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Planning for automobile cost recovery.

Planning for Automobile Cost Recovery

Annual cost recovery deductions for passenger automobiles are limited to modest amounts by statute. On the other hand, term interests acquired by purchase may be amortized without a cap on the annual deductions as long as the remainder is held by an unrelated party. Since both deductions are allowed at the same time, it appears possible to circumbent the cost recovery limitations on luxury cars by engaging in a split purchase of an auto. The cost recovery and amortization rules are explored together with possible counter arguments that may be raised by the IRS.

Luxury Car Limitations

Purchases

Under Section 280F, passenger autos that are more moderately priced must be cost recovered over an extended period of time. This is accomplished by limiting the cost recovery deductions in the year of acquisition and each succeeding year. The dollar limits are adjusted and annually. For autos placed in service in 1990, the maximum cost recovery deduction available are:
 1st taxable year (1990) $2,660
 2nd taxable year (1991) 4,200
 3rd taxable year (1992) 2,550


Each succeeding year

(1993 and later) 1,475

As a result, the first four taxable years yield only a total of $10,885 in cost recovery deductions for an auto used solely for business purposes.(1)

Example: Miss Household purchases a BMW for $50,000 in 1990 to be used exclusively to sell real estate in Beverly Hills. Her recovery period will be 31 years. She recovers $10,885 the first four years, $1,475 each year the next 26 years and $765 the last year. In the likely event that she disposes of the auto during the 31-year period, Miss Household will have a high basis, resulting in a loss or high basis in a trade-in.

Miscellaneous rules to keep in mind include: 1. Under Section 280F(d), the cost

recovery limitations include the

Section 179 expense election

amounts. As a result, the amount

elected expensed should be limited

to $2,660 less regular cost

recovery. Thus, Section 179 is

only relevant when an inexpensive

auto is purchased. 2. The dollar limitations are reduced

proportionately by the

percentage of personal use.

Therefore, if the auto is used

70% for business purposes, the

above limitations are cut by 30%.

Leases

When an auto is leased and used solely for business purposes, the lease payments are deductible in full regardless of the amounts paid and the cost of the auto. However, to discourage leasing as a means of circumventing the cost recovery limitations the lessee must report as gross income an "inclusion amount" each year of the lease in the case of an auto with a fair market value in excess of $12,800 (for lease terms beginning in 1990).(2)

Example: Miss Household leases a $50,000 BMW for $15,000 a year starting in 1990 and uses it 100% for business purposes. The lease payments are fully deductible. However, under Table 2 of Rev. Proc. 9022 she must report as income an inclusion amount of $503 in 1990, $1,103 in 1991, $1,634 in 1992, $1,963 in 1993 and $2,268 in 1994 and succeeding years, if any, of the lease.

It is clear that despite the inclusion amounts the net deduction for lease payments may be far in excess of the cost recovery limits.

Amortization of Present

Interests

For many decades it has been well established that the basis in a term interest, life estate or income interest in a trust may be written off, straight-line, through amortization deductions if acquired by purchase.(3)

Example: T and R engage in a split purchase of an asset for $50,000 in trust with T paying $30,000 for a five-year term interest and R paying $20,000 for the remainder. T is the present holder, R the remainderman. T will recover the basis in the beneficial interest in the trust through an annual amortization deduction of $6,000 a year for five years. R's basis is frozen at $20,000 which after five years becomes the basis in the property itself when R's interest ripens into full ownership at that time.

Since Section 167 is the general authority for depreciation and amortization deductions, the property must be used in a trade or business or held for investment. However, it is well established that the underlying property need not be depreciable but may consist of raw land, securities or or art works, to name a few.(4) However, Section 167(e), added to the Code by the Revenue Reconciliation Act of 1989, bans any amortization deduction if the split purchase is entered into by parties related for tax purposes.(5) Instead, the disallowed amortization deduction reduces the basis in the term interest and adds to the basis in the remainder.(6)

Example: The facts are the same as in the previous example, except that T and R are "related." T receives no amortization deduction, the basis in the term interest is reduced by $6,000 a year and the basis is the remainder is increased by $6,000 a year. After five years R owns the property outright with a basis of $50,000.

Cost Recovery Deduction

After a Split Purchase

Under Section 167(h) the depreciation (or cost recovery) deduction is allowed in full to the holder of the present interest, unless the trust instrument provides otherwise. Section 167(e), which bars the amortization deduction in cases where the holders of the present and future interests are held by related parties, does not affect the allowance of depreciation or cost recovery.(7) If the parties are unrelated, both amortization and cost recovery are available simultaneously, i.e., the basis in the term interest is amortized and the basis is the underlying property is depreciated (cost recovered) simultaneously.

Avoiding Luxury Car Limits

Through Split Purchases

The luxury car limitations under Section 280F apply only to passenger cars, and there is no indication that the limitations apply to intangible assets, such as beneficial interests in trusts. Therefore, it should be possible to claim both cost recovery on an auto held in trust, subject to the Section 280F limits and amortization deductions for the basis in a term interest in a trust, even if one of the assets in the trust, or the only asset in the trust, is an auto.

Combining Amortization and Cost

Recovery of Autos Held in Trust

Example: In 1990 T and R engage in a split purchase of a $50,000 auto to be used 100% for business. T pays $30,000 for a five-year term interest and R pays $20,000 for the remainder. The trust instrument is silent as to cost recovery. Under Section 167(h) all cost recovery deductions are to be claimed by T. Two possible approaches exist: 1. T will amortize his basis in the

term interest and cost recover

the basis in the remainder. 2. T will cost recover the full uniform

basis in the auto, allocate

the cost recovery 60% to the

term and 40% to the remainder,

then amortize the resulting declining

basis in the term interest.

Example - Cost recovery of remainder only: T will claim an amortization deduction of $6,000 a year for five years, reducing his basis in the term interest to zero. Since the $20,000 basis in the remainder is above the luxury car limit the maximum cost recovery amounts are allowable even though only the remainder basis is recovered, i.e., $2,660 the first year, $4,200 the second, etc. After five years R's basis in the auto is $20,000 - $2,660 - $4,200 - $2,550, - $1,475, or $7,640, to be recovered at the rate of $1,475 a year for five more years.

T's deduction over the five year life of his interest are shown in Table 1.

Table : Table 1
Year Amortization Cost Recovery Total
 1 $ 6,000 $ 2,660 $ 8,660
 2 6,000 4,200 10,200
 3 6,000 2,550 8,550
 4 6,000 1,475 7,475
 5 6,000 1,475 7,475
 $ 30,000 $ 12,360 $ 42,360


Example - Cost recovery of uniform basis: Because of the luxury car cost recovery limitations, basing cost recovery on the full basis does not increase the cost recovery deduction, but it does reduce the amortization expenses, as follows: Year 1: T claims $2,660 of cost recovery,

60% of which, or $1,596,

reduces the basis in the term

interest to $28,404. As a result

the amortization deduction is

reduced from $6,000 to one-fifth

of $28,404, or $5,681. The

basis in the remainder is reduced

by 40% of $2,660, or $1,064, to

$18,936. Year 2: T claims $4,200 of cost recovery,

60% of which, or $2,520,

reduces the basis in the term

interest to $20,203 ($30,000 - $1,596 - $5,681 - $2,520).

The

amortization deduction should

be computed as one-fourth of

$20,203, or $5,051, leaving a

basis of $15,152 for the third

year. (Taking one-fifth of the

declining balance each year

would leave an unamortized basis

in the term interest after five

years, resulting in an abandonment

loss under Section 165 at

that time).

T's deductions over the five year life of the term interest are shown in Table 2.

Table : Table 2
Year Amortization Cost Recovery Total
 1 $ 5,681 $ 2,660 $ 8,341
 2 5,051 4,200 9,251
 3 4,541 2,550 7,091
 4 4,098 1,475 5,573
 5 3,213 1,475 4,688
 $ 22,584 $ 12,360 $ 34,944


Since the total amortization deductions were reduced by 60% of the cost recovery deductions, the latter only yielded an extra $4,944 in total deductions to T as compared to merely amortizing the basis in the term interest. However, when R becomes the owner of the auto after five years his basis is $20,000 reduced by only 40% of the cost recovery deductions, or $15,056 ($20,000 less 40% of $12,360), to be recovered at the rate of $1,475 a year for some 10 more years. Therefore, because of the luxury car limitation, the most beneficial approach is to only cost recover the basis in the remainder. What is ordinarily the most aggressive position - to cost recover the full uniform basis of an asset in conjunction with the amortization deduction - should not be pursued in the case of an auto subject to the Section 280F ceilings.

IRS Opposition Possibilities

Purchase by remainderman, lease to term holder

The most aggressive IRS stance possible would be to view the remainderman, R, as having purchased the auto in full, then leasing it to the purchaser of the term interest, T, for the price paid for the present interest.

Example: T and R purchase an auto together in trust for $50,000 with T paying $30,000 for a five-year term interest and R paying $20,000 for the remainder. T is using the auto solely for business purposes. The IRS argues that, for purposes, R purchased the auto for $50,000, then leased it to T for five years for $30,000. The tax consequences of the "purchase-followed-by-lease" view to T would be: 1. T would have a basis in his

leasehold of $30,000, to be deducted

as rent straight line over

five years, i.e., $60,000 a year.

Thus, the deduction is the same

as if T amortized his basis in the

term interest. 2. T would have to report gross

income each year pursuant to the

inclusion amount table, i.e.,

$503 in the first year, $1,103

the second, $1,634 the third,

$1,963 the fourth and $2,268

the fifth (1990 numbers). 3. No cost recovery of the auto itself

is available to T.

R's tax consequences would be: 1. R is deemed to have purchased

the auto for $ 50,000, which

therefore becomes his basis for

gain, loss and cost recovery. 2. R will cost recover his $50,000

basis, but his deductions are limited

to $2,660 the first year,

$4,200 the second, $2,550 the

third and $1,475 each year thereafter

(1990 limits). 3. R has received $30,000 in advance

rental payments. The tax

consequences of this are extremely

unfavorable:

a. Under Treasury Regulations the

full amount is immediately taxable

without regard to R's accounting

method.(8)

b. No option of R's $50,000 basis

may be allocated to the rental

income to offset it.(9)

c. The $30,000 will constitute ordinary

income.(10)

If the IRS takes the purchase-followed-by-lease position it would be at odds with some 60 years of legal history. In an arm's length transaction, split purchases have been recognized by the courts since 1929, including the availability of amortization of the term interest. However, there is no question that the above results follow if, in fact, R purchased the auto then subsequently, in an unrelated transaction, leased it to T or sold him a term interest. As an aside, most likely, T must take the inclusion amounts into income whether the transaction is formally structured as a lease or as the purchase of a term interest in a trust funded with the auto.

Purchase by term holder, sale of

remainder

Another conceivable position the IRS may take is that the termholder, T, purchased the auto in full, then sold the remainder to R. Using the same example as above, where T paid $30,000 for a five-year term and R paid $20,000 for the remainder, the Tax consequences to T would be: 1. T initially has a cost basis of

$50,000 in the auto, but only for

a theoretical instant. 2. T sold the remainder in the auto

for $20,000, or 40% of the purchase

price. No gain or loss

should be recognized on the sale

since T may allocate 40% of his

basis, also $20,000, to the remainder.(11) 3. A unanimous view by the courts

is that a retained term interest in

property resulting from a disposition

of the remainder is

nonamortizable.(12) 4. T can still claim cost recovery on

the full $50,000 uniform basis

the trustee has in the auto under

Section 1 67(h). The deductions

are, of course, subject to the

luxury car limitations.

R's tax consequences would be: 1. R has a cost basis of $20,000 in

the remainder. 2. The basis in the remainder in

reduced each year by 40% of the

cost recovery deductions claimed

by T, i.e., 40% of $2,660 the

first year, 40% of $4,200 the

second, etc., if the split purchase

took place in 1990.

R's tax consequences do not differ from those resulting from a split purchase where T cost recovers the full basis, as discussed above. As usual R recognizes no income on the annual increase in the actuarial value of the remainder, nor on the cessation of T's present interest.

Unavailable Amortization

Deductions

Amortization deductions for a term interest are unavailable in the following situations:

Personal Use Assets. Under Section 167, the general authority for amortization and depreciation, the deduction is only allowed for property used in a trade or business or held for investment purposes. Thus, no amortization (or cost recovery) is available for autos used for personal purposes. In the numerous cases where an auto is used for both business and personal purposes, the amortization deductions are proportionately reduced.

Autos Acquired by Gift or Inheritance. Section 273 prohibits the write-off of term interests acquired by gift, bequest or inheritance. Since the deduction is not denied by Section 167(e), the basis in the present interest is not reduced nor is the basis in the remainder increased.

Retention of a Term Interest. When an owner of property disposes of the remainder while retaining a term interest, the courts have been unanimous in denying amortization deductions on the grounds that the present interest, as such, has not been acquired by purchase.

Split Purchase by "Related" Parties. When a split purchase is engaged in by parties related for tax purposes under Section 267(b) or (e), Section 167(b) denies the amortization deduction. However, the basis in the term interest is reduced, and the basis in the remainder is increased by the amount of the disallowed deduction.

Example: T and R are related for tax purposes. They purchase an auto, T paying $30,000 for a five-year term interest, R $20,000 for the remainder. T's amortization deduction is disallowed, however his basis is nevertheless reduced by it and R's basis is increased by the same amount.

Many taxpayers related by blood, marriage or in an economic sense are nevertheless unrelated for tax purposes. Examples included business partners, an individual and his or her aunt, uncle, nephew, niece and inlaws, an unmarried couple and an estate and its beneficiaries.

On the other hand related taxpayers include a partnership and its partners, an S corporation and its shareholders, a C corporation and a controlling shareholder, an individual and his siblings, spouse, ancestor and lineal descendants, a grantor and a trustee and a trustee and a beneficiary.

Conclusion

Split purchases of passenger autos by unrelated parties make it possible to combine cost recovery deductions on the auto itself with the amortization of the basis in the term interest. The result is a circumvention of the luxury car limitations on cost recovery. Although several adverse IRS challenges are theoretically possible, a 60-year history of allowing the amortization of term interests in court decisions, as well as Treasury Regulations and rulings, make such positions more difficult than is usually the case.

Footnotes

(1 ) Rev. Proc. 90-22, 1990-15 IRB 32.

(2 ) Ibid and Temp. Reg. 1.280F- 7T(a).

(3 ) Keitel v. Comm., 15 BTA 903 (1929), Bell v. Harrison, 212 F.2d 253 (CA-7, 1954), Rev. Rul. 62-132, 1962-CB 73.

(4 ) Reg. 1.1014-5(c), Example 3, Manufacturers Hanover Trust v. Commn., 431 F. 2d 664 (CA-2, 1 970).

(5 ) Code Section 1 67(e)(1).

(6 ) Code Section 167(e)(3)(A) and (B).

(7 ) Code Section 167(e)(4)(B).

(8 ) Reg. 1.61-8 (b).

(9 ) Hort v. Comm., 313 U.S. 28 (1941).

(10) P. G. Lake, Inc., 356 U.S. 260 (1958).

(11) Eileen M. Hunter, 44 TC 109 (1969).

(12) U.S. v. Georgia Railroad and Banking Co., 348 F. 2d 278 (CA-5, 1965), cert. denied, 382 U.S. 973 (1966), Gordon, 85 TC 309 (1980), Lomas Santa Fe, Inc., 74 TC 662 (1980), aff'd 693 F. 2d 71 (CA-9, 1982).
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Title Annotation:annual cost recovery deductions for passenger automobiles
Author:Auster, Rolf
Publication:The National Public Accountant
Date:Oct 1, 1991
Words:3117
Previous Article:Taxation and representation.
Next Article:Robert L. Gordon named NSPA Accountant of the Year.
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