Report calls for changes to antiquated tax
depreciation laws that cheat today's businesses
By Kay Bell • Bankrate.com

Spreading the cost of an expense over several tax years, known as depreciation, often can help a business's bottom line.

But it is at best a complicated and time-consuming exercise. Worse yet, the current system to figure depreciation is woefully outdated, limiting its usefulness for today's business taxpayers.

That's the determination of the U.S. Treasury Department, the parent agency of the Internal Revenue Service, in a report requested by Congress in 1998 seeking "more rational" ways to structure the tax depreciation system. Two years, 132 pages and 367 footnotes later, Treasury analysts confirmed the shortfalls of the system that business owners have been dealing with for years.

Now the question business owners -- from major manufacturers to small-business operators to sole proprietors -- want answered is, "What is going to be done about the depreciation system?"

In the short-term, Congress acknowledges, probably nothing. But in a legislative climate where tax simplification is the mantra, there is general support from tax-writing leaders to update the system. At issue is when that will happen and whether attempts to fix the depreciation structure could produce even more problems.

Decades-old foundation
A key finding of Treasury analysts: Modern business technologies are continually outpacing the tax system. That's because the foundation of today's depreciation system was based on estimates of how long property would last in the late 1950s.

Depreciation is a deduction allowed for the wearing away over time of such items as office equipment, vehicles, buildings and furniture. For tax purposes, the IRS determines the amount of time such material is expected to last and taxpayers depreciate, or spread the cost of, the asset over its estimated useful life rather than deducting the entire cost in the year it was purchased.

The system determining how long an asset should last -- what the IRS calls an item's class life -- was created in 1962, using data from earlier tax years. It was adjusted in 1971 and tweaked again in 1981. Then came the Tax Reform Act of 1986, which the following year assigned property to asset categories that reflected, in a general way, the differences in class lives.

Some adjustments have followed in the last 13 years, but well over half the current class lives still date back at least to 1962, and most small business owners find their depreciable property falls primarily into two categories:

Outdated and ambiguous system
While a seven-year life span for office furniture is reasonable, many business operators find a five-year depreciation schedule ludicrous for computers in today's high-tech world. Many systems are useless within that time frame, depreciation critics say, meaning capital investment is sometimes limited to the amount that the IRS allows businesses to write off in a single tax year. This capital investment approach may help on tax filing, they argue, but it's not necessarily a business's best long-term investment decision.

The Treasury study agrees.

"Over the past 20 years, entirely new assets and industries have sprung up, while technological changes have substantially modified many other assets," according to the report. "It is not clear how relevant 20-year-old depreciation estimates are to these new types of capital investments."

And modifications to the depreciation system over the decades have just added to the confusion.

Depreciation changes and additions, made under slightly different tax laws through the years, have resulted in ambiguous depreciation classes, according to the report. In addition to being an administrative nightmare -- for businesses and the IRS -- this ambiguity produces conflicts with taxpayers.

For example, the report notes that the IRS might view electrical wiring and junction boxes for specialized equipment as part of a building to be depreciated. The taxpayer, however, could argue that since the electric system is needed specifically to operate special equipment, it should be depreciated separately and more quickly.

Remedies produce new problems
But while Treasury analysts, business owners and many in Congress agree that the depreciation system is rife with problems, there's no clear-cut solution. In fact, the Treasury report warns that changing the current system poses "serious practical problems."

The popular proposal to index depreciation deductions for inflation could promote more uniform investment taxation, according to the report, but it would cost the federal government tax dollars. Plus, it would complicate the tax system by requiring annual adjustments in depreciation allowances.

And without corresponding inflation adjustments for interest deductions, the report says, indexing depreciation could lead to "undesirable tax shelter activity."

Better long-range prognosis
Given the complexity of the depreciation system and the numerous concerns raised by Treasury, businesses shouldn't expect any near-term depreciation help from Congress.

Lawmakers had expected the report in March instead of July. It's now too late in the Congressional session, say House and Senate tax committee spokesmen, for the tax writers to incorporate any of the report's findings in session-ending legislation.

But many in Congress say substantive changes in how business assets are depreciated is an attainable long-range tax goal.

Hearings and bills to address some of the bigger depreciation problems are likely next year. And some tax observers predict there's "a fairly good chance" that the 2001 Congress will adopt at least part of the Treasury report's recommendations.

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-- Posted: Aug. 17, 2000