58 Tax Notes 983

Tax Notes

FEBRUARY 15, 1993

LENGTH: 3848 words

DEPARTMENT: Letters to the Editor (LTE)

CITE: 58 Tax Notes 983

HEADLINE: 58 Tax Notes 983 - COMPONENT DEPRECIATION FOR THE PURCHASE OF BUSINESSES.

AUTHOR: Johnson, Calvin H.

TEXT:

To the Editor:

In 'INDOPCO & Newark: Defining the Intangible 'Asset' in the Larger Cost Recovery Context,' 70 Taxes 929 (December 1992), /1/ Michael Schlessinger of the Hopkins & Sutter firm in Chicago argues that goodwill in the purchase of a business should be broken down into depreciable components. Component depreciation, he argues, is in theory more accurate than composite depreciation. His fundamental principle comes from Shainberg v. Commissioner, 33 T.C. 241, 254 (1959), where the Tax Court allowed a building to be broken down into parts to calculate depreciable lives. Schlessinger uses Shainberg to applaud the demise of nondepreciable goodwill. Customer base should be amortized as individual customers turn over, Schlessinger argues, on the ground that the more finely divided the asset, the more accurate the result.

This letter argues that component depreciation is a false god in theory and in practice. It is too complicated to administer and, for all its complexity, it has no theoretical merit. Component depreciation has no bearing on the outcome in Newark Morning Ledger, in any event, because the taxpayer has not capitalized nor offered to capitalize the cost of replacement components.

1. Complexity. Component depreciation makes the system too complicated to administer. Before 1981, component depreciation was allowed for real estate under Shainberg, provided the taxpayer hired some appraiser experts to provide some basis for allocation of the overall costs. The result was that taxpayers carved short-lived parts an ongoing long-term investment so that, for instance, costs allocated to the air conditioning and dry wall were depreciated faster than would be available for the building as a whole. After all those expensive expert fees, the resulting depreciation was too large to reflect the taxpayer's real loss and the resulting adjusted basis was too small to reflect the taxpayer's real continuing investment. I had friends who complained in 1981 that the extraordinarily short 15- year life given to real estate in the 1981 act was no bonus because they had to give up what they had achieved by self-help through their component methods. Within the maze of component depreciation, the pre-1981 system could not control the false claims made on taxpayers' tax returns and the false proofs made by taxpayers' experts. Component depreciation was expelled from the pantheon of tax principles in 1981 because it was too convoluted for the system to control.

The history lesson of 1981 applies to corporate acquisitions today. With expensive experts, taxpayers have succeeded in carving out short-lived components from the value of an ongoing concern. The value of the going concern stays steady or grows, but the taxpayer reports a tax loss. Within short order, the taxpayer's adjusted basis understates its ongoing investment and overall the tax accounts for income understate real financial income. Taxpayers' allocations, with the help of experts, often amount to fraud. In Newark Morning Ledger, for instance, the taxpayer is trying to convince the Supreme Court (and managed to convince the trial court below) that real investors pay for an investment looking only to gross receipts and ignoring all of the costs. The costs allocated to depreciable costs, derived from that nonsense, were 14 to 30 times larger than real value of the subscription base at issue in Newark. /2/ Nationwide, goodwill is becoming extinct; in taxpayer reports, three-quarters of the value of intangibles in purchased businesses has been allocated away from goodwill. /3/ The tax system, alas, cannot rely on tax experts. We have to keep it simple.

2. In Theory: It's All Composite. The complexity might be worth it if theory demanded components, but component depreciation is also bad theory. Whether we are talking about machine parts or business parts, money is made only by composites. Components have value only if placed into some composite. The dry wall, for instance, in a productive office becomes just a nuisance if it is sitting out there on my street. Parts can have salvage value, ripped out of the whole, or a replacement cost. But the value of a working machine is almost always greater than the sum of its unassembled parts, and the value of an ongoing business concern is almost always higher than the sum of its slavageable parts. A business is a living, reproducing organism that can draw resources from many places and make them generate money. A human being, to take another example, has only about 75 cents worth of minerals in it; the miracle comes in the composite.

There is no way, even in theory, to allocate the premium value of an assembled engine or a going concern to any of its parts. Take Mother Steinberg's chicken soup, made from five inexpensive parts. Alone the chicken fat, parsley, et al. /4/ are quite inexpensive. But in composite, the soup cures things from colds to walking pneumonia. Absent any part, the soup will not cure. The exclusive seller of any one part could hold up Mrs. Steinberg to grab the full premium she adds. But it is important that the basis of any saleable part should be equal to its saleable value; we do not want to give a tax incentive for Mrs. Steinberg to sell parts just for tax purposes or to avoid a sale just because of tax. Thus we cannot allocate any of the premium to any one part lest basis exceed value. The premium value, in any event, comes from the income stream that comes only with the assemblage. Take away the composite and the soup parts will not cure.

Those expensive valuation experts hired to allocate costs of the whole to some depreciable account are, accordingly, arguing about purely made-up angels on the head of a pin. There is no theory to justify allocation of the premium from the composite to anything; the value resides in the business as a whole. Fire them all, the experts. Just as in 1981 we moved to composite depreciation for real estate and machinery, so in 1993 we need to move to composite depreciation for the intangibles in a purchased business.

3. Implications for H.R. 11. The 1981 act provides a bad example history lesson as well as a good example. The 1981 act is responsible for our $400 billion deficits because it made the depreciable lives far too short. The shortened lives dramatically decreased the effective tax rates on savings and, in response, our savers said thank you and reduced the amount they saved. Just as 15-year depreciation was too short for real estate (although the composite idea was such a good idea as to be inevitable), so 14 or 16 years for corporate takeover costs is far too short. For goodwill and perpetual mass assets like customer, depositor, or supplier base, a 14-16 year tax life leads to effective tax rates between 8 and 17 percent. /5/ Simplicity counts for something, but it does not justify effective tax rates for corporate takeover investments that are so dramatically below the general statutory tax rates.

Revenue neutrality is not enough of a norm here. For my real estate friends in 1981, 15-year depreciation was revenue-neutral or a revenue gainer compared to component depreciation. But 15-year depreciation, like the 14- to 16-year lives proposed now, was far too short for long-term investments. Fifteen-year lives lead to low and negative effective tax rates and to the scourge of syndicated shelters. The Great Chicago Fire and Supply Side Depreciation need to be remembered for the same reason: both of them were disasters.

Congress has been hostile enough to takeovers in recent years that it seems plausibly willing to impose the normal statutory 34- percent tax rates as the true effective tax rates on corporate- takeover investments. Taxpayers may be claiming short lives that lead to 8- to 17-percent effective tax rates, but Congress need not endorse it. In truth, if Congress is in a bad mood, it would be quite willing to impose supra-statutory tax rates on corporates takeover investments. /6/

4. Schlessinger's Defense: The Constant Income Goal. Schlessinger offers a hypothetical to prove component depreciation, but his accounting understates income even for his model case. /7 In his hypothetical, the taxpayer buys a $120 building with two components: a shell, costing $100, and a roof, costing $20. Schlessinger assumed a shell lasting 20 years and a roof lasting 10 years, but here I assume a 'shell' lasting four years and a 'cover' lasting two years, just to fit the whole life on a single line of text. /8 Under Schlessinger's hypothetical, as modified, the cover lasts for two years and it is replaced at the end of two years with another one, also costing $20. With the shortened lives, I also increase revenue to $40.25 per year, which maintains the 6.6-percent annual return built into Schlessinger's hypothetical.

Schlessinger assumes that component depreciation is correct in theory because it maintains constant income from constant revenue. His depreciation is a constant $35 $100/4 or $25 from the shell and $20/2 or $10 per year from the two covers. The revenue of $40.25 covers the recovery of investment ('depreciation') plus the interest- like profit from the investment ('income'). Income under Schlessinger's ideal is a constant $5.25:

Schlessinger assumes that constant income is so clearly a right result that all he needs to do is say voila! His alternative regimes (which are not much more attractive than his model) /9 are straw men set up to fall before his model because they give falling rather than constant income.

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Table 1

Schlessinger's Ideal

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1 2 3 4

1. Adjusted Basis $ 120.00 $ 85.00 $ 70.00 $ 35.00 $ 0.00

2. Depreciation

(reduced 1 for

next year) $ 35.00 $ 35.00 $ 35.00 $ 35.00

3. Income (revenue

less 2) $ 5.25 $ 5.25 $ 5.25 $ 5.25

4. Income as %

of investment (1.) 4.38% 6.18% 7.50% 15.00%

Revenue = $ 40.25 per year. Year three basis reflects new $ 20 at year

start.

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Constant income, however, is a wrong result from an investment that is supposedly depreciating. Return from depreciated capital is less than the return amount from higher capital, all other things being equal. Depreciation in theory is like a withdrawal from a savings account in that it recovers and reduces the amount of capital invested. With less capital invested, Schlessinger's income figures should go down.

Expressed as an interest-like return rate, Schlessinger's income produces a higher percentage as time goes on (row 4). Schlessinger has given us no natural phenomena to explain why his shell and cover grow four times more productive by the mere passage of time. His return rates, in fact, are just an artifice from a depreciation that he is trying to describe.

To provide a coherent theoretical baseline, I offer economic depreciation, which analyzes real estate the way the financial world does; that is, as if the real estate were just another kind of interest-producing capital. As shown in Table 2, the investment with $40.25 revenues for four years gives a constant annualized interest return of 6.5 percent of capital per year:

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Table 2

Economic Depreciation

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1 2 3 4

1. Adjusted Basis $ 120.00 $ 87.66 $ 73.19 $ 37.76 $ 0.00

2. Depreciation

(reduces 1 for

next year.) $ 32.34 $ 34.47 $ 35.43 $ 37.76

3. Income (revenue

less 2.) $ 7.91 $ 5.78 $ 4.82 $ 2.49

4. Income as %

of investment

(1.) 6.59% 6.59% 6.59% 6.59%

Revenue = $ 40.25 per year. Year three basis reflects new $ 20 at year

start.

As Table 2 shows, if the revenue and the return rate from a

depreciable investment are constant, then neither depreciation nor

the interest-like net income will be constant. As row 1 shows, the

economic depreciation for a constant revenue investment has a pattern

like the repayment of principle on a constant rate mortgage -- for

the very good reason that in financial terms, a mortgage and a

tangible investment are indistinguishable. Schlessinger's $ 35 'model'

depreciation is too high in early years and his $ 5.25 income is too

low. His model is understating income in early years and pushing tax

off to later and less detrimental periods at the end.

Economic depreciation is terrific theory. Only with economic

depreciation is it possible to have effective tax rates that match

the statutory tax rates Congress voted for when fairly informed. Only

with economic depreciation will high- and low-bracket investors pay

the same amount for the property. Under Schlessinger's model

depreciation, high-bracket taxpayers will bid up the price for his

shell and cover to get the advantage of his tax mismeasurement. In a

world of razor sharp competition, high-bracket investors will exclude

talented lower-bracket investors, optimal owners of the shell and its

cover, solely because of tax.

Schlessinger has a common accountant's fallacy; that is that any

income that is smooth must be good. Constant income is the highest

form of smooth. I suppose under his thinking pattern, the fact he has

an accountant's fallacy puts him in some kind of mainstream. /10/

There is no doubt that our tax system in fact has allowed depreciation methods

for buildings and equipment that are no better and sometimes worse than

Schlessinger's model, but Schlessinger is claiming that componet depreciation

is more accurate in theory, and theory is not quite so forgiving as is the

least-taxing available method.

If Schlessinger is going to take his constant income goal

seriously, in any event, then he will have to make his investments in

intangibles nonamortizable. Only nondepreciating investments like

land and constant-balance savings accounts in fact give equal annual

interest. I do not think that denial of amortization in Newark

Morning Ledger is what he sets out to prove, but if we assume his

ultimate goal of constant interest-like income, nondepreciability is

what results.

5. Newark Morning Ledger. Schlessinger's article purports to be

an unquestionable, two-sided discussion /11/ of the larger,

fundamental concerns underlying Newark Morning Ledger, but it is

important to note that the facts in Newark are such that his ideal

model does not apply to the case. Schlessinger's model depreciation,

while quite generous, assumes that replacement costs are capitalized

and recovered only over the period that the new cover contributes to

income. In Newark Morning Ledger that assumption requires that the

taxpayer capitalize costs equal to the value of new customers as new

customers replace the old. Newspaper customers are attracted

primarily by qualities of the newspaper. Thus Schlessinger's model,

taken seriously, would require that the normal operating costs of

running a newspaper would be capitalized so that the adjusted basis

could approach the value of the newspaper's capital in its customer

base.

The taxpayer in Newark Morning Ledger has in fact not

capitalized nor offered to capitalize its costs as new customers

replace its old, and it also claimed amortization of the old

customers. Look what that method does to the shell and cover

investment:

Table 3

Amortization and Expensing of Roof Combined

1 2 3 4

1. Adjusted Basis $ 120.00 $ 85.00 $ 50.00 $ 25.00 $ 0.00

2. Depreciation $ 35.00 $ 35.00 $ 55.00 $ 25.00

3. Income (revenue

less 2.) $ 5.25 $ 5.25 (14.75) $ 15.25

4. Income as %

of investment

(1.) 4.38% 6.18% (29.50%) 61.00%

Revenue = $ 40.25 per year. Year three basis reflects new $ 20 at year

start.

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The income is very back-end loaded with most of it coming, at a 61-percent rate, in the final year, when the investment has lost 80 percent of its original value. When Schlessinger discusses his ideal depreciation, he in fact clearly rejects depreciation that allows the replacement cost to be expensed, combined with depreciation of the original cover. /12/

Newark's method is also too generous, measured in net present value terms. Measured in net present value terms, the difference between Schlessinger's model and economic depreciation is not all that great for our very short four-year investment. For economic depreciation, the present value at 6.6 percent of depreciation amounts (Table 2, row 2) is $119.21. In Schlessinger's model, the depreciation amounts (Table 1, row 2) have a present value of $119.65. The method that Newark Morning Ledger claimed, applied to the shell and cover (Table 3, row 2), has a value of $128.43, which is far too generous under both the Schlessinger and economic depreciation theories.

Schlessinger did not want to make it all that clear in his article that he was coming down on the government's side in Newark and he is rather critical of my work. Still the import of his model and the constant income goal behind it is that the taxpayer should lose its claim for amortization in Newark Morning Ledger before the Supreme Court this term.

Schlessinger has trouble reconciling the INDOPCO case with the government's case in Newark. INDOPCO capitalized takeover costs because they were investments, and in Newark the government would deny amortization of investments that the taxpayer has not lost. The common principle to the two cases is both simple and quite elegant: in a true income tax, investments are made and continued with hard- money, after-tax amounts. Only by maintaining the amount of the investment as undeducted basis is it possible to make tax neutral among taxpayers and between investments subject to an income tax. Insofar as the taxpayer makes or continues an investment, the cost of the investment should not be deductible. The purpose of the basis account in a system of true income is to describe the taxpayer's true investment, at least as far as that can be reconciled with the principle of realization. Basis accounts that systematically misdescribe the taxpayer's true investments do not clearly reflect the taxpayer's income under the prohibition of section 446(b). In INDOPCO, the Court adopted an economic definition of investment to determine that costs that were not lost could not be expensed, but resulted in basis instead. The principle of INDOPCO applied to Newark would force the taxpayer to continue his basis when his investment has not been lost. Standing together, INDOPCO and Newark will stand for the simple proposition that accounting needs to describe. /13/

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Sincerely,

Calvin H. Johnson

Austin, Texas

January 31, 1993

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FOOTNOTES

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/1/ Debates about an article published in Taxes as part of the proceedings of the University of Chicago Annual Tax Conference are arguably outside of the jurisdiction of Tax Notes or at least forum nonconvenience. But Tax Notes has become the forum of record for all current tax disputes. Tax Notes is now the established market for trade on all tax issues, no matter where they arise.

/2/ Johnson, 'The Mass Asset Rule Reflects Income and Amortization Does Not,' 56 Tax Notes 629, 639 (1992).

/3/ General Accounting Office, Tax Policy Issues and Policy Proposals Regarding Tax Treatment of Intangible Assets' 24 (1991).

/4/ I do not think it appropriate for me to reveal the full recipe just to add marginally more realism to one small hypothetical.

/5/ The formula for effective tax rate is (id)/1 where i is the pretax interest-like return, and d is the posttax interest-like return. For a perpetuity, d and i bear the relationship such that 1/i = (1t)/ d+t/in*[[1+d)n]/d], where n is the years for tax amortization and t is the tax rate. The left side of the equation represents the purchase price ('P'): the annual pretax return from a perpetuity is Pi, hence P = the annual amount (unit or $1) divided by i. The equation says that the purchase price (1/i) for a perpetuity will equal the present value of the after tax perpetual cash flow ((1t)/d) plus the present value of the amortization deductions taken over n. See also, 56 Tax Notes at 633, n. 25-28. Isolating i, the equation becomes i = dt/n*[1(1+d)n]. With a high discount rate assumption (general taxable interest at 10 percent, so 34-percent -bracket corporations expect 10 percent (1t) or 6.6 percent), t .34, and n = 16, the effective tax rate is 16.9 percent. With low discount rate, d = 2.64 percent, t = .34, n = 14, the effective tax rate is 8.2 percent.

/6/ Say at rates between 35 and 108 percent of the true financial return.

/7/ 70 Taxes at 933.

/8/ The principles gleaned from two- and four-year assets apply to longer investments.

/9/ Schlessinger's 'composite depreciation,' for instance, has a tax life that ends almost three years before the revenue from the composite investment stops.

Schlessinger's third alternative treats an investment having value for 10 years beyond the end of the taxable year when made as if the cost were an expense in the year made.

/10/ Schlessinger, 70 Taxes at 930 n. 14, says that I have characterized myself as 'out of the mainstream' because I have shown that accountants have a 'steady state fallacy' that leads them to underestimate the importance of capitalization, citing my 'Soft Money Investing Under the Income States,' 1989 U. Ill. L. Rev. at 1075.

His footnote 160, 70 Taxes at 947 (only Professor Johnson believes both in nonamortization and capitalization of replacements) is curious given how clear I have been that both nondepreciability and capitalization of replacement leads to too high an adjusted basis. Johnson, 'Mass Asset Rule Reflects Income and Amortization Does Not,' 56 Tax Notes 629, 634-635 (1992). See also Letters to the Editor, 'The Mass Asset Rule is Not the Blob That Ate Los Angeles,' 57 Tax Notes 1602 (December 14, 1992); his footnotes 132, 153, 155, all citing me, are also curious, for various reasons. Footnote 145 (much replacement is a result of just being in business) is accurate.

/11/ 70 Taxes at 930, accompanying note 14.

/12/ 70 Taxes at 933.

/13/ I worry that this statement, too, may pull me 'out of the mainstream.'

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