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IOWA DEPRECIATION - LAST SHOT AT SANITY

October 12, 2004

This afternoon the Iowa legislature's Administrative Rules Committee will consider the Department of Revenue's position on handling the change in depreciation deductions passed in last month's special session. The legislature retroactively adopted federal depreciation rules for property placed in service after May 5, 2003.

Most 2003 returns had been filed by the time the legislation was passed. The Department has taken the position that it must require all taxpayers affected by this rule to file amended returns, no matter how small the deduction change. We maintain that the Department can allow taxpayers to treat the change as an "accounting method change," which could be taken on 2004 returns -- saving taxpayers the time and expense of filing amended returns for small amounts of tax savings.

We have submitted a statement to the committee, which is reproduced below. We plan to attend the meeting at 2:45 pm in Room 116 at the Capitol. (UPDATE: go here to see how this adventure went.)

The Department lacks good statistics on how many taxpayers will be affected. We did some estimating of our own based on federal filing statistics. Our guess is that the Department would save taxpayers over $30 million in unnecessary return preparation costs by allowing taxpayers to treat the change as a change in accounting method. The statistics used to arrive at the $30 million compliance cost estimate may be found here.

Our submission:

Administrative Rules Committee
Statehouse
Des Moines, IA 50319

Re: Rules relating to depreciation method changes

Greetings:

The retroactive change in Iowa’s depreciation rules presents a unique challenge to Iowa’s taxpayers and tax administrators. We are aware of no similar legislative change that affected a tax year for which most returns were already filed.

The Department of Revenue is considering whether the only way to implement this retroactive change in the tax law is to require all affected taxpayers to amend their 2003 returns. This is clearly a poor result from a policy standpoint. The only issue is whether it is dictated by statute.

The Department’s legal team appears to believe that amended returns are the tool available under the law to comply with the legislative change. Their position appears to be that because the Iowa statute lacks specific authorization for any other treatment of the change in depreciation rules, amended returns are required.

Stakes

The economic and policy stakes are high. The cost of re-preparing and re-filing thousands of business and personal returns is, on a statewide basis, a multi-million dollar proposition. I think a total compliance cost of $30 million is a conservative estimate – assuming taxpayers actually all try to comply with the law by filing amended returns. In many cases, taxpayers will find the cost of compliance prohibitive and simply remain out of compliance. As a matter of principle, it is unwise to adopt a course with compliance costs that are economically indefensible – especially when there is no discernable policy justification to begin with.

The Department also faces the burden of processing a flood of amended returns in the face of staff reductions. Processing amended returns necessarily diverts resources away from other needs.

Given such costs, the Department has a moral burden to justify such a policy with an ironclad legal argument. The Department has yet to make such an argument.

Preferred Solution: Accounting Method Change

Federal tax law has long considered depreciation to be a “method of accounting.” Federal rules require that accounting methods may be changed prospectively with IRS permission. An IRS revenue procedure, Rev. Proc. 2002-9, permits taxpayers to change depreciation methods automatically without amended returns if certain disclosures are made with the tax return for the year of change.

By permitting (not requiring) taxpayers to adopt Rev. Proc. 2002-9 with respect to their Iowa depreciation, taxpayers could bring their depreciation deductions into compliance on their 2004 returns. This would eliminate the need for them to pay for the preparation of an amended return, permitting such taxpayers to make the change on a return they will be filing anyway.

Departmental Authority to Treat Depreciation Change as Accounting Method

The Director of the Department of Revenue has the following mandate (Iowa Code Sec. 422.68):

The director shall have the power and authority to prescribe all rules and regulations not inconsistent with the provisions of this chapter, necessary and advisable for its detailed administration and to effectuate its purposes.

This is not a narrowly-drafted authority. The duty of “detailed administration” is no less than what is normally delegated to an executive agency by a legislature. The charge “to effectuate its purposes” contemplates an executive with more than a paint-by-numbers approach to a complex area of the law.

The Director has promulgated a rule applicable to the depreciation problem. IAC Section 701-41.2(422) provides:

   In determining whether “taxable income,”
   “net operating loss deduction” or  any 
   other deductions are computed for 
   federal tax purposes under, or have 
   the same meaning as provided by, the 
   Internal Revenue Code of 1954, the 
   Department will use applicable rulings
   and regulations that have been duly 
   promulgated by the commissioner of 
   internal revenue, unless the director 
   has created rules and regulations or 
   has exercised discretionary powers as 
   prescribed by statute which calls for 
   an alternative method for determining 
   “taxable income,” “net operating loss 
   deduction” or any other deduction, or 
   unless the Department finds that an 
   applicable internal revenue ruling or 
   regulation is unauthorized according 
   to the Iowa Code.  (Emphasis added).

This regulation has been used to permit Iowa-only changes in accounting method, even when the resulting change to taxable income is not enumerated in Iowa Code Sections 422.7 or 422.35. For example, in a policy letter dated May 16, 1989, this regulation is cited as authority to apply federal rules on accounting method changes to municipal bond income accrued but unpaid as of the date on which a bank changes from cash-basis accounting to accrual accounting. If the Director can approve an Iowa-only method change in that instance, he can do so for the HF 2582 changes.

In short, the Director’s inherent authority to administer the tax law prudently “to effectuate its purposes,” his acknowledged authority to use federal rules in applying the law to Iowa income, and the specific precedent of the municipal interest accounting method change all illustrate the Director’s authority to authorize Iowa-only accounting method changes.

Another Perspective.

It may be instructive to review a hypothetical example. Iowa has a tax law provision governing “speculative shell buildings.” Such buildings are generally subject to a 39-year depreciable life for federal purposes, but may be depreciated over a 15-year life on Iowa tax returns.

If ten years after a $1.5 million building is placed in service, the department determines that it fails to meet the definition of “speculative shell building,” the statute of limitations has expired on 7/15ths of the depreciation for the building, or $700,000. The proper depreciation for this period would only $269,230. The only way for the Department to “make up” the difference would be to treat the depreciation as an “accounting” method, and to take the $430,770 excess depreciation otherwise lost to the statute of limitations is through an accounting method adjustment.

It is difficult to imagine that the Director would deny himself the authority to impose an accounting method change in such a circumstance, even though such a method change is not specified in Sections 422.7 and 422.35. Such authority is inherent in the Director’s administrative responsibility – as it is in the case of the HF 2581 depreciation adjustment.

I look forward to discussing this issue further with you.

Sincerely,

Joe Kristan, CPA

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