While 100% bonus depreciation may be the “flavor of the month” when it comes to accelerated depreciation, it is limited to original-use property and is currently scheduled to sunset for most property at the end of 2011. IRC § 179 expensing therefore remains a prime option for small businesses, especially since it contains allowances similar to those for bonus depreciation for qualified restaurant and leasehold and retail improvement property and the expensing limit remains pegged at an ample $500,000.
These provisions are temporary through 2011 as well but may stand a better chance of extension than 100% bonus depreciation, which was billed as an emergency stimulus. One hurdle section 179 imposes, however, is that noncorporate taxpayers must follow some exacting rules to expense property they lease to others.
Under section 179(d)(5)(A), taxpayers may take a deduction for eligible property they lease to others if they manufactured or produced the property. But for leased property they did not manufacture or produce, the term of the lease (including options to renew) must be less than 50% of the class life of the property, and during the first 12 months after the property’s transfer to the lessee, the lessor’s deductions with respect to the property under section 162 (other than rents and reimbursements) must total more than 15% of rental income produced. This presumably ensures that the lease is not a finance lease.
Eligible taxpayers can benefit from this provision but will need to carefully plan their leasing and expenditures. They’d also do well to peruse the guidance and court cases that applied to identical provisions under former section 46(e)(3)(B) for the investment credit as it existed before 1991. See, for example, Treas. Reg. § 1.46-4(d). See also IRC § 168(i)(3) for a further definition of “lease term.”
A more recent example of an attempted section 179(d)(5)(B) deduction can be found in the Tax Court opinion in Ross P. Thomann v. Commissioner, TC Memo 2010-241. The IRS disallowed the entire claimed section 179 deduction for farm equipment for three tax years; the Tax Court upheld the disallowance, along with accuracy-related penalties. The taxpayer’s main problem was the lack of a written lease covering the years at issue that clearly identified the property leased and the lease term. There also was no evidence of any attempt to document class life and compare lease income with section 162 expenses.
If the court had examined the property’s class lives, it might have performed this analysis:
|Property Leased|| |
Maximum Lease Term
|Drainage tile|| |
|Grain bins, grain dryer and fence|| |
|Office fixtures and equipment|| |
* Revenue Procedure 87-56: Asset class no. 00.3, land improvements and drainage facilities; 01.1, agriculture grain bins, machinery and equipment, and fences; 00.241, light general-purpose trucks; 00.11, office fixtures and equipment.
If it had determined the terms of the leases were for less than 50% of the class life of the property, the court next would have had to examine whether section 162 deductions equaled at least 15% of rental income produced in the first 12 months of the leases (it didn’t reach either issue). If, for example, the pickup truck’s lease amount had been $5,000 in the first 12 months after it was transferred to the lessee, the taxpayer would have to have claimed more than 15% of that amount, or $750, in section 162 deductions related to it during that period. Therefore, lessors using this method should make sure they make the required amount of expenditures for repairs and maintenance or other deductible costs at the required time. This may mean frontloading scheduled maintenance, perhaps most successfully for used property that needs repairs and maintenance as it is placed in service or soon afterward. Multiple lease terms may complicate the leasing transaction, but more common settings of nonfarm commercial property and residential real estate may entail fewer asset classes—perhaps only one. Whatever extra effort the method requires could well be worthwhile; it might have saved Thomann nearly $100,000 in deficiencies and penalties.
CPA and attorney John J. Connors, author of the AICPA-published Depreciation, Amortization, and Property Transfers: Issues and Strategies, said these provisions may come into play, perhaps inadvertently, by the common practice of forming an LLC to hold property, where the LLC then leases the property to a related entity. Second, Connors said, taxpayers should be aware that even a lease that is properly structured under these provisions may trigger state sales and use taxes in some states.
By JofA senior editor Paul Bonner. To comment on this article or to suggest an idea for another article, contact him at email@example.com or 919-402-4434.
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