Someone once said that the sure cure for insomnia is to call the accountant's hotline and have someone explain what depreciation is. While this may be true for some, for others it is quite a different matter.
In many family law cases it is sometimes automatic that the courts tend to add back, or disallow depreciation as an allowable expense in the calculation of income available for child and spousal support. This has been done for both pendente lite and permanent support calculations. While this may be appropriate in some instances (see discussion below) there can be many times when such an exercise creates a fallacy and lack of economic reality for the payor spouse. This article discusses what depreciation is, why it is, and some viewpoints on how the courts should consider it.
Depreciation is often confused with the valuation of an item. A car, for example, once driven off the lot depreciates in value because it is now used. It is therefore worth less than it was. The measurement of the difference between the value before and after would be the amount it has depreciated. In accounting and tax however, depreciation has an entirely different meaning. It is essentially a method of cost allocation, not valuation. More insight can be gained by examining the different definitions and concepts in the following areas:
Income tax depreciation
There was a significant change in how a taxpayer could depreciate assets placed in service after 1986. Prior to that time a taxpayer had several methods to choose from and even had such things as "bonus depreciation" and "investment credits." They were based on estimated useful lives and even included concepts such as salvage value. The methods available included:
Straight-line or fixed percentage method
Double declining-balance method
Sum-of-the years digits method and
Other consistent methods
I believe it best to spare the reader the definitions of the above methods at this time in the interest of safety. Someone could be reading this article to you while driving or using heavy equipment, and I would not want to be responsible for the possible lead-weighted eyelids and concomitant danger. What is important to note is that there was a change in the methods for assets placed in service after 1986. There was a shift from "estimated useful lives" to a concept of "recovery period."
The concept of recovery period began in the Reagan era and was designed to help businesses and other taxpayers recover the cost of the depreciable assets on a more rapid basis. This was done in the hopes of reducing taxes and therefore giving more money available for expansion and generally encouraging investment in these types of assets. The method involves the recovery of the cost of an asset over statutory defined periods. Currently, this method is referred to as the Modified Accelerated Cost Recovery System (MACRS). While the statutory periods have changed over the years due to tax law changes, the categories currently available to a taxpayer are as follows:
- 3 Year Property
- 5 Year Property
- 7 Year Property
- 10 Year Property
- 15 Year Property
- 20 Year Property
- 27.5 Year Property
- Non-residential Real Property
- Indian Reservation Property
There are even special rules on automobiles and "listed property." Again, in the interest of safety, I will spare the reader the definitions of the above categories and the many special rules about when the property was placed in service. The reader needs only to know that the cost of an asset will be allocated over the specified periods above and referred to on the income statement as depreciation.
Oh, there is one more thing you should know about the depreciation rules. That is something known as Section 179 expense. The reference is to the Internal Revenue Code § 179 and was designed primarily as a tax benefit to small businesses. Essentially it is an option for the taxpayer to treat the acquisition of a depreciable asset as an expense rather than a capital expenditure. The amount is limited and can be phased out if you acquire assets over a specified amount. For 1999, for example, the Section 179 expense is limited to $19,000.00 and if you acquire assets in excess of $200,000.00 you reduce the maximum amount dollar for dollar for amounts purchased in excess of the $200,000.00. There are special rules for "enterprise zone" businesses.
Generally Accepted Accounting Principles (GAAP) approach depreciation in a slightly different manner. It is still the allocation of the cost of an asset over a specified period, but it is based on an accounting theory known as the "matching concept." This concept stands on the premise of matching revenues with the expenses incurred to generate that revenue. If an asset has a useful life of greater than one year, it will generally be expensed (depreciated) over its estimated useful life. It is similar to the method described above for assets placed in service prior to 1987.
Not much more really needs to be said for accounting depreciation other than it is still a method of allocating the cost of an asset over a specified period.
Many small businesses adopt tax depreciation as their accounting depreciation as being the same number. While technically it is not GAAP depreciation, it is often mistaken as such. The distinction is in the method of accounting shown at the top of the income statement. There are many other methods of accounting that are not GAAP full accrual. Some of them are:
Income tax basis of accounting
Cash basis method of accounting
Modified cash basis of accounting
Generally speaking, accounting depreciation is only found in larger businesses because of the cost of maintaining different calculations for tax and accounting purposes. It is also thought of as a normal reserve or sinking fund for the eventual replacement of assets.
The primary expressed reason for not permitting depreciation as an allowable expense in determining income available is because of the belief that depreciation is not an item requiring the outlay of cash during the period. Well, this may or may not be true. Remember, a check may in fact be written, but the IRS does not allow it to be written off in one period (See § 179 expense exception above). What needs to be done is to take an in-depth look at the economic reality of what is happening for each specific circumstance.
Clarity of the problem can best be described with two extreme, but real life, examples. Everything else is somewhere in-between and commands proper analysis. The two examples are:
The rental property
The capital intensive business
Often times an income generating asset can be a piece of rental property. It also is common for the rental property to be rented to a related business on what is known as a triple-net lease to the business. This means that owners may have no expenses that they personally spend. The lease would require the lessee to pay for items of real estate taxes, insurance and maintenance. In analyzing the cash flow from the property it may be that the only expense offsetting the income is depreciation. If there is debt on the property you will most likely have interest as the only other offset for income tax purposes. In that case a further examination should be made to determine the normal principal reductions on the loan to complete the determination of the cash flow from the property. Just adding back depreciation to the income available is only one-half of the equation to get to cash flow.
In this example, it would be proper to ignore depreciation as an expense necessary to determine income available for support purposes.
The capital intensive business
Assume for the moment that the business before the court is a Taxicab business. The business owns a fleet of taxis and, as a result, has a figure for depreciation on the income statement, which is the same as the company uses for income tax purposes. As one can imagine, the taxis get worn out and get replaced on a regular basis. If one was to add back depreciation in this instance, an economic fallacy is created. The company spends money on a regular basis (writes a check), but it is only because of the tax law that they cannot recognize it as a current expense (See § 179 expense exception above).
What should be done in this instance is to examine the following:
Projections of the company's plan for future replacement of taxis
Company's history of asset expenditures
Comparison of depreciation figures shown in the income statement to the first two items above
If it is determined that the depreciation figure shown on the income statement is materially different than the conclusion reached above, then an adjustment could be made for the normal replacement of taxis. One has to be careful in reviewing the company's future plans. It is not uncommon for the business operator to suddenly want to "replace the entire fleet" while going through a divorce. Common sense and careful analysis is a solution to this problem.
The following are some factors to analyze in determining whether or not to allow depreciation as an expense in determining income available for support purposes:
Is the depreciation material in the determination of income available?
On what basis is depreciation expressed? Tax basis? GAAP basis?
Is § 179 expense included in the depreciation figure?
Does the expense represent the normal replacement of assets?
What are the company's expected future plans for the replacement of assets?
What is the condition of the existing assets?
Will the company need to replace assets because of technology changes?
Does the company have to make changes because of technology in order to survive?
Has the company reached a level of assets, which will allow itself to continue operating for the future?
What is the age of the existing assets?
What is the estimated useful life of the existing assets?
Depreciation is allocation of the cost of an asset over a specific time period, not the valuation of the asset. A careful analysis of the reasonableness of the depreciation figure should be considered before an arbitrary "add back" is done. To do so may create a false income figure. In the long-run depreciation equals capital expenditures. While the courts may treat depreciation differently for temporary purposes than it does for permanent support, it should consider many factors on a case by case basis.