Expensing depreciable assets; proposed Sec. 179 regulations clarify recent tax act changes.

• Author: Beehler, John M.

Proposed Sec. 179 Regulations Clarify recent Tax Act Changes On Mar. 28, 1991, the IRS published proposed regulations on the Sec. 179 election to expense certain depreciable assets. These proposed regulations, which incorporate changes to Sec. 179 made by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) and the Tax Reform Act of 1986 (TRA), provide guidance on the dollar and taxable income limits affecting Sec. 179, in addition to clarifying the computation of Sec. 179 expense for partnerships, S corporations and their owners. The proposed regulations also define the meaning of "active conduct of a trade or business" for purposes of applying the taxable income limit and provide detailed guidance for applying the carryover provision of Sec. 179 for expense amounts blocked by the taxable income limit.

This article will cover the operation of Sec. 179; discuss the application of the carryover rules; analyze the recapture provision affecting Sec. 179; and explain the application of Sec. 179 to married taxpayers and passthrough entities and the application of the proposed regulations to controlled groups.

Operation of Sec. 179

Under Sec. 179(a), taxpayers other than trusts, estates and certain noncorporate lessors(1) can elect to treat the cost, or a portion of the cost, of certain depreciable assets as a current expense. Failing to make the election requires taxpayers to capitalize and depreciate the full cost.

Two limits apply to the amount of Sec. 179 expense that a taxpayer may claim: a dollar limit and a taxable income limit. The dollar limit, which is applied first, restricts the maximum amount of Sec. 179 expense the taxpayer may claim for the affected asset or assets; the taxable income limit limits the tax deduction for Sec. 179 expense that may be claimed in the current year. A Sec. 179 expense amount that exceeds the taxable income limit may be carried forward to future years.

Assets Qualifying for the Sec. 179 Election

Only assets defined as "Sec. 179 property" qualify for the expensing election.(2) Sec. 179 property is any tangible personal property subject to depreciation and Sec. 1245 recapture(3) that is placed in service during the tax year.(4) This restricts Sec. 179 property to tangible, depreciable personalty.

To qualify for the Sec. 179 election, the property must be acquired by purchase. Assets cannot be acquired from a related party, as defined by Sec. 267, from one member of a controlled group by another, or by gift or inheritance.(5)

Sec. 179 property must also be acquired for use in the active conduct of a trade or business.(6) Thus, assets acquired solely for personal or investment purposes do not qualify for the Sec. 179 election. However, a mixed-use asset, such as one used for business/investment or business/personal use may have the business use portion of its cost qualify for the Sec. 179 election if the asset is used "predominately in a trade or business."(7) The predominate use test is met if over 50% of the property is used for business purposes.(8) Example 1: Taxpayer X purchases a used car for $10,000. The vehicle will be used 80% of the time in X's business and 20% of the time for personal use. Since the car is used predominately for business (over 50%), the business portion of the vehicle's cost qualifies for the Sec. 179 election. Thus, X may elect to expense up to $8,000 (80% of the cost of the car), subject to the dollar and taxable income limits.(9) Example 2: Assume the same facts as in Example 1, except that X inherited the car and, therefore, had a basis in the car equal to its fair market value of $10,000. Since X did not acquire the car by purchase, none of the vehicle's basis qualifies for the Sec. 179 election even though it is used more than 50% for business.

Cost Subject to Expense

The expense deduction under Sec. 179 is allowed for up to $10,000 of the business portion of the cost of one or more items of qualifying property.(10) This expense deduction is subject to the dollar and taxable limits of Sec. 179(11) (to be discussed later). The taxpayer may select the properties for which the expensing election will be made, as well as the portion of each property's cost to be expensed.(12)

The Sec. 179 deduction is determined without having to prorate the expensed amount by either the period of time the property has been in service during the tax year or the length of the tax year, as in the case of short tax years. Example 3: On Dec. 1, 1991, ABC, a calendar-year corporation, purchases and places in service office furniture costing $20,000. For its tax year ending Dec. 31, 1991, ABC may elect to expense up to $10,000 of the furniture's cost (subject to the dollar and taxable income limits), without having to prorate this expense for the number of days in 1991 during which the furniture was actually in service.(13)

Interaction of Sec. 179 and MACRS

In general, the taxpayer electing Sec. 179 must reduce the depreciable basis of the affected property by the amount of the Sec. 179 deduction.(14) For partnerships and corporations, this reduction in basis must occur even if application of Sec. 179(b)'s dollar and taxable income limits would prevent a particular partner or shareholder from deducting all or a part of the Sec. 179 expense.(15) (The application of Sec. 179 to flowthrough entities will be discussed later.)

For the sole proprietor, the amount by which the asset's basis is reduced is the Sec. 179 amount after the application of the dollar limitation, but before the application of the taxable income limit. While the proposed regulations do not deal with sole proprietorships specifically, they are emphatically clear on the reduction in basis for partnerships and S corporations. The asset's basis must be reduced by the full Sec. 179 expense elected, even if part or all of the Sec. 179 expense must be carried forward by the business due to the taxable income limitation.(16) It would be inconsistent to think that any other approach would apply to a sole proprietorship. Example 4: E, a sole proprietor, purchases and places in service in 1991 a five-year recovery period asset, which is Sec. 179 property, costing $22,000. E elects Sec. 179 and is able to use the modified accelerated cost recovery system (MACRS) with the half-year convention. There are no other assets purchased in 1991. E's taxable income, before the Sec. 179 deduction, is $2,000. In 1991, E is entitled to $10,000 of Sec. 179 expense, but his deduction for that year is limited to $2,000 because of the taxable income limitation.

E's depreciable basis for MACRS must be reduced by the full Sec. 179 expense, not just by the $2,000 allowed as a deduction in 1991. Thus, the asset's depreciable basis is $12,000 ($22,000 - $10,000). E claims a total of $4,400 in depreciation expense in 1991: $2,400 in MACRS expense ($12,000 x 0.20) + $2,000 allowed for Sec. 179. There is an $8,000 Sec. 179 carryover to future years. In the alternative, E could elect to expense only $2,000 of the $22,000 cost and take MACRS depreciation on $20,000 ($22,000 - $2,000).

Making the Sec. 179 Election

The Sec. 179 election is made on the tax return for the tax year in which the property was placed in service by completing and attaching Form 4562, Depreciation and Amortization (Including Information on Listed Property), to the return. The election may be made on extended tax returns and on amended returns, so long as the latter are filed within the time prescribed by law, including extensions.(17) A Sec. 179 election can be revoked only with the consent of the IRS.(18)

When electing Sec. 179, a taxpayer must specify the items of Sec. 179 property to which the election applies and the portion of the cost of each asset that is expensed.(19) The taxpayer must maintain records that specifically identify each piece of Sec. 179 property, how and from whom the property was acquired and when it was placed in service.(20)

Limits on the Sec. 179 Deduction

The actual deduction a taxpayer receives after making a Sec. 179 election is the smaller of (1) the actual cost of the property, (2) $10,000, reduced dollar for dollar by the cost of Sec. 179 property placed in service that year in excess of $200,000 ("the dollar limitation") or (3) taxable income for the year ("the taxable income limitation"). The dollar and taxable income limitations apply to each taxpayer and not to each trade or business in which the taxpayer has an interest.(21) Example 5: Taxpayer Y purchases and places in service a business computer costing $25,000. No other purchases of personalty were made that year. Y's taxable income for the year is $3,000. If Y makes a Sec. 179 election, she is entitled to a Sec. 179 deduction of $10,000. However, because of the taxable income limitation, Y's allowable Sec. 179 deduction for the year is limited to $3,000. The remaining $7,000 of Sec. 179 deduction must be carried over to succeeding years.(22)

* The dollar limitation The $10,000 maximum amount allowed for Sec. 179 expense in any one year must be reduced, dollar for dollar, by the amount by which the total cost of Sec. 179 property placed in service that year exceeds $200,000.(23) Example 6: A, a sole proprietorship, purchases and places in service $203,000 of equipment in 1991. Taxable income for the business, before any Sec. 179 deduction, is $55,000. A's Sec. 179 expense will be limited to $7,000, which is the $10,000 maximum amount reduced by the excess of Sec. 179 property placed in service over $200,000 ($10,000 - ($203,000 - $200,000)). The entire $7,000 is deductible in the current year, since it is not greater than taxable income.

* The taxable income limitation The amount that may...