Complexities of the sec. 179 deduction.

The Sec. 179 expense deduction seems simple enough on the surface. Basically, a taxpayer may elect to treat the cost of any qualifying property as an expense that is allowed as a deduction for the tax year in which the property is placed in service. The deduction is subject to both cost and taxable income limitations.

The aggregated cost that may be deducted in any tax year may not exceed $17,500. The cost limitation is reduced dollar-for-dollar (but not below zero) by the amount of excess Sec. 179 property placed in service during the year exceeding $200,000 (Sec. 179(b)(1)(2)).

The amount allowed as a deduction also may not exceed the aggregate amount of taxable income the taxpayer has from the active conduct of his trade or business during the tax year (Sec. 179(b)(3)).

As with most sections of the Code, Sec. 179 initially raises more questions than it answers, including:

* How are the income and cost limitations calculated in the case of passthrough entities, such as S corporations and partnerships?

* Is the Sec. 179 expense deduction available on an individual level if the taxpayer has a loss from an entity and wages from that entity or other sources?

* Is the Sec. 179 expense deduction available to an entity if it has not taxable income?

To answer these and other questions, one must first understand how, and at what level (i.e., entity or individual), income is determined under Sec. 179 and the excess Sec. 179 property cost limitation is applied.

The taxable income limitation applies at the S corporation or partnership level as well as at the shareholder or partner level. In determining the taxable income of an individual, S corporation or partnership, the net income (or loss) from all of the trades or businesses actively conducted by the individual, S corporation or partnership must be aggregated. Items of income derived from the active conduct of a trade or business include Sec. 1231 gains (or losses) from the trade or business and interest from working capital of the trade or business (Regs. Sec. 1.179-2(c)(1)).

For purposes of Sec. 179, the term "trade or business" means any activity for which ordinary and necessary expense deductions are allowed under Sec. 162. For purposes of Sec. 179, a taxpayer is generally considered to "actively conduct" a trade or business if the taxpayer meaningfully participates in the management or operations of the trade or business (Regs. Sec. 1.179-2(c)(6)(ii)). Therefore, the taxable income from activities in which a taxpayer is a mere passive investor, merely holds property for the production of income, or engages in an activity not entered into with a profit motive, is not taken into account for the taxable income limitation (Regs. Sec. 1.179-2(c)(6)(i)).

When a passthrough entity's tax return shows a taxable loss, a tax preparer may dismiss the possibility of taking advantage of a Sec. 179 deduction in the current tax year due to the taxable income limitation. After all, the Code states that the amount allowed as a deduction shall not exceed the aggregate taxable income of the taxpayer for the tax year in question. Further, the Code's only reference to the computation of taxable income under Sec. 179 merely states that "...taxable income derived from the conduct of a trade or business shall be computed without regard to the deduction allowable under this section" (Sec. 179(b)(3)(C)). One might think that the obvious answer would be to calculate the expense deduction, carry it forward to a year the entity has taxable income and deduct it then as allowed by the Code.

A close reading of the regulations, however, reveals that certain items are not taken into account in determining taxable income of passthrough entities for purposes of the Sec. 179 income limitation. These items may be over-looked, and when added back create taxable income against which the Sec. 179 expense deduction can be taken in the current year. In the case of partnerships, these items consist of credits, tax-exempt income and guaranteed payments to partners (Regs. Sec. 1.179-2(c)(2)(iv)). For S corporations, the items are credits, tax-exempt income and deductions for compensation paid to S shareholders/employees (Regs. Sec. 1.179-2(c)(3)(ii)). Guaranteed payments and compensation paid to S shareholders/employees can be large addbacks, as is tax-exempt income (including the increase in the cash surrender value of an officer's life insurance).

Once the taxable income limitation has been determined at the entity level, taxable income is determined again at the individual level. It should be kept in mind that when computing the taxable income limitation at the individual level, the taxable income derived from the active conduct of a trade or business is determined by aggregating the net income or loss from all of the trades or businesses actively conducted by the individual. The terms "active conduct" and "trade or business" have the same meanings as previously discussed when determining taxable income at the entity level. At the individual level, employees are considered to be engaged in the active conduct of the trade or business of their employment. Thus, wages, salaries, tips and other compensation (not reduced by unreimbursed employee business expenses) derived by a taxpayer as an employee are included in the taxpayer's aggregate amount of taxable income (Regs. Sec. 1.179-2(c)(6)(iv)).

Once the income limitation hurdle has been overcome, one must also keep in mind the property cost limitations associated with Sec. 179. As stated in the introduction, the aggregate amount of Sec. 179 property that a taxpayer can elect to deduct for any tax year is $17,500, reduced (but not below zero) by the amount of any Sec. 179 property placed in service during the tax year exceeding $200,000 (Sec. 179(b)(1) and (2)). There is no carryover or carryback of any portion of the Sec. 179 deduction disallowed due to the property cost limitations. Therefore, in order to maximize allowable deductions, it is critical to advise the client as to the proper timing of purchases and placement in service of Sec. 179 property.

It should also be noted that when applying the $17,500 limitation to a taxpayer who is a partner in one or more partnerships, the partner's share of Sec. 179 expenses allocated to him from each partnership is aggregated with any nonpartnership Sec. 179 expenses for the tax year (Sec. 179(d)(8) and Regs. Sec. 1.179-2(b)(3)(i)); the same rule applies for S shareholders. Therefore, prudent planning will consider Sec. 179 expenses from all partnerships and S corporations with which the client is involved, in addition to any individual Sec. 179 expense, in order to arrive at the proper current-year deduction or carryover.

However, in determining the excess Sec. 179 property placed in service by a partner in a tax year, the cost of Sec. 179 property placed in service by the partnership is not attributed to any partner (Regs. Sec. 1.179-2(b)(3)(i)); the determination of excess Sec. 179 property has already been made at the entity level. It is important to understand this concept. If, when calculating the excess Sec. 179 property limitation, the cost of the partner's individual Sec. 179 property is aggregated with the partnership's Sec. 179 property, the dollar limitation on the $17,500 expense deduction would be too great, resulting in a lower deduction than is actually allowed.

So, just because a client has a loss from the active conduct of a trade or business, do not rule out the possibility of a Sec. 179 expense deduction in the current year as long as the taxable income limitations are met. Being aware of the addbacks to taxable income at the entity level and including wages in the aggregate amount of taxable income at the individual level, more often than not, will allow the taxpayer to take a Sec. 179 expense in the current year.