Rev. Proc. 96-61: Correcting Depreciation Errors

Revenue Procedure 96-61 and its successors establish simplified IRS guidelines for correcting depreciation errors. These procedures provide an automatic consent process for taxpayers to switch from an impermissible to a permissible method of accounting for depreciation. The purpose is to streamline the correction of common mistakes made under the Modified Accelerated Cost Recovery System (MACRS). This framework allows taxpayers to fix certain errors without undergoing the lengthy and formal application process that would otherwise be required.

By offering an automatic change, the IRS reduces the administrative burden on both taxpayers and the government, providing a standardized pathway for resolution.

Scope and Eligibility for Automatic Change

An “impermissible method of accounting for depreciation” is any method not allowed by the Internal Revenue Code or its regulations for a specific property. This includes fundamental errors like using an incorrect recovery period or applying a method from a previous system, like the Accelerated Cost Recovery System (ACRS), to property under MACRS rules. If a taxpayer uses an incorrect method on two or more consecutively filed tax returns, they are considered to have adopted that impermissible method.

The automatic change procedures, updated annually and established by Rev. Proc. 2015-13, cover several specific changes. These include:

• Correcting the recovery period for an asset, for instance, changing a misclassified 15-year property to its correct 5-year recovery period.
• Treating a depreciable asset correctly after it was improperly classified as non-depreciable.
• Fixing an asset that was improperly expensed when it should have been capitalized and depreciated.
• Beginning to claim depreciation that was mistakenly omitted in prior years.

Certain situations fall outside this automatic procedure. A taxpayer cannot use it to change from one permissible depreciation method to another, such as from the 200% declining balance method to the straight-line method, without advance IRS consent. The procedure also does not apply to corrections of simple mathematical or posting errors, which must be fixed by filing an amended return. A taxpayer under an IRS examination may still file for an automatic change during specific window periods.

Calculating the Section 481(a) Adjustment

Correcting an accounting method for depreciation requires a Section 481(a) adjustment to prevent the duplication or omission of deductions. This adjustment represents the cumulative difference between the depreciation claimed under the incorrect method and the depreciation that should have been claimed under the correct method. The calculation is performed as of the beginning of the tax year in which the change is made, known as the “year of change.”

The first step is to re-calculate the total depreciation for the asset from the date it was placed in service up to the start of the year of change, using the proper method and recovery period. This determines the cumulative depreciation that should have been taken. The second step is to sum the total depreciation that was actually claimed on prior tax returns under the impermissible method.

The Section 481(a) adjustment is the difference between these two totals. For example, assume a taxpayer placed a $70,000 asset in service three years ago and incorrectly used a 7-year recovery period instead of the correct 5-year period. Under the incorrect method, they claimed $20,000 in depreciation, but under the correct 5-year period, they should have claimed $38,000. The adjustment is a negative $18,000 ($20,000 actual minus $38,000 correct), which represents under-depreciation. A positive adjustment occurs if too much depreciation was taken.

Completing and Filing Form 3115

To implement the change, a taxpayer must file Form 3115, Application for Change in Accounting Method. On the form, the taxpayer must provide details about the former (impermissible) and new (permissible) methods of accounting, along with the calculated Section 481(a) adjustment. There is no user fee for filing for an automatic change.

The filing process involves two steps. First, a copy of the completed Form 3115 must be mailed to the designated IRS processing center in Ogden, Utah. This copy must be filed no earlier than the first day of the year of change and no later than the date the original form is filed with the tax return.

The second step is to attach the original Form 3115 to the taxpayer’s timely filed federal income tax return for the year of change, including any valid extensions. If a taxpayer files the return on time but forgets to attach the form, a six-month automatic extension is available to file an amended return with Form 3115 attached. This extension is only granted if the taxpayer timely filed the original return and had already filed the required duplicate copy with the IRS by the original due date of that return.

Tax Treatment and Effect of the Change

The tax treatment of the Section 481(a) adjustment depends on whether it is positive or negative. A negative adjustment, which results from having claimed too little depreciation, is favorable to the taxpayer. The entire amount of a negative adjustment is deducted on the tax return for the year of change, providing an immediate tax benefit.

A positive adjustment, resulting from having claimed too much depreciation, increases taxable income. To ease the burden, this adjustment is typically spread ratably over a four-year period, beginning with the year of change. However, if the change is made while the taxpayer is under an IRS examination, this adjustment period is shortened to two years. If the total positive adjustment is less than $50,000, the taxpayer can elect to recognize the entire amount in the year of change.

A benefit of filing under this automatic procedure is receiving audit protection. This means the IRS cannot require the taxpayer to change their accounting method for the same depreciation item in a year prior to the year of change. This protection prevents the IRS from imposing changes and potential penalties for years before the taxpayer voluntarily corrected the error.