Tuesday, October 12, 2010

Year-End Planning For Capital Goods Purchases In Light Of The Small Business Jobs Act Of 2010—Part I

In a bid to help stave off a dreaded double-dip recession, the Small Business Jobs Act of 2010 signed into law on Sept., 27, 2010 (P.L. 111-240), retroactively resuscitates bonus depreciation, boosts Code Sec. 179 expensing to an extraordinarily high level, and for the first time ever makes certain real estate assets eligible for expensing. In short, for those enterprises confident enough to expand, now is an excellent time to buy machinery and equipment (and make expensing eligible qualified real estate purchases). However, these tax breaks may not be around after this year due to ever-present concerns about expanding budget deficits. This is the first of a multi-part Practice Alert on how businesses may be able to lock in accelerated deductions by buying qualifying assets this year and placing them in service before year-end. Part I examines the revived 50% bonus depreciation (and a new long-term contract accounting rule for bonus depreciation) and an additional $8,000 luxury auto depreciation limit that applies for qualified property placed in service in 2010 (as well as 2011 for certain aircraft and long production period property). Part II examines the increased Code Sec. 179 expensing ($500,000 limit, with $2 million phaseout threshold) that applies for tax years beginning in 2010 and 2011, see ¶Â 3. Part III will examine the new qualified real property expensing ($250,000 limit) that applies for tax years beginning in 2010 and 2011.

Buy Depreciable Property and Place it in Service This Year to Lock In Bonus First-Year Depreciation

Although bonus first-year depreciation has been extended once again by the Small Business Jobs Act of 2010, another lease on life for this tax break may not be in the cards. Unless Congress acts, additional depreciation deductions under Code Sec. 168(k) in the placed-in-service year equal to 50% of the adjusted basis of qualified property won't be available after this year (unless the property is aircraft and certain long-production-period property). Thus, enterprises planning to purchase new depreciable property this year or the next should try to accelerate their buying plans, if doing so makes sound business sense. Here's how the Code Sec. 168(k) rules work for qualifying property acquired and placed in service before Jan. 1, 2011.

Basic bonus depreciation mechanics. If Code Sec. 179 expensing (substantially liberalized by, and once again extended by, the Small Business Jobs Act of 2010) is claimed on qualified property, the amount expensed "comes off the top" before the additional 50% first-year depreciation allowance is computed. Then the taxpayer computes regular first-year depreciation (and depreciation for future years) with reference to the adjusted basis remaining after expensing and after the additional 50% first-year allowance. There is no AMT depreciation adjustment for property written off under Code Sec. 168(k), which provides for the additional 50% first-year depreciation allowance.

Illustration 1: Widget, Inc., a calendar-year business, needs to buy and additional $500,000 of new five-year MACRS property. It is not eligible for expensing. If Widget makes the purchase before Jan. 1, 2011, and places the property in service before that date, Widget may claim a first year depreciation allowance of $300,000 [($500,000 ×.50 = $250,000) + ($500,000 − $250,000 ×.20 = $50,000)]. This assumes that the half-year convention applies for 2010. If it waits until 2011 to buy the assets, and bonus first year depreciation isn't extended, Widget's regular first-year depreciation allowance using the mid-year convention would be only $100,000 (20%).

Observation: The bonus depreciation deduction is determined without any proration based on the length of the tax year. As a result, accelerated first-year deductions are available even if qualifying assets are in service for only a few days in 2010.

Caution: Accelerating a purchase in 2010 may not always be a good idea. For example, it may not produce good results for a taxpayer that has an about-to-expire net operating loss.

How to qualify for bonus depreciation for 2010. In general, an asset purchased in 2010 qualifies for the bonus depreciation allowance if:

... It falls into one of the following categories: property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less; computer software other than computer software covered by Code Sec. 197; qualified leasehold improvement property; or certain water utility property.

... It is placed in service before Jan. 1, 2011. (Certain long-production-period property and certain transportation property may be placed in service before Jan. 1, 2012.)

... Its original use commences with the taxpayer. Original use is the first use to which the property is put, whether or not that use corresponds to the taxpayer's use of the property.

Observation: In other words, the property must be new property in the hands of the taxpayer.

Reconditioned property. Additional capital expenses incurred by the taxpayer to recondition or rebuild property acquired or owned by the taxpayer satisfies the original use requirement, but the cost of reconditioned or rebuilt property acquired by the taxpayer does not. (Reg. § 1.168(k)-1(b)(3)(i))

Illustration 2: On Nov. 1, 2010, XYZ Inc. buys a used machine for $50,000 and reconditions it for $15,000. The purchase price is ineligible for bonus depreciation but the $15,000 reconditioning cost is eligible (assuming the other requirements are met), whether or not it is added to the cost of the machine or capitalized as a separate asset. (Reg. § 1.168(k)-1(b)(3)(v), Ex. 1)

The question of whether property is reconditioned or rebuilt generally is a question of fact. However, a safe harbor provides that property containing used parts isn't treated as reconditioned or rebuilt if the cost of the used parts doesn't exceed 20% of its total cost. (Reg. § 1.168(k)-1(b)(3)(i))

Observation: In other words, for example, a taxpayer that buys a machine consisting of 80% new parts and 20% reconditioned parts is treated as having bought a new machine, not a reconditioned one.

Converted property. New property initially used by a taxpayer for personal use and then subsequently used by him in a trade or business meets the original-use requirement. (Reg. § 1.168(k)-1(b)(3)(ii))

Illustration 3: In 2009, an individual bought a new pickup truck and used it for personal driving only, but in 2010, he began using it exclusively for his landscaping business. The truck is qualified properly eligible for bonus depreciation.

The 50% additional first year depreciation allowance applies to qualified property unless the taxpayer "elects out." The election out may be made for any class of property for any tax year, and if made applies to all property in that class placed in service during that tax year.

Caution: A taxpayer that "elects out" of additional first-year depreciation for a specific class of property is subject to the AMT depreciation adjustment for property in that class. That means AMT depreciation is computed using the 150% declining balance method (switching to straight-line in the year necessary to maximize the allowance), except that straight line is used for property for which straight line depreciation must be used for regular tax purposes. The recovery period is the same for AMT and regular tax purposes.

Last Year for Extra-Generous Luxury Auto Depreciation Limits?

If bonus first-year depreciation deductions come to an end at the close of 2010, so will the extra-generous first-year dollar limit on autos, light trucks and vans subject to the Code Sec. 280F "luxury auto" rules.

Under Code Sec. 280F, depreciation deductions (including Code Sec. 179 expensing) that can be claimed for passenger autos is subject to dollar limits that are annually adjusted for inflation. For passenger automobiles placed in service in 2010, the adjusted first-year limit generally is $3,060. For light trucks or vans, the adjusted first year limit generally is $3,160. Light trucks or vans are passenger automobiles built on a truck chassis, including minivans and sport-utility vehicles (SUVs) built on a truck chassis that are subject to the Code Sec. 280F limits because they are rated at 6,000 points gross (loaded) vehicle weight or less.

However, for new vehicles bought and placed in service in 2010, and that qualify for bonus first-year depreciation, the first-year dollar limit is increased by $8,000. Thus, the first-year dollar limit is $11,060 ($3,060 general first year allowance for 2010 plus $8,000) for autos (not trucks or vans), and $11,160 for light trucks or vans. These boosted dollar amounts apply only for vehicles bought and placed in service before 2010. As a result, taxpayers thinking of buying a new auto, light truck or van for trade or business use should buy the vehicle and place it in service this year if they want to maximize first-year deductions.

Illustration 4: A real estate appraisal company is thinking of adding another $30,000 minivan to its fleet of vehicles used by appraisers to visit properties. If it buys the minivan and places it in service before the end of 2010, the first-year depreciation deduction will be $11,160 for 2010. If it waits until 2011 (assuming Congress doesn't extend bonus depreciation and assuming regular first-year allowances remain the same as they are for this year), the first-year depreciation deduction for the minivan will be only $3,160.

Caution: The dollar limits must be reduced proportionately if business/investment use of a vehicle is less than 100%. For example, assume a taxpayer who is a self-employed person buys a new $35,000 minivan and uses it 60% for business and 40% for personal driving. The first year dollar limit is $6,695 if he buys the minivan in 2010 and it is eligible for bonus first-year depreciation ($11,160 ×.60), and $1,896 if he buys it in 2011 and bonus depreciation and enhanced auto writeoffs aren't available ($3,160 ×.60).

Observation: Heavy SUVs—those that are built on a truck chassis and are rated at more than 6,000 pounds gross (loaded) vehicle weight—are exempt from the luxury-auto dollar caps because they fall outside of the Code Sec. 280F(d)(5) definition of a passenger auto. Under Code Sec. 179(b)(6), not more than $25,000 of the cost of a heavy SUV may be expensed under Code Sec. 179. The balance of the heavy SUV's cost may be depreciated under the regular rules that apply to 5-year MACRS property (e.g., a 20% first-year depreciation allowance if the half-year convention applies for the placed in service year). However, with the 50% first year bonus depreciation available for qualified assets bought and placed in service in 2010 (in addition to the $25,000 expensing allowance and regular depreciation), taxpayers buying and placing in service new heavy SUVs in 2010 may be entitled to write off most of the cost of the vehicle.

New Long-Term Contract Accounting Rule for Bonus Depreciation on Post-2009 Qualified Property

The Small Business Jobs Act of 2010 carries a new twist for taxpayers that use bonus first-year depreciation: For property placed in service after Dec. 31, 2009, solely for determining the percentage of completion under Code Sec. 460(b)(1)(A), the cost of qualified property is taken into account as a cost allocated to the contract as if bonus depreciation had not been enacted. (Code Sec. 460(c)(6), as amended by Act Sec. 2023(a))

Qualified property is property otherwise eligible for bonus depreciation that has a MACRS recovery period of 7 years or less and that is placed in service after Dec. 31, 2009, and before Jan. 1, 2011 (Jan. 1, 2012, in the case of Code Sec. 168(k)(2)(B) property (longer-lived property).

Observation: Thus, 50% bonus depreciation on "qualified property" placed in service after Dec. 31, 2009, is not taken into account as a cost in applying the percentage of completion method. By contrast, for property placed in service before Jan. 1, 2010, for purposes of reporting income under the percentage-of-completion method, all depreciation, amortization and cost recovery allowances on equipment and facilities used to perform the contract are taken into account as costs under the contract. Without the new rule, bonus depreciation would have the effect of accelerating the reporting of income under the percentage of completion method by increasing the costs and thus the completion percentage in the year in which the bonus depreciation was claimed.

Illustration 5: C, a calendar year taxpayer, is required to use the percentage-of-completion method to account for a long-term contract during 2010. During 2010, C purchases and places into service equipment with a cost basis of $500,000 and MACRS recovery period of 5-years, and uses the equipment exclusively in performing its obligation under the contract. C doesn't elect to expense this equipment under Code Sec. 179. The amount of the depreciation deduction that may be claimed by the taxpayer in 2010 for the equipment is $300,000 [($500,000×.50 bonus depreciation) + (($500,000-($500,000×.50)) ×.20]. However, in computing the percentage of completion under Code Sec. 460(b)(1)(A), the depreciation on the equipment (assuming a half-year convention) taken into account as a cost allocated to the contract for 2010 is only $100,000 ($500,000 ×.20 first year MACRS allowance). (Committee Report)

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