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

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 be expensed under Sec. 179 for any tax year is also limited to the taxable income the taxpayer earns from the active conduct of any trade or business.(24) For purposes of applying this limit, the aggregate amount of taxable income derived from the active conduct by an individual, a partnership or an S corporation of any trade or business is computed by totaling the taxable income or loss from all of the trades or businesses actively conducted by these operations during the year.(25) Thus, for the taxpayer, the taxable income limit is the dollar amount derived from the total taxable incomes or losses from all businesses the taxpayer actively conducts, and not just from the business that had purchased the Sec. 179 property. Example 7: Taxpayer C has income and losses from the following sources: $3,000 income from a sole proprietorship, $12,000 income from an S corporation interest in which C actively participates, and a $6,000 loss from a limited partnership interest. C's taxable income for purposes of applying the Sec. 179 limitation is $15,000 ($3,000 + $12,000). The loss from the limited partnership is not included because it is not from the active conduct of a trade or business by C.

While, as this example suggests, the aggregation of taxable income from several active businesses may work to the taxpayer's advantage by increasing the taxable income limit in profitable business years, the requirement to aggregate may prove disadvantageous in loss years, as the next example illustrates. Example 8: Taxpayer H has business income and losses from the following sources: $40,000 income from a sole proprietorship and $36,000 loss from a partnership in which H actively participates. The sole proprietorship purchased and placed in service Sec. 179 property costing $22,000. There were no other purchases of Sec. 179 property by either business. H's maximum Sec. 179 expense is $10,000. However, only $4,000 ($40,000 - $36,000) of this may be deducted this year, since the taxable income limit applies.

For a C corporation, the aggregate amount of taxable income from an active trade or business is the corporation's taxable income before the net operating loss (NOL) deduction and special deductions such as the dividends received deduction, adjusted to exclude items of income or deductions not derived from actively conducted businesses.(26)

Taxable income from the active conduct of a trade or business is operating income less related expenses, in addition to any Sec. 1231 gains or losses and any interest income from the working capital of the business.(27) Thus, investment income and expenses would not be a component of this measure of taxable income.

Finally, taxable income for purposes of the Sec. 179 election is computed before any reduction for the Sec. 179 expense, any deduction for one-half of self-employment taxes,(28) and any NOL carryback or carryforward.(29)

* Ordering rule for certain circular problems The proposed regulations also provide rules for computing taxable income for Sec. 179 when the taxpayer must apply another Code section subject to a taxable income limit.(30) For example, a C corporation's charitable contribution deduction is computed by applying a 10% limit of taxable income net of any Sec. 179 deduction. However, the corporation's Sec. 179 deduction is limited to taxable income net of any charitable contribution. The proposed regulations offer a three-step process to calculate the Sec. 179 taxable income limitation in such a case. 1. Compute taxable income for the other Code section, deducting otherwise allowable Sec. 179 expense without regard to any interaction from the other Code section. 2. Compute a hypothetical amount of deduction for the other Code section, using the taxable income from step 1. 3. Calculate the actual taxable income limitation for Sec. 179 as follows: taxable income less the hypothetical deduction for the other Code section. Example 9: X, a calendar-year corporation, elects to expense $10,000 of the cost of Sec. 179 property purchased and placed in service in 1991. The dollar limitation does not apply. X also makes a charitable contribution of $5,000 this year. X's taxable income before any Sec. 179 or charitable contribution deductions is $11,000. To compute its taxable income limit for Sec. 179, X first computes a hypothetical charitable contribution deduction of $100 after deducting the Sec. 179 expenses and applying the Sec. 170 10% limitation (0.10 x ($11,000 - $10,000)). The actual Sec. 179 taxable income limitation is taxable income reduced by the hypothetical charitable contribution deduction, or $10,900 ($11,000 - $100). Thus, X may deduct the maximum $10,000 Sec. 179 expense in 1991, since it is less than the taxable income limit.(31)

* Defining "active conduct" The existing Sec. 179 regulations do not define what is meant by "active conduct of a trade or business." Under the proposed regulations, a "trade or business" is defined in the same manner as in Sec. 162 and its regulations.(32) Thus, property held only for the production of income or used in an activity not engaged in for profit (as described in Sec. 183's hobby loss provision) would not qualify as Sec. 179 property. Further, taxable income from property held for the production of income or from an activity not engaged in for profit is not included in calculating the taxable income limitation.

The determination of whether a trade or business is actively conducted by a taxpayer is to be made from all the facts and circumstances under the proposed regulations.(33) The purpose of the active conduct requirement of Sec. 179 is to prevent passive investors in businesses from deducting Sec. 179 expenses against the taxable incomes from those businesses.

* Meaningful participation required A taxpayer is generally considered to actively conduct a trade or business under the proposed regulations if the taxpayer "meaningfully participates in the management or operations of the trade or business."(34) A partner or S shareholder must also meaningfully participate in order to achieve the active conduct standard. A passive investor in a trade or business is not considered to have meaningfully participated in management or operations and thus is unable to claim Sec. 179 expenses from that business since the active conduct standard is not met. The following example (as well as Example 7) illustrates the active conduct requirement. Example 10: Taxpayer P owns a beauty salon as a sole proprietor and employs R to operate it. P frequently meets with R to review operations and approve budgets prepared by R. R performs necessary operating functions such as hiring, acquiring supplies, and paying bills and salaries. In 1991, the salon purchased and placed into service Sec. 179 property costing $9,500. There were no other Sec. 179 purchases. P's taxable income from the salon, before any Sec. 179 deduction, was $8,000.

P is also a partner in NOP, a partnership that owns a grocery store. N, another partner, runs the store, making all management and operating decisions. NOP did not purchase any Sec. 179 property in 1991. P's share of income from NOP was $6,000.

Based on the facts and circumstances, P meaningfully participates in the management of the salon but not in NOP. Thus, P's aggregate taxable income for purposes of the Sec. 179 limit is $8,000, the taxable income from the salon.(35) The $9,500 of Sec. 179 expense is limited to $8,000 under the taxable income limit.

For taxpayers and their advisers familiar with the passive loss rules of Sec. 469, it is tempting to draw a parallel between that section's definitions of "material participation" and "active participation" and the Sec. 179 proposed regulations' creation of "meaningful participation." However, the introduction to the proposed regulations seems to work against this, as it cautions: "No inference is to be drawn with respect to the definition of active conduct of a trade or business under any other provision of the Code."(36)

* A bonus for employees The proposed regulations contain a remarkable piece of good news for selected taxpayers under the active conduct rule: employees are considered to be engaged in the active conduct of the trade or business of their employment.(37) Thus, wages, salaries, tips and other compensation are included when calculating the taxable income limit of Sec. 179. Example 11: S is employed by I Corp. at a salary of $50,000. In addition, he runs a consulting business as a sole proprietor. In 1991, the consulting business had a net loss of $20,000. The business also purchased and placed into service Sec. 179 property costing $14,000. No other purchases of Sec. 179 property were made. Because S is able, under the proposed regulations, to compute the Sec. 179 taxable income limit by aggregating his salary with his net income or loss from the active conduct of businesses, his taxable income limit for 1991 is $30,000 ($50,000 - $20,000). Thus, the full $10,000 of Sec. 179 expense is deductible, despite the NOL of the sole proprietorship.

Carryover of Disallowed Sec. 179 Deductions

When the taxpayer's Sec. 179 deduction, computed after the dollar limitation, exceeds the taxable income limitation, the excess Sec. 179 expense must be carried forward to future years.(38) There is no limit to the number of carryover years. This carryforward applies only to the Sec. 179 expense disallowed due to the taxable income limitation, not that disallowed due to the dollar limitation.

Despite the existence of Sec. 179 carryovers, the maximum amount of Sec. 179 expense a taxpayer may claim in any year is no more than $10,000, adjusted for the dollar and taxable income limits of that year. Thus, to deduct a Sec. 179 carryover, the taxpayer must reduce the amount of Sec. 179 expense elected in the current year. Example 12: Taxpayer D, who has a calendar tax year, has a $2,000 Sec. 179 carryover from a previous year. In 1991, D purchases and places in service in her sole proprietorship $30,000 of Sec. 179 property. There are no other purchases of Sec. 179 property. D's taxable income from the business is $26,000. D may claim and deduct the maximum $10,000 Sec. 179 expense in 1991. However, if D wishes to deduct the $2,000 carryover, this will reduce the amount claimed as Sec. 179 expense for the 1991 purchase to $8,000 ($10,000 - $2,000). If D instead wishes to deduct the full $10,000 against the current year's purchase, the carryover of $2,000 cannot be used in 1991 and must be carried forward to 1992.

The properties and the allocation of cost subject to the carryover of a disallowed Sec. 179 deduction must be selected by the taxpayer in the year the properties are placed in service.(39) This selection must be noted on the taxpayer's books and applied in a consistent fashion in later years. If the taxpayer makes no such selection of properties, the proposed regulations provide that the carryover is apportioned equally over the Sec. 179 properties for that year. This means that a pro rata portion of the Sec. 179 deduction is attributed to eligible properties based on relative purchase prices. Example 13: In 1991, T, a sole proprietor, purchases and places in service the following items of Sec. 179 property: asset A: $10,000; asset B: $20,000. T makes a Sec. 179 election but does not designate a specific asset. There are no other purchases of Sec. 179 property. T's aggregate taxable income is $4,000, so her Sec. 179 expense for 1991 is limited to this amount. Since T has not designated a specific property to which Sec. 179 applies, the $4,000 deduction and the $6,000 carryover are allocated between assets A and B on the basis of their purchase prices, as follows: $1,333 Sec. 179 expense $10,000/$30,000) and $2,000 carryover to A; $2,667 Sec. 179 expense ($20,000/$30,000) and $4,000 carryover to B.

In years when there are several carryovers of disallowed Sec. 179 expenses and the taxpayer can deduct only a portion of the carryovers, due to the overall Sec. 179(a) limit, the taxpayer must deduct the carryovers on a FIFO basis.

Dispositions and Transfers of Sec. 179 Property

The need to allocate carryovers of disallowed Sec. 179 expenses is not immediately apparent until one considers the tax problems that result on disposition of a Sec. 179 asset. The proposed regulations consider two types of dispositions or transfers: those in which the taxpayer parts with the property, such as a sale, and those in which the taxpayer fails to maintain the requirement of using the Sec. 179 asset over 50% of the time in the active conduct of a trade or business.

* Disposition of Sec. 179 property When an asset to which a Sec. 179 carryover applies is disposed of through a taxable or nontaxable transfer, the asset's adjusted basis immediately before the transfer must be increased by the outstanding Sec. 179 carryover.(40) Computation of any gain or loss on the transfer is then done with this new, higher basis. The rationale for this increase is that the carryover, which already reduced the property's basis, will never be deducted. Example 14: In 1991, M, a sole proprietor, sells an asset with an adjusted basis of $22,000 for $30,000. Sec. 179 was elected in the year the asset was purchased and placed in service and there is currently a $3,000 carryover of disallowed Sec. 179 expense attributable to this asset. M's adjusted basis for the sold asset must be increased by the $3,000 Sec. 179 carryover, resulting in a $25,000 basis. M's recognized gain on sale thus becomes $5,000 ($30,000 - $25,000).

Only the original holder of the property to which a Sec. 179 carryover applies may use this amount. The carryover of the disallowed Sec. 179 deduction is not available to the transferee of the Sec. 179 property.(41)

* Recapture of Sec. 179 expense If a taxpayer's Sec. 179 property fails to be used predominately in a trade or business of the taxpayer at any time before the end of the asset's depreciable life, the taxpayer must recapture as ordinary income the Sec. 179 expense originally claimed on the asset.(42) The failure of the taxpayer to meet the over-50% business use test for the property also mandates a switch to straight-line depreciation, with recapture of the excess of prior years' MACRS expense over straight-line as ordinary income.(43) Example 15: G, a sole proprietor, purchases and places in service in 1991 Sec. 179 property costing $18,000. The asset, which is used 100% in G's business, has a five-year cost recovery life. G chooses MACRS and is able to use the half-year convention. There are no other purchases of Sec. 179 property in 1991 and G's aggregate taxable income is $100,000. In 1991, G's total depreciation expense is $11,600 ($10,000 Sec. 179 expense + $1,600 MACRS expense [($18,000 - $10,000) x 0.02]). In 1992, G's depreciation expense will be $2,560 (($18,000 - $10,000) x 0.32). Thus, G's total depreciation expense for the two years is $14,160 ($11,600 + $2,560).

In 1993, G's business use of the asset falls to 40%. This requires recapture of the Sec. 179 deduction and any MACRS deduction in excess of straight-line. Had G used the alternative depreciation system (ADS) from 1991 onward and claimed no Sec. 179 expense, G's total depreciation deductions for the prior two years would have been $5,400 ($1,800 in 1991 [$18,000 x 0.10] + $3,600 in 1992 [$18,000 x 0.20]). The amount G must recapture in 1993 as ordinary income is the difference between the actual expenses claimed and the recalculated "as if" straight-line amounts, or $8,760 ($14,160 - $5,400).

The recaptured amount increases G's adjusted basis in the asset. Thus, G's adjusted basis at the start of 1993 is $12,600 ($18,000 - $14,160 + $8,760). For 1993, G's ADS deduction will be $1,440 (($18,000 x 0.40) x 0.20) and the resulting adjusted basis at the end of 1993 will be $11,160 ($12,600 - $1,440).

Application of Sec. 179 to Married Taxpayers

Married taxpayers filing a joint return are treated as one taxpayer in applying the limitations under Sec. 179.(44) The dollar limitation is $10,000 reduced by the amount of property placed in service by both spouses that exceeds $200,000. The taxable income limitation is based on the combined trade or business income of the spouses for the year. It is immaterial which spouse purchased or placed in service the property subject to the Sec. 179 election. Example 16: H and W are married and file a joint return for 1991. H and W placed in service $150,000 and $54,000, respectively, of Sec. 179 property during the year. Under the dollar limitation, H and W may take a Sec. 179 deduction of only $6,000 ($10,000 - ($204,000 - $200,000)). As long as H and W have combined trade or business taxable income of at least $6,000, the $6,000 Sec. 179 deduction will be allowed.(45)

Application of Sec. 179 to Passthrough Entities

The proposed regulations clarify the application of Sec. 179 to partnerships and their partners and S corporations and their shareholders. Since the treatment of S corporations and their shareholders generally parallels that of partnerships and their partners under Sec. 179, the following discussion focuses on the latter. S corporations and their shareholders will be referred to specifically only when the rules vary from those for partnerships and their partners.

The determination of which property is Sec. 179 property and the election to expense the cost of assets under Sec. 179 must be made at the partnership level.(46) The dollar and taxable income limitations under Sec. 179 apply both at the partnership level and the individual partner level.(47) At the partnership level, the dollar limitation of $10,000 is reduced dollar-for-dollar by the amount of the partnership's investment in Sec. 179 property that exceeds $200,000. This amount is then limited by the partnership's taxable income limitation. For this purpose, the taxable income/losses from all the partnership's trades or businesses are aggregated.(48) The taxable income/losses from any activities conducted within the partnership constituting investments or hobbies are not aggregated for purposes of the taxable income limitation. Example 17: The XYZ partnership placed in service $202,000 of Sec. 179 property during the year. XYZ elected to expense the maximum allowable cost of these assets under Sec. 179. It had the following taxable income/losses from various activities for the year: $35,000 income from its retail business, $28,000 loss from its consulting business and $3,000 of income from investments. The dollar limitation for XYZ is $8,000 ($10,000 - ($202,000 - $200,000)). Taxable income from trades or businesses is $7,000 ($35,000 income -- $28,000 loss). Therefore, the amount allowed as Sec. 179 expense for the year is limited to $7,000 under the taxable income limitation. Note that the income from investments is not aggregated with trade or business income.

Any amounts not currently allowed as Sec. 179 expense by the partnership due to the taxable income limitation are carried over indefinitely to future partnership years.(49) The basis of partnership property must be reduced by the amount of Sec. 179 expense elected before the taxable income limitation, even though part of it is carried over to future years.(50) In Example 17, the basis of partnership property must be reduced by $8,000, even though only $7,000 is currently allowable and $1,000 must be carried over due to the taxable income limitation.

Like other taxpayers, the partnership that sells Sec. 179 property must increase basis in that property immediately before the sale by any Sec. 179 expense carryover outstanding.(51) This prevents the partnership from having an inflated gain (or a lesser loss) from a prior basis reduction for which no deduction was allowable.

Once the Sec. 179 limits are applied at the partnership level, the amounts available for pass-through must be allocated among the partners. This passthrough is limited to the amount of Sec. 179 expense allowed to the partnership after application of both the dollar and taxable income limitations. As a result, any amounts disallowed to the partnership under the taxable income limitation that are carried over the future partnership years are not available to be allocated among the partners in the current year.(52) In Example 17, only $7,000 is available to be allocated among the partners. The $1,000 carried over by the partnership is not available for passthrough in the current year.

The allocation of Sec. 179 expense among the partners is determined under the partnership agreement and under Sec. 704.(53) In the case of an S corporation, the allocation is determined under the per share/per day rules of Sec. 1366.(54) When the partnership and its partners are not on the same tax year-ends, Sec. 706 applies to determine the tax year of the partner within which the Sec. 179 expense and other items of taxable income/loss from the partnership get allocated. The partner reports these items in the tax year with or within which the partnership year ends.(55) This same rule applies to S corporations and their shareholders via Sec. 1366. Example 18: The ABC partnership is on a fiscal year ending Apr. 30, 1991, while partner A is on a calendar year-end. ABC placed in service a Sec. 179 asset on Sept. 30, 1990 and elected to expense its cost under Sec. 179 for the partnership year ending Apr. 30, 1991. The Sec. 179 expense (after all limitations) is $6,000. A's distributive share of this expense is $2,000. It must be reported in A's tax year ending Dec. 31, 1991.(56)

At the partner level, Sec. 179 expenses allocated to a partner must be aggregated with nonpartnership Sec. 179 expenses in applying the dollar and taxable income limitations.(57) For purposes of the dollar limitation, Sec. 179 property placed in service by the partnership is not attributed to the partner. The partner considers only property placed in service in nonpartnership trades or businesses in ascertaining whether any reduction is necessary due to investment in more than $200,000 of Sec. 179 property. Example 19: The XYZ partnership placed in service $160,000 of Sec. 179 property during the year and elected to expense $10,000 of the cost under Sec. 179. Partner X placed in service $55,000 of Sec. 179 property in his sole proprietorship for the year. If X elects to expense the maximum amount under Sec. 179 and his distributive share of partnership Sec. 179 expense is $2,000, the dollar limitation is $10,000. X's Sec. 179 property placed in service consists of only the $55,000 from his sole proprietorship. None of the property placed in service by the partnership (including any amount taken by X as an expense under Sec. 179) is included as property placed in service by X for the year.

In applying the taxable income limitation at the partner level, the partner must include all business income/loss passed through to the partner from the partnership. The only requirement for this treatment is that the partner actively participate in at least one trade or business of the partnership. This means that the partner must meaningfully participate in the management or operations of the trade or business and not simply be a passive investor.(58) Example 20: XYZ partnership conducts two trades or businesses: construction and retail. Partner Z actively manages the construction business but does not get involved in the retail business. Z's distributive share of the partnership's taxable income for the year is $7,000, consisting of $12,000 income from the construction business and a $5,000 loss from the retail business. Under the partnership agreement, Z is allocated the full $10,000 of Sec. 179 expense allowable to the partnership. (Assume that this allocation has economic effect under Sec. 704(b).) If Z has no other taxable income and elects to expense the full $10,000, which is not restricted by the dollar limitation, Z would be able to deduct only $7,000. Even though Z actively participates only in the construction business, his taxable income for Sec. 179 includes his share of income/loss from all the partnership's trades or businesses.

The partner's taxable income passed through from the partnership must be combined with the partner's other taxable income from nonpartnership activities in determining the taxable income limitation. Therefore, in Example 20, if Z had taxable income from nonpartnership businesses of at least $3,000, the full $10,000 of Sec. 179 expense could be deducted for the year. Any Sec. 179 expense disallowed by the taxable income limit applied at the partner level is carried over to future years.(59) To the extent that the expense is taken against nonpartnership property, it reduces the basis of such property. To the extent Sec. 179 expense is allocated to a partner from the partnership, it reduces the basis of the partner's partnership interest. Any amounts carried over to future years due to disallowance by the taxable income limitation reduce either the partner's basis in nonpartnership property or the partner's basis in his partnership interest. For this purpose, carryovers must be apportioned between nonpartnership property and the partner's partnership interest basis by appropriate notation in the partner's books and records. Example 21: XYZ partnership allocates $4,000 of Sec. 179 expense and $11,000 of taxable income to partner Y for the year. Y has a loss from her sole proprietorship of $5,000 and elects to expense $6,000 under Sec. 179 relating to machinery placed in service by the sole proprietorship. Y's Sec. 179 expense is limited to taxable income of $6,000 ($11,000 income from the partnership -- $5,000 loss from the proprietorship). Y records in her books that this $6,000 consists of $3,000 from proprietorship machinery and $3,000 from the partnership. Y must reduce the basis of her partnership interest by the full $4,000 allocated to her by the partnership. Further, Y must reduce her basis in the proprietorship machinery by the $6,000 elected before the taxable income limit. These reductions are required despite carryovers of Sec. 179 expense related to the machinery of $3,000 and to the partnership allocation of $1,000.

On the disposition of a partner's partnership interest, the partner must increase the basis of the interest immediately before the transfer by any outstanding Sec. 179 carryover.(60) This occurs since the basis for this interest was previously reduced by the carryover even though no deduction was allowed for that part of the Sec. 179 expense passed through from the partnership. In Example 21, Y would increase the basis of her partnership interest by the $1,000 outstanding balance of the carryover before determining gain or loss on a sale of the interest.

A special rule applies when a trust or estate is a partner or an S shareholder. Since a trust or estate is not eligible to elect under Sec. 179, a trust or estate that is a partner or an S shareholder is not allowed to deduct any Sec. 179 expense allocated from the partnership or S corporation.(61) Accordingly, the entity does not reduce its basis for such property by any Sec. 179 allocation and can take depreciation based on the unreduced basis. Example 22: XYZ partnership elects to expense $10,000 under Sec. 179 for the year. The dollar and taxable income limitations did not reduce this amount. XYZ allocates $6,000 of this expense to trust X, which is a partner. Partners Y and Z (individuals) are allocated $2,000 each. In this case, XYZ will reduce its basis of partnership Sec. 179 property by only $4,000 ($2,000 x 2). No reduction is allowed for the $6,000 of Sec. 179 expense allocated to X since the trust cannot deduct this amount.

Application of Sec. 179 to Controlled Groups

The proposed regulations clarify the application of Sec. 179 to a controlled group of corporations.(62) As mandated by Sec. 179(d)(6)(B), they address the allocation of Sec. 179 expense among the component members of the controlled group. They also address the requirements for making the election and revoking an allocation in a controlled group setting. For Sec. 179 purposes, a controlled group is defined in the same manner as in Sec. 1563(a) except "more than 50 percent" ownership is substituted for "at least 80 percent" ownership.(63)

The requirements for making a Sec. 179 election for a controlled group depend on whether a consolidated return is filed or if some or all of the component members file separate returns. If all the members join in filing a consolidated return, the election is made on the consolidated return with the common parent filing a separate statement along with the return.(64) If separate returns are filed by some or all of the members of the controlled group, each component member not included in filing the consolidated return must make the election and file a separate statement attached to the return on which the election is made. The statement to be filed in either case must include the name, address, employer identification number and the tax year of each member of the controlled group. It must also include a copy of any allocation agreement stating the allocation of the Sec. 179 expense among the members of the group, signed by persons duly authorized to act on behalf of the members of the controlled group. Once made, an allocation generally cannot be revoked after the due date of the return (including extensions) has passed.(65)

In applying the dollar limitation, the component members of the controlled group are treated as a single taxpayer.(66) Once the amount of Sec. 179 expense after the dollar limitation is determined, it may be allocated among the members of the controlled group in any manner.(67) If a consolidated return is filed by a common parent for all members of the group, the allocation is determined by the common parent. If all of the component members file separate returns, the allocation is based on an agreement among the component members. The allocation is determined on the basis of an agreement between the common parent and members of the group who choose to file separate returns when a consolidated return is filed by some but not all members of the group. Example 23: A Corp. owns 80% of B Corp. and 60% of C Corp. These corporations constitute a controlled group of corporations. A is the common parent. If all three corporations file a consolidated return, A, as the common parent, determines how Sec. 179 expense is to be allocated among the three corporations. If the corporations file separate returns, the allocation of Sec. 179 expense must be determined through an allocation agreement between the three component members. If A and B file a consolidated return while C files a separate return, A, as common parent, must enter into an agreement with C allocating the Sec. 179 expense between the consolidated group (A and B) and C, which files a separate return.

One restriction imposed on the allocation of the Sec. 179 expense after the dollar limitation to component members is that it cannot exceed the cost of Sec. 179 property placed in service by the member for the year.(68) A further consideration is the taxable income limitation that must be applied. The regulations are silent on how to apply the taxable income limitation in a controlled group setting. Implicity, since Sec. 179(d)(6)(B) refers to the allocation of the dollar limitation among the component members of the controlled group, the taxable income limitation should be applied at the component member level.(69) Before the proposed regulations become final, this issue should be addressed.

Other Issues

The prior regulations' treatment of the leasing of Sec. 179 property and noncorporate lessors was not revised in this new set of regulations.(70) The proposed regulations do address the application of the uniform capitalization rules to Sec. 179. Fortunately for practitioners, amounts allowed as a deduction under Sec. 179 are specifically excluded from the application of the uniform capitalization rules.(71)

Conclusion

The new proposed regulations under Sec. 179 clarify the application of the election to expense the cost of certain business assets in light of recent tax act changes. The proposed regulations are generally fair to taxpayers. They do not take a pro-government revenue enhancement approach. Of particular note to taxpayers is the beneficial interpretation taken by the proposed regulations that employees are considered to be engaged in the active conduct of the trade or business of their employment. This allows an employee with an outside business generating little or no taxable income to maximize the Sec. 179 deduction since taxable income for the "taxable income" limitation includes the employee's compensation.

The proposed regulations provide guidance to tax practitioners in areas of great uncertainty where it had previously been lacking. First, they exempt amounts allowed as a Sec. 179 deduction from the uniform capitalization rules. Second, they provide ordering rules for certain circular problems when the Sec. 179 taxable income calculation involves another deduction (e.g., charitable contributions) whose calculation depends on the Sec. 179 deduction. Third, the proposed regulations provide much needed and detailed guidance on the application of Sec. 179 to partnerships, S corporations and their owners. Finally, they provide important guidance in applying Sec. 179 to members of a controlled group of corporations. However, while the proposed regulations specifically address the application of the dollar limitation to a controlled group, they are silent on the application of the taxable income limitation in that setting. This issue should be addressed before the regulations become final.

(1)Sec. 179(d)(4) and (5); Prop. Regs. Sec. 1.179-1(a). (2)Sec. 179(a); Prop. Regs. Sec. 1.179-1(a). (3)Sec. 179(d)(1); Prop. Regs. Sec. 1.179-4(a). (4)Sec. 179(a); Prop. Regs. Sec. 1.179-1(a). (5)Sec. 179(d)(2) and (3); Prop. Regs. Sec. 1.179-4(a), (c) and (d). (6)Prop. Regs. Sec. 1.179-4(a). (7)Sec. 179(d)(10); Prop. Regs. Sec. 1.179-1(e)(1). (8)Regs. Sec. 1.179-1(e)(2); Prop. Regs. Sec. 1.179-1(d)(1). (9)Adapted from the example in Prop. Regs. Sec. 1.179-1(d)(2). (10)Sec. 179(b)(1). (11)Sec. 179(b)(2) and (3). (12)Prop. Regs. Sec. 1.179-1(b). (13)Adapted from the example in Prop. Regs. Sec. 1.179-1(c)(2). (14)Prop. Regs. Sec. 1.179-1(f)(1). (15)Prop. Regs. Sec. 1.179-1(f)(2). (16)Prop. Regs. Sec. 1.179-3(g)(2). (17)Prop. Regs. Sec. 1.179-5(a). (18)Sec. 179(c)(2); Prop. Regs. Sec. 1.179-5(b). (19)Sec. 179(c)(1)(A); Prop. Regs. Sec. 1.179-5(a)(1) and (2). (20)Prop. Regs. Sec. 1.179-5(a), flush language. (21)Prop. Regs. Sec. 1.179-2(a). (22)Sec. 179(b)(3)(B); Prop. Regs. Secs. 1.179-2(a) and -3(a). (23)Sec. 179(b)(2); Prop. Regs. Sec. 1.179-2(b)(1) and (2). (24)Sec. 179(b)(3)(A); Prop. Regs. Sec. 1.179-2(c)(1). (25)Prop. Regs. Sec. 1.179-2(c)(4)(i). (26)Id. (27)Id. (28)Sec. 164(f). (29)Prop. Regs. Sec. 1.179-2(c)(4)(i). (30)Prop. Regs. Sec. 1.179-2(c)(4)(ii)(A). (31)Adapted from the example in Prop. Regs. Sec. 1.179-2(c)(4)(ii)(B). (32)Prop. Regs. Sec. 1.179-2(c)(5)(i). (33)Prop. Regs. Sec. 1.179-2(c)(5)(ii). (34)Id. (35)Adapted from the example in Prop. Regs. Sec. 1.179-2(c)(5)(iii). (36)Notice of Proposed Rulemaking, IRB 1991-17, 17, at 19. (37)Prop. Regs. Sec. 1.179-2(c)(5)(iv). (38)Sec. 179(b)(3)(B); Prop. Regs. Sec. 1.179-3(a). (39)Prop. Regs. Sec. 1.179-3(e). (40)Prop. Regs. Sec. 1.179-3(f)(1). (41)Id. (42)Sec. 179(d)(10); Prop. Regs. Sec. 1.179-3(f)(2). (43)Sec. 280F(b)(2) and (3). (44)Prop. Regs. Sec. 1.179-2(b)(5) and (c)(6). (45)For the application of Sec. 179 to married taxpayers filing separate returns, see Prop. Regs. Sec. 1.179-2(b)(6) and (c)(7). (46)Prop. Regs. Sec. 1.179-1(h). (47)Prop. Regs. Secs. 1.179-2(b)(3), (c)(2) and -3(g). (48)Prop. Regs. Sec. 1.179-2(c)(4). (49)Prop. Regs. Sec. 1.179-3(a). (50)Prop. Regs. Sec. 1.179-3(g)(2). (51)Prop. Regs. Sec. 1.179-3(g)(3). (52)Prop. Regs. Sec. 1.179-2(c)(2). (53)Prop. Regs. Sec. 1.179-2(b)(3)(iii). (54)Prop. Regs. Sec. 1.179-2(b)(4). (55)Prop. Regs. Sec. 1.179-2(b)(3)(iv) and (c)(2)(ii). (56)Adapted from the example in Prop. Regs. Sec. 1.179-2(b)(3)(v). (57)Prop. Regs. Sec. 1.179-2(b)(3). (58)Prop. Regs. Sec. 1.179-2(c)(4)(iii) and (5)(ii). (59)Prop. Regs. Sec. 1.179-3(h)(1). (60)Prop. Regs. Sec. 1.179-3(h)(2). (61)Prop. Regs. Sec. 1.179-1(f). (62)Prop. Regs. Sec. 1.179-2(b)(7). (63)Prop. Regs. Sec. 1.179-4(f). (64)Prop. Regs. Sec. 1.179-2(b)(7)(ii). (65)Prop. Regs. Sec. 1.179-2(b)(7)(iii). (66)Sec. 179(d)(6)(A); Prop. Regs. Sec. 1.179-2(b)(7)(i). (67)Prop. Regs. Sec. 1.179-2(b)(7)(i). (68)Id. (69)This conclusion was discussed with the IRS person responsible for the Sec. 179 regulations, Winston H. Douglas, who agreed with this interpretation. (70)Regs. Sec. 1.179-1(i). (71)Prop. Regs. Sec. 1.179-1(j).

John M. Beehler, Ph.D., CPA Assistant Professor College of Business Administration The University of Texas at Arlington Arlington, Tex. Debra Hopkins, Ph.D., CPA Professor College of Business Administration The University of Texas at Arlington Arlington, Tex.
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Author:Hopkins, Debra
Publication:The Tax Adviser
Date:Jan 1, 1992
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