Chap 9 Lecture Notes

Chap 9 Lecture Notes - 1Chapter 9 CAPITAL RECOVERY:...

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1Chapter 9 CAPITAL RECOVERY: DEPRECIATION, AMORTIZATION, AND DEPLETION LECTURE OUTLINE I. Introduction. A. Concept of capital recovery. 1. Income doesn’t occur until taxpayer recovers cost of producing income. 2. Examples. a. Sale of asset or inventory: compute gain by subtracting adjusted basis (which is a recovery of the taxpayer’s cost). b. Example: for assets providing indirect benefits, such as equipment, the cost is deducted or allocated to periods benefitted. B. Cost allocation methods. 1. There are three types of cost allocation; each of these is concerned with assigning the cost of an asset to one or more accounting periods. a. Depreciation is the term given to the process of allocating the cost of tangible assets, such as plant, machinery, and equipment. b. Amortization is the term given to the process of allocating the cost of intangible assets, such as patents, copyrights, and goodwill. c. Depletion is the term given to the process of allocating the cost of natural resources, such as oil, gas, minerals, and timber. 2. Methods in general. a. Straight-line. b. Declining-balance. c. Sum-of-the-years’-digits. 3. Accounting conventions: as discussed below, methods have been devised to deal with depreciation for partial periods. II. General rules governing depreciation for tax purposes. A. Statutory framework. 1. Section 167 provides general rule: taxpayers may deduct a reasonable allowance for the exhaustion, wear, and tear (including a reasonable allowance for obsolescence) of property used in the trade or business or held for the production of income. a. The problem of determining what in fact is a reasonable allowance for depreciation has been a constant source of friction between taxpayers and the IRS. 1. In the early years, the IRS was satisfied if the depreciation calculations (useful life and salvage value) were reasonable, given the “facts and circumstances.” 2. As time passed, however, the IRS attempted to deal with the abuse that could result from a systematic approach by merely understating the asset’s useful life and salvage value. Various systems were established by the IRS that the taxpayer could use in lieu of the facts-and-circumstances methods and know that his or her method would not be challenged: a. 1942: Bulletin F prescribed useful lives for literally thousands of assets, yet taxpayers were still free to establish their own useful life when they believed appropriate; b. 1962: Revenue Procedure 62-21 issued “Depreciation Guidelines and Rules,” providing useful lives 30-40 percent shorter than those in Bulletin F; c. 1971: § 1.167(a)-11 issued establishing Asset Depreciation Range (ADR) system allowing a taxpayer to elect a useful life from a range that was up to 20 percent shorter or longer than the guideline life. This system was made part of the law, § 167(m), by the Revenue Act of 1971 and referred to as the Class Life System (the names ADR and class life are often used interchangeably and sometimes are referred to as the
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This note was uploaded on 04/03/2012 for the course TAX 802 taught by Professor Angelini during the Spring '12 term at Suffolk.

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Chap 9 Lecture Notes - 1Chapter 9 CAPITAL RECOVERY:...

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