IRS Finalizes Bonus Depreciation Regs; Withdraws Partnership Look-Through Rule

(Parker Tax Publishing September 22, 2020)

The IRS issued final bonus depreciation regulations, which generally affect taxpayers who depreciate qualified property acquired and placed in service after September 27, 2017. Among other changes, the final regulations (1) withdraw a complex partnership-look thru rule contained in the proposed regulations which addressed the extent to which a partner was deemed to have a depreciable interest in property held by a partnership; (2) clarify the application of the five-year safe harbor rule for depreciable interests in used property; (3) clarify a de minimis interest rule relating to dispositions of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service; and (4) remove a cut-off date for when larger self-constructed property must be placed in service to qualify for bonus depreciation. T.D. 9916.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) made several significant changes to the additional first year depreciation deduction provisions in Code Sec. 168(k) (i.e., the bonus depreciation deduction). First, the bonus depreciation deduction percentage was increased from 50 to 100 percent. Second, property eligible for the bonus depreciation deduction was expanded, for the first time, to include certain used depreciable property and certain film, television, or live theatrical productions. Third, the placed-in-service date was extended from before January 1, 2020, to before January 1, 2027 (and from before January 1, 2021, to before January 1, 2028, for longer production period property or certain aircraft property described in Code Sec. 168(k)(2)(B) or (C)). Fourth, the date on which a specified plant eligible for bonus depreciation may be planted or grafted by the taxpayer was extended from before January 1, 2020, to before January 1, 2027.

In August of 2018, the IRS issued proposed regulations (REG-104397-18) relating to the bonus depreciation rules as amended by the TCJA (2018 Proposed Regulations). The 2018 proposed regulations updated existing regulations and provided a new regulation, Reg. Sec. 1.168(k)-2, for property acquired and placed in service after September 27, 2017. In September of 2019, the IRS issued final regulations in T.D. 9874 (2019 Final Regulations), which clarified the rules relating to the increase of the bonus depreciation benefit and the expansion of the universe of qualifying property, particularly to certain classes of used property authorized by the TCJA. Concurrently, the IRS issued additional proposed regulations under Code Sec. 168(k) in REG-106808-19 (2019 Proposed Regulations) that addressed comments the IRS received regarding the 2018 Proposed Regulations.

On September 21, 2020, in T.D. 9916, the IRS finalized the 2019 Proposed Regulations. The final regulations address bonus depreciation issues that were not addressed in the 2019 Final Regulations, and provide some clarifying changes to the 2019 Final Regulations. Specifically, the final regulations (1) withdraw a complex partnership-look thru rule contained in the proposed regulations which addressed the extent to which a partner was deemed to have a depreciable interest in property held by a partnership; (2) clarify the application of the five-year safe harbor rule for depreciable interests in used property; (3) clarify a de minimis interest rule relating to dispositions of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service; (4) remove a cut-off date for when larger self-constructed property must be placed in service to qualify for bonus depreciation; (5) provide that, for purposes of determining whether the mid-quarter convention applies, depreciable basis is not reduced by the amount of bonus depreciation; and (6) clarifies the term "qualified improvement property." The IRS also moved the bonus depreciation rules for consolidated groups to Reg. Sec. 1.1502-68.

Partnership Look-Through Rule Withdrawn

The 2019 Proposed Regulations contained a complex Partnership Look-through Rule, which addressed the extent to which a partner is deemed to have a depreciable interest in property held by a partnership. Under that rule, a person would be treated as having a depreciable interest in a portion of property before the person's acquisition of the property if the person was a partner in a partnership at any time the partnership owned the property. The Partnership Look-through Rule further provided that the portion of property in which a partner was treated as having a depreciable interest was equal to the total share of depreciation deductions with respect to the property allocated to the partner as a percentage of the total depreciation deductions allocated to all partners during the current calendar year and the five calendar years immediately before the partnership's current year.

At least one practitioner requested that the Partnership Look-through Rule be withdrawn and replaced with a rule that treats a partner as having a depreciable interest in an item of property only if the partner was a controlling partner in a partnership at any time the partnership owned the property during the applicable look-back period. The IRS agreed that the rule should be withdrawn because the complexity of applying it would place a significant administrative burden on both taxpayers and the IRS. Thus, under the final regulations, a partner will not be treated as having a depreciable interest in partnership property solely by virtue of being a partner in the partnership. In addition, the IRS determined that a replacement rule that applies only to controlling partners is not necessary because the related party rule in Code Sec. 179(d)(2)(A) applies to a direct purchase of partnership property by a current majority partner, and the series of related transactions rules in Reg. Sec. 1.168(k)-2(b)(3)(iii)(C) (discussed below) prevents avoidance of the related party rule through the use of intermediary parties.

Five-year Safe Harbor for Depreciable Interest in Used Property

Used property qualifies for the bonus depreciation deduction if the property was not used by the taxpayer or a predecessor at any time before such acquisition. The 2019 Final Regulations provide that property is treated as used by the taxpayer or a predecessor at any time before acquisition by the taxpayer or predecessor if the taxpayer or the predecessor had a depreciable interest in the property at any time before such acquisition, whether or not the taxpayer or the predecessor claimed depreciation deductions for the property. To determine if the taxpayer or a predecessor had a depreciable interest in the property at any time before acquisition, the 2019 Final Regulations provide that only the five calendar years immediately before the taxpayer's current placed-in-service year of the property are taken into account. This is known as the "Five-Year Safe Harbor." If the taxpayer and a predecessor have not been in existence for this entire five-year period, the 2019 Final Regulations provide that only the number of calendar years the taxpayer and the predecessor have been in existence are taken into account.

With respect to the Five-Year Safe Harbor, practitioners raised the following issues:

(1) whether the "placed-in-service year" is the tax year or the calendar year;

(2) whether the portion of the calendar year covering the period up to the placed-in-service date of the property is taken into account; and

(3) how the Five-Year Safe Harbor applies to situations where the taxpayer or a predecessor was not in existence during the entire five-year look-back period.

In the preamble to the final regulations, the IRS advised that it intended for the "placed-in-service year" to be the current calendar year in which the property is placed in service by the taxpayer. Additionally, it intended the portion of that calendar year covering the period up to the placed-in-service date of the property to be considered in determining whether the taxpayer or a predecessor previously had a depreciable interest. This approach, the IRS said, is consistent with an exception to the de minimis use rule in Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(4) of the 2019 Proposed Regulations (discussed below). Pursuant to that exception, when a taxpayer places in service eligible property in Year 1, disposes of that property to an unrelated party in Year 1 within 90 calendar days of that placed-in-service date, and then reacquires the same property later in Year 1, the taxpayer is treated as having a prior depreciable interest in the property upon the taxpayer's reacquisition of the property in Year 1. This rule, the IRS noted, would be superfluous if the Five-Year Safe Harbor did not consider the portion of the calendar year covering the period up to the placed-in-service date of the property.

Accordingly, the IRS amended the final regulations in Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(1) to clarify that the five calendar years immediately before the current calendar year in which the property is placed in service by the taxpayer, and the portion of such current calendar year before the placed-in-service date of the property determined without taking into account the applicable convention, are taken into account to determine if the taxpayer or a predecessor had a depreciable interest in the property at any time prior to acquisition (look-back period). The IRS also amended Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(1) to adopt the suggestion that both the taxpayer and the predecessor be subject to a separate look-back period. The final regulations clarify that if the taxpayer or a predecessor, or both, have not been in existence during the entire look-back period, then only the portion of the look-back period during which the taxpayer or a predecessor, or both, have been in existence is taken into account to determine if the taxpayer or the predecessor had a depreciable interest in the property.

De Minimis Use Rule

The 2019 Proposed Regulations provided an exception, known as the De Minimis Use Rule, to the prior depreciable interest rule in the 2019 Final Regulations when a taxpayer disposes of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service. The 2019 Proposed Regulations provided that the De Minimis Use Rule did not apply if the taxpayer reacquires and again places in service the property during the same tax year the taxpayer disposed of the property.

Practitioners requested clarification regarding the application of the De Minimis Use Rule in the following situations:

Situation 1: The taxpayer places in service property in Year 1, disposes of that property to an unrelated party in Year 1 within 90 calendar days of that original placed-in-service date, and then reacquires and again places in service the same property later in Year 1 and does not dispose of the property again in Year 1.

Situation 2: The taxpayer places in service property in Year 1, disposes of that property to an unrelated party in Year 2 within 90 calendar days of that original placed-in-service date, and then reacquires and again places in service the same property in Year 2 or later.

Situation 3: The taxpayer places in service property in Year 1 and disposes of that property to an unrelated party in Year 1 within 90 calendar days of that original placed-in-service date, then the taxpayer reacquires and again places in service the same property later in Year 1 and disposes of that property to an unrelated party in Year 2 within 90 calendar days of the subsequent placed-in-service date in Year 1, and the taxpayer reacquires and again places in service the same property in Year 4.

With respect to Situation 1, the IRS noted that, pursuant to Reg. Sec. 1.168(k)-2(g)(1)(i) of the 2019 Final Regulations, the bonus depreciation deduction is not allowable for the property when it was initially placed in service in Year 1 by the taxpayer. The bonus depreciation deduction also is not allowable when the same property is subsequently placed in service in Year 1 by the same taxpayer under the De Minimis Use Rule in the 2019 Proposed Regulations. A practitioner argued that the bonus depreciation deduction should be allowable for the property when it is placed in service again in Year 1 and is not disposed of again in Year 1, because the bonus depreciation deduction is not allowable for the property when it initially was placed in service in Year 1 by the taxpayer. The IRS said that it agreed with this if the property is originally acquired by the taxpayer after September 27, 2017, but did not agree with respect to property that was originally acquired by the taxpayer before September 28, 2017, as the exception to the De Minimis Use Rule was intended to prevent certain churning transactions involving such property. According to the IRS, property that is placed in service, disposed of, and reacquired in the same tax year is more likely to be part of a predetermined churning plan.

With respect to Situation 2, the IRS said that the bonus depreciation deduction is allowable for the same property by the same taxpayer twice (in Year 1 when the property is initially placed in service, and in Year 2 when the property is placed in service again). The IRS noted that this result is consistent with the De Minimis Use Rule in the 2019 Proposed Regulations, and this result was not changed in the final regulations.

With respect to Situation 3, the IRS noted that the De Minimis Use Rule provides only one 90-day period that is disregarded in determining whether the taxpayer had a depreciable interest in the property before its reacquisition. That 90-day period is measured from the original placed-in-service date of the property by the taxpayer. As a result, the second 90-day period in Situation 3 (during which the taxpayer reacquired the property in Year 1, again placed it in service in Year 1, and then disposed of it in Year 2) is taken into account in determining whether the taxpayer previously used the property when the taxpayer again places in service the property in Year 4. Accordingly, the IRS clarified the De Minimis Use Rule in the final regulations to reflect these results. The IRS also added additional examples to the final regulations to illustrate the application of the De Minimis Use Rule in the three situations described above.

Series of Related Transactions

In the 2019 Proposed Regulations, the IRS provided special rules for a series of related transactions (Proposed Related Transactions Rule). Under the Proposed Related Transactions Rule, the relationship between the parties under Code Sec. 179(d)(2)(A) or (B) in a series of related transactions would be tested immediately after each step in the series, and between the original transferor and the ultimate transferee immediately after the last transaction in the series. The Proposed Related Transactions Rule also provided that the relationship between the parties in a series of related transactions is not tested in certain situations.

The IRS agreed with practitioners that the Proposed Related Transactions Rule should be simplified and that the rule should be modified to take into account changes in the relationship between the parties, including a party ceasing to exist, over the course of a series of related transactions. For example, under the Proposed Related Transaction Rule, the IRS said that in a situation where, pursuant to a series of related transactions, A transfers property to B, B transfers property to C, and C transfers property to D, relatedness is tested after each step and between D and A. The IRS noted that if, at the beginning of the series, C was related to A but, before acquiring the property, C ceases to be related to A, or A ceases to exist, the Proposed Related Transactions Rule does not address how to treat such changes.

Accordingly, the final regulations addresses such situations and provide that each transferee in a series of related transactions tests its relationship under Code Sec. 179(d)(2)(A) or (B) with the transferor from which the transferee directly acquires the depreciable property (immediate transferor) and with the original transferor of the depreciable property in the series. The transferee is treated as related to the immediate transferor or the original transferor if the relationship exists either immediately before the first transfer of the depreciable property in the series or when the transferee acquires the property. Any transferor in a series of related transactions that ceases to exist during the series is deemed to continue to exist for purposes of testing relatedness. The final regulations also provide a special rule that disregards certain transitory relationships created pursuant to a series of related transactions.

Finally, the final regulations provide that, if a transferee in a series of related transactions acquires depreciable property from a transferor that was not in existence immediately before the first transfer of the property in the series (new transferor), the transferee tests its relationship with the party from which the new transferor acquired the depreciable property. The IRS provides examples illustrating these revised rules in these final regulations.

Acquisition of a Trade or Business or an Entity

Under the 2019 Proposed Regulations, a contract to acquire all or substantially all of the assets of a trade or business, or to acquire an entity, is binding if it is enforceable under state law against the parties to the contract and certain conditions do not prevent the contract from being a binding contract. This applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 338.

The IRS said it was aware of potential questions regarding whether this rule also applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 336(e). The IRS noted that the federal income tax consequences of a Code Sec. 336(e) election made with respect to a qualified stock disposition not described, in whole or in part, in Code Sec. 355(d)(2) or Code Sec. 355(e)(2) are similar to the federal income tax consequences of a Code Sec. 338 election. Accordingly, in the final regulations, the IRS has clarified that this provision applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 336(e) made for a disposition described in Reg. Sec. 1.336-2(b)(1).

Component Election

Under the 2019 Proposed Regulations, a taxpayer could elect to treat one or more components acquired or self-constructed after September 27, 2017, of certain larger self-constructed property as being eligible for the bonus depreciation deduction (Component Election). The larger self-constructed property must be qualified property under Code Sec. 168(k)(2), as in effect before the enactment of the TCJA, for which the manufacture, construction, or production began before September 28, 2017. However, the election is not available for components of larger self-constructed property when such components are not otherwise eligible for the bonus depreciation deduction.

Under the 2019 Proposed Regulations, larger self-constructed property that is placed in service by the taxpayer after December 31, 2019, or larger self-constructed property described in Code Sec. 168(k)(2)(B) or (C), as in effect on the day before enactment of the TCJA, that is placed in service after December 31, 2020, is not eligible larger self-constructed property. Accordingly, any components of such property that are acquired or self-constructed after September 27, 2017, do not qualify for the Component Election. Practitioners requested that the final regulations remove this cut-off date for when the larger self-constructed property must be placed in service because it does not reflect the intent of the TCJA of promoting capital investment, modernization, and growth.

The IRS agreed with the practitioners and the final regulations provide that eligible larger self-constructed property also includes property that is manufactured, constructed, or produced for the taxpayer by another person under a written contract that does not meet the definition of a binding contract under Reg. Sec. 1.168(k)-2(b)(5)(iii) of the 2019 Final Regulations (written non-binding contract) and that is entered into before the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for its production of income. Further, the final regulations remove the requirement that the larger self-constructed property be qualified property under Code Sec. 168(k)(2), as in effect on the day before the enactment of the TCJA, and instead provide that the larger self-constructed property must be (1) MACRS property with a recovery period of 20 years or less, computer software, water utility property, or qualified improvement property under Code Sec. 168(k)(3) as in effect on the day before the enactment date of the TCJA, and (2) qualified property under Reg. Sec. 1.168(k)-2(b) of the 2019 Final Regulations and these 2020 final regulations, determined without regard to the acquisition date requirement in Reg. Sec. 1.168(k)-2(b)(5), for which the taxpayer begins the manufacture, construction, or production before September 28, 2017. As a result of this change, the cut-off dates for when the larger self-constructed property must be placed in service by the taxpayer now align with the placed-in-service dates under Code Sec. 168(k)(6) and Reg. Sec. 1.168(k)-2(b)(4)(i).

Definition of Qualified Improvement Property

While the TCJA committee reports indicated that qualified improvement property was to have a 15-year life -- the same as it did before TCJA -- thus making such property eligible for the bonus depreciation deduction, a drafting error prevented such property from being included in the list of 15-year property. Because qualified improvement property was not specified in Code Sec. 168(e)(3)(E) as 15-year property, such property had the recovery period specified in Code Sec. 168(c) -- 39 years for nonresidential real property placed in service in tax years after 2017. However, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was signed into law in March of 2020, fixed this glitch as if it never happened (Pub. L. 116-136, Sec. 2307). Thus, such property meets the bonus depreciation criteria specified in Code Sec. 168(k)(2)(A) (i.e., the recovery period is 20 years or less) and such property is eligible for bonus depreciation.

The final bonus depreciation regulations amend Reg. Sec. 1.168(b)-1(a)(5)(i)(A) to provide that such improvements must be made by the taxpayer. The IRS said that it was aware of questions regarding the meaning of "made by the taxpayer" with respect to third-party construction of the improvement and the acquisition of a building in a transaction described in Code Sec. 168(i)(7)(B) (pertaining to treatment of transferees in certain nonrecognition transactions) that includes an improvement previously made by, and placed in service by, the transferor or distributor of the building. According to the IRS, an improvement is made by the taxpayer if the taxpayer makes, manufactures, constructs, or produces the improvement for itself or if the improvement is made, manufactured, constructed, or produced for the taxpayer by another person under a written contract. In contrast, if a taxpayer acquires nonresidential real property in a taxable transaction and such nonresidential real property includes an improvement previously placed in service by the seller of such nonresidential real property, the improvement is not made by the taxpayer.

Effective Date

Taxpayers can apply the final bonus depreciation regulations under Reg. Sec. 1.168(k)-2 and Reg. Sec. 1.1502-68, in their entirety, to depreciable property acquired and placed in service or certain plants planted or grafted, as applicable, after September 27, 2017, by the taxpayer during a tax year ending on or after September 28, 2017, provided the taxpayer consistently applies all rules in the final regulations. However, once the taxpayer applies the final regulations for a tax year, the taxpayer must continue to apply them in all subsequent tax years. Alternatively, taxpayers can rely on the 2019 Proposed Regulations for depreciable property acquired and placed in service or certain plants planted or grafted, as applicable, after September 27, 2017, by the taxpayer during a tax year ending on or after September 28, 2017, and ending before the taxpayer's first tax year that begins on or after January 1, 2021, if the taxpayer follows the 2019 Proposed Regulations in their entirety, except for Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(5) (relating to the partnership look-through rule which has been withdrawn), and in a consistent manner.

For a discussion of the bonus depreciation rules, see Parker Tax ¶94,200.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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