ACE and without the alternative tax NOL deduction under Sec. 56(a)(4)."
Prop. Reg. Sec. 1.56(g)-(1)(a)(5)(ii) then defines ACE as pre- adjustment AMTI "adjusted as provided in this section and in
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section 56(g)." Sec. 56(g)(4)(A) provides for five depreciation adjustments in determining ACE. Note that the adjustment for AMT depreciation purposes is not the same as the ACE depreciation adjustment. Thus, corporate taxpayers must compute a depreciation adjustment for AMT purposes and, in most cases, a second depreciation adjustment for ACE purposes.
To deal with the complexity wrought by "simplification," a workable solution is required. The three time lines in Figure 1 summarize the periods for application of the rules for: 1) MACRS property; 2) ACRS property; and 3) property depreciated outside ACRS or MACRS. These time lines direct the reader to the appropriate property group narratives and examples which follow.
Property Group I
Property Group I consists of all properties subject to ACRS and MACRS placed in service in a tax year beginning after 1989. 2 Under ACRS transition rules, property with a class life of at least 20 years and real property meeting specified criteria that is placed in service after 1986 and before 1991 may still qualify as ACRS property. 3
The ACE depreciation deduction for Property Group I is computed under the Alternative Depreciation System (ADS) of Sec. 168(g). ADS depreciation is computed using the straight-line (SL) method and no salvage value. The ADS recovery period for most property is detailed in Rev. Proc. 87-56. 4 The applicable convention for non-residential real and residential rental property is the mid-month convention. For all other property the required half-year or mid-quarter convention is employed.
Example 1. ECA, Inc., a calendar year C corporation, placed $800,000 of 5-year property (7-year class life) and a $1 million commercial building (31.5-year asset) into service on April 10, 1990. These were the only assets placed in service in 1990. For 1990, ECA's regular taxable income is $210,000 after deducting regular tax depreciation on the above properties. ECA has a regular tax liability of $65,150 and no AMTI adjustments, AMTI preferences, or ACE adjustment items other than those related to the two assets placed in service in 1990. Three depreciationi calculations are necessary to calculate ECA's 1990 AMTI and ACE, using data shown in Figure 2.
ECA's 1990 pre-adjustment AMTI and ACE are calculated (shown in Figure 3) to arrive at ECA's AMTI for 1990. ECA's tentative AMT for 1990 is $62,104 (AMTI of $310,520 x .2). 5 ECA will not owe any corporate AMT for 1990; $62,104 is less than ECA's $65,150 regular tax liability. However, if ECA has other AMT or ACE adjustments, it could easily incur a corporate AMT liability for the year.
Property Group II
Property Group II consists of properties subject to MACRS that were placed in service in a tax year beginning before 1990. Properties excluded from MACRS
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under paragraphs (1), (2), (3), or (4) of Sec. 168(f) are also excluded from this group (see Property Group V). Also excluded from Group II are properties excluded from the MACRS by virtue of Sec. 168(f)(5)(i), relating to certain churning transactions. 6
The ACE depreciation for Group II properties is based on the following formula:
Property Group II ACE Depreciation = Adjusted Basis of the Properties for AMT Purposes at the Close of the Last Tax Year Beginning Before 1990/Remaining Recovery Period Applicable to the Properties Under the ADS of Sec. 168(g)
In computing the numerator of this formula, the adjusted basis is that determined for AMT purposes. Because 150 DB or SL depreciation (for realty) is used for AMT purposes, the AMT basis will usually be larger than the regular income tax adjusted basis of the property. Furthermore, once determined, the numerator is the same throughout the remaining ADS recovery period.
Example 2. Continuing the facts of Example 1, assume ECA had placed two additional depreciable properties in service in 1988. For ease of illustration, assume the correct regular tax depreciation on these properties (i.e., the assets placed in service in 1988) for 1990 was deducted in calculating the $210,000 taxable income. The additional properties are: 1) a
$500,000, 7-year MACRS property (with a class life of 10 years) placed in service on January 20, 1988; and 2) a $1,200,000, 31.5-year MACRS real property placed in service on March 3, 1988. The regular income tax and the AMT depreciation deductions for the years 1988-1990 are shown in Figure 4.
The adjusted bases of the two properties for AMT purposes at the beginning of the 1990 tax year are shown in Figure 5.
For the 7-year property in Figure 4, the recovery period for ACE adjustment purposes is the 10-year ADS life. The remaining ADS recovery period at January 1, 1990 is 8.5 years--10 years with a half year convention subtracted for 1988 and a full year subtracted for 1989. Thus, the 1990 ACE depreciation for the 7-year property is determined as follows:
ACE depreciation = $393,100 (AMT basis)/8.5 (years per above) = $46,247
For the 31.5-year property in Figure 4, the recovery period for ACE adjustment purposes is the 40-year ADS life. The remaining ADS recovery period at January 1, 1990 is 458.5 months; 480 months less 9.5 months of depreciation in 1988 and a full 12 months for 1989. Thus, the 1990 ACE depreciation for the 31.5-year property is determined as follows:
ACE depreciation = $1,146,252 (AMT basis)/458.5 (months per above) x 12 = $30,000
ECA's 1990 pre-adjustment AMTI and ACE are calculated as shown in Figure 6 to arrive at ECA's AMTI for 1990.
ECA's tentative AMT for 1990 is $71,329 ($356,647 x .2). Thus, it incurs a corporate AMT liability for 1990 of $6,179 (the difference between the $71,329 AMT liability and the $65,150 regular corporate tax liability).
Property Group III
Property Group III consists of ACRS properties placed in service in a tax year beginning before 1990 and properties placed in service after 1980 and before 1987 that are excluded from the ACRS. To exclude ACRS transition properties (discussed under Property Group I) placed in service in a tax year beginning after 1989 from Property Group III, RRA 89 modified pre-RRA 89 Sec. 56(g)(4)(A)(iii). 7
ACE depreciation for Group III properties is based on the following formula:
Property Group III ACE Depreciation = Adjusted Basis of Properties for Regular Tax Purposes at the Close Of the Last Tax Year Beginning Before 1990/Remaining Recovery Period Applicable to the Property Under the ADS of Sec. 168(g)
In computing the numerators of this formula, the adjusted basis is that determined for regular tax purposes. This differs significantly from the numerator utilized for Property Group II.
In computing the denominator, Prop. Reg. Sec. 1.56(g)-1(b)(4)(ii) requires taxpayers to apply the ADS lives to properties placed in services at a time preceding the adoption of the ADS, which was introduced with MACRS in 1986. The specification of the lives "under Sec. 168(g)(2)" without a reference point (date) may also cause confusion due to the fact that several amendments to the original Sec. 168(g)(2) recovery periods were made by RRA 89 Act Secs. 1002(i)(2)(F), 6027(b)(2), and 6029(c).
Example 3. Continuing the facts of Example 2, assume ECA had placed two additional depreciable properties in service in 1986. Assume the regular tax depreciation on these properties (i.e., the assets placed in service in 1986) for 1990 was
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deducted in arriving at the $210,000 taxable income. The additional properties placed in service in 1986 are: 1) $600,000 of asset class 22.3 equipment (5-year ACRS property, 9-year class life) placed in service November 30, 1986; and 2) $1 million 19-year ACRS real property placed in service January 10, 1986. The regular income tax depreciation (as well as the SL depreciation for the real property) deductions for the years 1986-1990 are set forth in Figure 7.
The adjusted bases of the two properties placed in service in 1986 for regular income tax purposes at the beginning of the 1990 tax year are shown in Figure 8.
For the 5-year property in Figure 7, the recovery period for ACE adjustment purposes is the 9-year ADS life. The remaining ADS recovery period at January 1, 1990 is 5.5 years (9 years less a half year convention for 1986 and a full year for each of 1987, 1988 and 1989). Thus, the 1990 ACE depreciation for the 5-year property is determined as follows:
ACE depreciation = $126,000 (regular tax basis)/5.5 (years per above) = $22,909
For the 19-year real property in Figure 7, the recovery period for ACE adjustment purposes is the 40-year ADS life. The remaining ADS recovery period at January 1, 1990 is 432.5 months (480 months less 11.5 months depreciation in 1986 and a full 12 months for each of 1987, 1988, and 1989). Thus, the 1990 ACE depreciation for the 19-year property is determined as follows:
ACE depreciation = $683,000 (regular tax basis)/432.5 (months as above) x 12 months = $18,950
ECA's 1990 pre-adjustment AMTI and ACE are calculated as shown in Figure 9 to arrive at ECA's AMTI for 1990.
ECA's tentative AMT for 1990 in Example 3 is $93,901 ($469,503 x .2). Thus, it incurs a corporate AMT liability of $28,751 ($93,901 - $65,150, the regular corporate tax liability) for 1990.
Property Group IV
Property Group IV consists of all depreciable and amortizable properties placed in service before 1981. Thus, it includes depreciable and amortizable properties not eligible for either ACRS or MACRS because of the time they were placed in service. Prop. Reg. Sec. 1.56(g)- 1(b)(5)(i) makes it clear that properties excluded from both ACRS and MACRS by reason of pre-TRA 86 Sec. 168(e)(4) and post-TRA 86 Sec. 168(f)(5)(A)(i), the anti-churning provisions, are also included in Property Group IV. For this property group, the amount allowable as depreciation or amortization for purposes of computing ACE is "... determined in the same manner as used in computing taxable income." 8 Thus, there is no ACE depreciation adjustment for Group IV property.
Property Group V
Property Group V consists of properties placed in service after 1986 that are excluded from MACRS at the taxpayer's election under Sec. 168(f)(1)-(4), (e.g., property utilizing a unit-of-production method, videotape, and sound recordings).
Sec. 56(g)(4)(A)(v) provides that the amount of depreciation allowable on such property for purposes of the regular tax shall be treated as the amount allowable under the alternative system of Sec. 168(g).
Prop. Reg. Sec. 1.56(g)-1(b)(3) makes it clear that once the taxpayer had elected to exclude such properties from MACRS under Sec. 168(f), the regular tax depreciation deduction would also be used for purposes of computing ACE. In other words, there is no ACE depreciation adjustment for Group V property.
ACE ADJUSTED BASIS
There is a very significant additional complication resulting from the ACE depreciation adjustment. TAMRA 88 added Sec. 56(g)(4)(I). This provision states:
"(I) ADJUSTED BASIS. The adjusted basis of any property with respect to which an adjustment under this paragraph applies shall be determined by applying the treatment prescribed in this paragraph."
Example 4. Referring to the post-1989 properties described in Example 1, the properties will have three bases for purposes of calculating ECA's corporate tax liability as shown in Figure 10.
If the 31.5-year property in Figure 10 were sold, before allowing further depreciation, for its original cost of $1 million, a $22,490 ($1,000,000 - $977,510) gain would be included in regular taxable income. 9 However in calculating pre-adjustment AMTI, the includible gain would be $17,710 ($1,000,000 - $982,290). Thus a downward adjustment of $4,780 ($17,710 - $22,490) would be required to calculate pre-adjustment AMTI. For ACE purposes, the basis of the 31.5-year property is the same as that computed for pre-adjustment AMTI. Therefore, no adjustment to the amount of gain would be made to calculate ACE.
If the 5-year property were sold, (again before allowing additional depreciation)
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for its original cost of $800,000, a $160,000 ($800,000 - $640,000) gain would be included in regular taxable income. In calculating pre- adjustment AMTI, the includible gain would be $85,680 ($800,000 - $714,320). A downward adjustment of $74,320 ($85,680 - $160,000) would be required to calculate pre-adjustment AMTI. For ACE purposes, the basis of the property is $742,880. Thus, in calculating ACE, the includible gain would be $57,120 ($800,000 - $742,880). A downward adjustment of $28,560 ($57,120 - $85,680) is required to calculate ACE. Thus two basis adjustments are required, one to properly compute AMTI and a second to properly compute ACE.
Excluding any other AMT adjustments, preferences, etc., ECA's ACE for the year of sale would be calculated as follows, based on the foregoing facts.
Regular corporate taxable income, including $182,490 ($22,490 + $160,000) of regular tax gain from the above sales;
Deduct: Pre-adjustment AMTI gain adjustment of $79,100 ($4,780 + $74,320)
Equals: Pre-adjustment AMTI 10
Deduct: ACE gain adjustment of $28,560 ($0 + $28,560) 11
Equals: ACE 12
The MACRS property added in Example 2 (i.e., the property placed in service in 1988) would require computations similar to those of Example 4. However, for ACRS property the required calculations are significantly different; for ACRS property, the regular tax basis and the AMT basis are the same.
Example 5. Referring to the ACRS properties described in Example 3, the properties placed in service in 1986 will have two bases for purposes of calculating their corporate tax liability as shown in Figure 11.
If the 19-year property in Figure 11 was sold before allowing further depreciation 13 for its original cost of $1 million, a $380,000 ($1,000,000 - $620,000) gain would be included in regular taxable income. For purposes of calculating pre-adjustment AMTI, there is no adjustment for gain on the sale of ACRS property, as the basis is the same for both regular tax and AMT purposes. However, for ACE purposes, the basis of the 19-year property is $664,050. Thus, in calculating ACE, the includible gain would be $335,950 ($1,000,000 - $664,050). A downward adjustment of $44,050 ($335,950 - 380,000) is required to calculate ACE.
If the 5-year property in Figure 11 were sold for $200,000, a $200,000 ($200,000 -- $0) gain would be included in regular taxable income. 14 Again, no adjustment is made in calculating pre-adjustment AMTI for ACRS property. However, for ACE purposes, the basis of the property is $103,091. Thus, in calculating ACE, the includible gain would be $96,909 ($200,000 -- $103,091). A downward adjustment of $103,091 ($96,909 -- $200,000) is required to calculate ACE.
For tax years beginning after 1989, an ACE adjustment is required to compute AMTI for most corporate taxpayers. In this article, three time lines and five property groups have been used to summarize the required depreciation adjustments in computing ACE.
Several observations are in order:
* For realty subject to MACRS, the depreciation adjustment for ACE purposes is zero. This results from the fact that both the AMTI depreciation adjustment and the ACE depreciation calculation utilize a 40-year life and a SL method (see Example 1).
* The ACE depreciation adjustment for realty subject to ACRS may be substantial as either 15-, 18-, or 19-year 175 DB depreciation may be utilized for regular tax purposes, but 40-year SL is required for ACE purposes (see Example 3). Furthermore, this differential in the amount of depreciation can lead to substantial differences between the regular tax adjusted basis for the property and the ACE adjusted basis (see Example 5).
* For ACRS property other than realty that is not fully depreciated prior to a tax year beginning after 1989, the mandatory use of the ADS for ACE purposes will also lead to substantial differences between
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regular tax and ACE depreciation (see Example 3) and also leads to substantial differences between the regular tax and the ACE adjusted basis (see Example 5).
The advent of ACE requires most corporate taxpayers to calculate depreciation at least four ways for tax purposes. Depreciation must be computed for: 1) regular tax purposes; 2) AMTI adjustment purposes; 3) ACE adjustment purposes; and 4) for E&P purposes. Furthermore, each of these calculations, results in a different basis for income tax purposes.
1 Unless noted to the contrary, all references to a "Section" or "Sec." refer to the Internal Revenue Code of 1986 as amended through December 1990.
2 See Sec. 56(g)(4)(A)(i) before RRA 89 for prior wording.
3 See TRA 86 Sec. 203(a)(1)(A) for a description of this property.
4 1987-2 C.B.674.
5 Corporations with AMTI exceeding $310,000 are not entitled to any of the $40,000 AMT exemption.
6 Prop. Reg. Sec. 1.56(g)-1(b)(2)(i).
7 See pre-RRA 89 Sec. 56(g)(4)(A)(iii) for prior wording.
8 Prop. Reg. Sec. 1.56(g)-1(b)(5).
9 This specification is made to simplify the calculations. Under the MACRS conventions, additional depreciation must be computed even if the property were sold on January 1, 1991.
10 This simplified computation excludes all the other preferences and adjustments required to compute pre-adjustment AMTI. Only the pre- adjustment AMTI gain adjustment is included.
11 Under Sec. 56(g)(2), a negative adjustment is limited to the aggregate positive adjustments made to pre-adjustment AMTI in the current and prior years less any prior negative adjustment.
12 This simplified computation excludes all the other adjustments required to compute ACE. Only the ACE gain adjustment is included.
13 This specification is made to simplify the calculations. Under the ACRS conventions for real property, additional depreciation must be computed even if the property were sold on January 1, 1991.
14 This property is fully depreciated for regular tax purposes at the end of 1990.
Brian L. Laverty, PhD, CPA, is Associate Professor of Accounting and Taxation at The University of Toledo.
Dr. Laverty was engaged in public practice with Danielson, Shultz & Co., P.C. in Lansing, Michigan. He has served as a discussion leader for various house programs for accounting firms, the Kansas Society of CPAs, NYSSCPA, AICPA, and for several MACPA Tax Training programs.
Dennis J. Gaffney, PhD, CPA, is Professor of Accounting and Chairperson of the Accounting Department at The University of Toledo. Professor Gaffney has engaged in public practice with Haskins & Sells and Ernst & Ernst. He is the co-author of several federal tax textbooks and has contributed to numerous tax periodicals.
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