method ordinarily followed by the Bureau of Internal Revenue is to write off the March 1, 1913, value, less the salvage value of the property, in equal annual installments over the period of the useful life of the building from March 1, 1913. The Bureau has refrained from establishing any fixed rates of depreciation. It has taken the position that the facts in each particular case would govern as to the depreciation rates to be used. REFERENCE: Sec. 214 (a): "That in computing net income there shall be allowed as deductions: . . . (8) a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of such property acquired before March 1, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March 1, 1913;" Bureau of Internal Revenue Bulletin "F," page 19: "When the fair market price or value of property as of March 1, 1913, is used as the basis for computing depreciation deductions, such price or value should be spread ratably over the remaining useful life of the property and deductions made accordingly. Such deductions are allowable until the total equals the fair market price or value of the property as at March 1, 1913, irrespective of amounts deducted prior to that date." Bureau of Internal Revenue Bulletin "F," pages 30 and 31: "The proper allowance which may be deducted from gross income for depreciation and obsolescence of property used in the trade or business is an amount which should be set aside by a taxpayer during each year of the useful life of the property according to a consistent plan by which the total of such amounts for the useful life of the property, together with its salvage value at the end of its useful life in the business, will provide in place of the property its cost or its fair market value as of March 1, 1913, if acquired by the taxpayer prior to that date. . . . The capital sum to be replaced by allowances for depreciation should be charged off over the useful life of the property, either in equal annual installments, this plan being generally known as the 'fixed percentage' method, or in accordance with any other recognized trade practice, such as apportionment over units of production." (See Problem 124 for illustration of allowance based on units of production.) CORPORATIONS: The conditions that apply to individuals with respect to property used in business, apply equally to corporations. Sec. 234 (a): "That in computing the net income of a corporation subject to the tax imposed by section 230, there shall be allowed as deductions: . . . (7) a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of such property acquired before March 1, 1913, this deduction shall be computed upon the basis of its fair market price or value as of March 1, 1913;" PROBLEM 121 Illustrating Modification of Method of Computing FACTS: On July 1, 1918, the Hemstead Chemical Company installed certain apparatus to be used in the manufacture of the company's product. This apparatus represented a new invention, and the company had no past experience on the basis of which accurately to estimate the future life of this apparatus. However, from the best knowledge available at the time of the purchase, the company estimated that the useful life of the apparatus in question would be five years. The cost of the apparatus in question was $100,000. Up to December 31, 1920 the company had written off by way of depreciation on account of this apparatus the sum of $50,000. This depreciation was duly claimed as a deduction from gross income by the company in filing its income tax returns. At the end of 1921, as the result of a survey made by engineers of the company, it was determined that the apparatus had a remaining life of four years, that is, its usefulness would expire at the close of 1925. The company files its returns on the calendar-year basis. QUESTION: What is the allowable depreciation on account of the apparatus above mentioned? ANSWER: The depreciated balance of the apparatus in question, that is $50,000, should be spread over the estimated remaining life of the property which is five years from the beginning of 1921. The depreciation allowable therefore for the year 1921 would be 20% of $50,000, or $10,000. REFERENCE: Art. 166, Reg. 62: "Modification of method of computing depreciation. If it develops that an error has been made in estimating, the useful life of the property, the plan of computing depreciation should be modified and the balance of the cost of the property, or its fair market value as of March 1, 1913, not already provided for through a depreciation reserve or deducted from book value, should be spread over the estimated remaining life of the property. Inasmuch as under the provisions of the income tax acts in effect prior to the Revenue Act of 1918 deductions for obsolescence of property were not allowed except as a loss for the year in which the property was sold or permanently abandoned, a taxpayer may for 1918 and subsequent years revise the estimate of the useful life of any property so as to allow for such future (not past) obsolescence as may be expected from experience to result from the normal progress of the art. No modification of the method should be made on account of changes in the market value of the property from time to time, such as, on the one hand, loss in rental value of the buildings due to deterioration of the neighborhood, or, on the other, appreciation due to increased demand. The conditions affecting such market values should be taken into consideration only so far as they affect the estimated useful life of the property." PROBLEM 122 Illustrating Increase in Depreciation Resulting from FACTS: The Baltimore Machinery Company in the year 1921 was confronted with a strike on the part of certain machinists and helpers. During the period while these employees were out on strike, it obtained the services of "strike breakers." These "strike breakers" were not fully acquainted with the type of machinery used by the company, with the result that they caused an unusual wear and tear to be suffered. The depreciation in prior years had been based upon an estimated life of ten years. The particular machines upon which these "strike breakers" were engaged were purchased at the beginning of 1919, at a cost of $50,000. The depreciation had been computed for 1919, and 1920, at the rate of $5,000, per annum so that the depreciated balance at the beginning of 1921 was $40,000. It was estimated that on the basis of the usage to which the machinery in question was put, and on a basis of a similar usage in the future, the remaining useful life beyond the close of 1921, would be not more than three years, even though the machinery was kept in good repair. The company intends, under the circumstances, to claim a deduction for depreciation on account of these machines for the calendar year 1921, of $10,000. QUESTION: Would such claim be entertained by the Bureau of Internal Revenue? ANSWER: Where the "straight-line" method of depreciation has been adopted by the taxpayer, that is, where the capital sum subject to depreciation is written off in equal annual installments, the Bureau expects that this method will be consistently followed. However, it has permitted allowances for depreciation in addition to the amounts which would result from the employment of the straight-line method, where unusual conditions have existed which give rise to extraordinary wear and tear. Consequently, it would appear that as the corporation's claim is based upon actual facts, and as the computation of the depreciation is correctly made in accordance with those facts, the claim should be allowed. The computation of the depreciation for 1921 is as follows: The depreciation rate of 25% (based upon a four-year life under the conditions existing in 1921) is applied to the depreciated balance of the property at January 1, 1921, viz., $40,000, resulting in a depreciation of $10,000. REFERENCE: Cf. Bul. 16-20-862; A. R. R. 45: "When delicate machinery designed for the manufacture of a certain product is used in manufacturing a product of much coarser materials for which use it is not fitted, and is operated at a heavy overload of its normal capacity, the owner is entitled to deduct from gross income an amount representing extraordinary depreciation." PROBLEM 123 Illustrating Deductions Allowed Individuals-Depreciation of Property used in Professions FACTS: Dr. F. W. Scott, a specialist in diseases of the throat, opened an office in Pittsburg February 1, 1921. He installed in that office his medical library, office furniture and the necessary equipment for the practice of his profession. In addition to this office, he used three rooms in his residence of 8 rooms, for an office, beginning Feb. 1, 1921, which was also properly equipped. In June, 1921, his practice grew to such an extent that it became necessary for him to purchase an automobile which he used partly in connection with his practice. The residence was purchased in 1920. His return is made on a calendar year basis. QUESTION: What amount would he be entitled to take as a deduction on account of depreciation? ANSWER: In Bulletin "F," the Bureau has held that it is "considered impracticable to prescribe fixed definite rates of depreciation which would be allowable for all property of a given class or character. The rate at which property depreciates necessarily depends upon its character, locality, purpose for which used, and the conditions under which it is used." Under these circumstances each taxpayer should determine as accurately as possible according to his judgment and experience the rate at which his property depreciates. There would be an allowance for depreciation on each class of property referred to in the given facts above. As his return. is made on a calendar year basis, the allowance for 1921, covering his office furniture, equipment and library would be 1112 of the annual allowance. In the case of his residence office |