Rev. Rul. 79-285

ISSUES

Does use of a "sliding scale" method of computing depreciation for a book manuscript result in a reasonable allowance for depreciation under section 167(a) of the Internal Revenue Code of 1954 under circumstances described below?

When is a book manuscript placed in service for purposes of section 1.167(a)-10)(b) of the Income Tax Regulations?

FACTS

On January 1, 1975, A, an individual, purchased all rights to a book manuscript for the sum of 200x dollars and entered into an agreement with P, a publisher, to print, publish, and sell the book. The first copies of the regular trade edition were published and sold during October 1975.

Under terms of the publishing contract, A will receive specified royalties on sales of the book, and a share of the proceeds from the sale or licensing of other publication rights by the publisher. In April and October of each year following publication of the book, P will provide A with semi-annual statements showing royalties or other sums accruing to A for the preceding semi-annual periods ending December 31 and June 20 respectively, together with payment of amounts due A for the period covered by the statement.

A reported no income from the book for the taxable year 1975. However, A did claim a depreciation deduction in the amount of 100x dollars computed by use of a "sliding scale" method of depreciation. The schedule attached to the return showed an estimated life for the book of 4 years with depreciation rates of 50 percent for the first year, 25 percent for the second year, 15 percent for the third year, and 10 percent for the fourth year.

LAW

Section 461(a) of the Internal Revenue Code provides that any deduction shall be taken for the taxable year that is proper under the method of accounting used in computing taxable income.

Section 446(b) of the Code provides that if the taxpayer does not use a regular method of accounting, or if the method used by the taxpayer does not clearly reflect income, taxable income will be computed in accordance with a method that, in the opinion of the Secretary, does clearly reflect income.

Section 167(a) of the Code provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or held for the production of income.

Section 167(b) of the Code provides that the term "reasonable allowance" shall include an allowance computed under the straight line method, the declining balance method at a rate not exceeding twice the straight line rate, the sum-of-the-years digits method, or any other method that does not, during the first two-thirds of the useful life of the property, produce total allowances that exceed the amount that would have been allowable under the declining balance method. Nothing in this section shall be construed to limit or reduce an allowance otherwise allowable under section 167(a).

Section 167(c) of the Code provides that the declining balance method, the sum-of-the-years digit method, and any other consistent method provided under section 167(b)(4) are available only for tangible property with a useful life of 3 years or more.

Section 1.167(a)-3 of the regulations provides that intangible assets such as copyrights and patents with determinable useful lives may be the subject of a depreciation allowance. Section 1.167(a)-6(a) provides that a patent or copyright may be depreciated over its remaining useful life.

Section 1.167(a)-10(b) of the regulations provides that the period of depreciation for an asset begins when the asset is placed in service and ends when the asset is retired from service. A proportionate part of one year's depreciation is allowable for that part of the first year and last year during which the asset was in service.

Rev. Rul. 60-358, 1960-2 C.B. 68, as amplified by Rev. Rul. 64-273, 1964-2 C.B. 62, recognizes that methods of computing depreciation described in section 167(b) of the Code are in most cases inadequate when applied to motion picture and television films and other property of a similar character, because such methods result in a distortion of income. Rev. Rul. 60-358 states that the usefulness of such assets in the taxpayer's trade or business is measurable over the income it produces and cannot be adequately measured by the passage of time alone. Therefore, in order to avoid distortion of income, depreciation must follow the "flow of income." The Revenue Ruling holds that the income forecast method of depreciation is an acceptable method for computing a reasonable allowance for depreciation of the cost of such property.

Rev. Rul. 78-28, 1978-1 C.B. 61, holds that income reflected in the numerator of the fraction used to compute the depreciation for the taxable year under the income forecast method must reflect the same gross income used to compute taxable income from the property for the same period.

ANALYSIS

Section 167(c) of the Code limits the use of section 167(b) methods of depreciation deemed to result in an allowance that clearly reflects income for intangible assets to the straight line method.

In Rev. Rul. 60-358, it is recognized that the usefulness of assets such as movie and television films, and property used to generate a similar uneven flow of income, is measurable over the income it produces, and that the income forecast method of computing depreciation permits recovery of asset costs without producing any serious distortion of income. Books, patents, and sound recordings used to produce income in a manner similar to television and movie films are other property similar in character for purposes of Rev. Rul. 60-358.

Any method other than the straight line and income forecast methods of computing depreciation deductions for intangible assets must clearly reflect income as provided in section 446(b) of the Code. In KIRO, Inc. v. Commissioner, 51 T.C. 155 (1968), acq., 1974-2 C.B. 3, the court found that the "sliding scale'" method of computing depreciation for television films subject to contract terms limiting their use, and indicating a rate of exhaustion as a function of sequential exposures, resulted in a reasonable depreciation allowance. The sliding scale rate was based largely on the rate of exhaustion indicated by the contract terms. Films not subject to comparable contract terms could not be depreciated by use of the sliding scale method.

In the present case, there is no contract or other pertinent data to support the contention that the depreciation deductions computed by use of the "sliding scale" method are reasonable and clearly reflect income.

Motion picture rights are placed in service when the film is initially released for public exhibition. See S. Rep. No. 94-938, 94th Cong. 2nd Session 186 (1976), 1976-3 C.B. (Vol. 3) 49, 224. Manuscript rights having the same characteristics for purposes of depreciation as motion picture film rights, are placed in service when books produced from the manuscript are first released for distribution and sale.

HOLDING

In this case, the sliding scale method of computing depreciation allowances for the book manuscript fails to clearly reflect income as provided in section 446(b) of the Code and is, therefore, not an acceptable method of depreciation for Federal income tax purposes. The income forecast and straight line methods are acceptable methods for computing depreciation allowances for book manuscripts. The same conclusion applies to patents and master recordings.

Rights to manuscripts are placed in service when copies of the book are first released for distribution and sale. Similarly, rights to patents and master recordings are placed in service when products or processes resulting from these rights are first released for distribution and sale, or are used in the trade or business or for the production of income. However, patents are not placed in service prior to the issue date.

EFFECT ON OTHER REVENUE RULINGS

Revenue Ruling 60-358 is amplified.