The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010,1 signed into law last December, temporarily increases bonus depreciation deductions under Section 168(k) from 50 percent to 100 percent. This immediate recovery of costs for certain qualifying property was designed to encourage investment and, in connection with the other tax cuts and provisions in the legislation, to otherwise promote economic growth. We outlined the new 100 percent bonus depreciation provisions and potential issues in our January 2011 Tax Update (available online at www.pepperlaw.com/pdfs/TaxUpdate0111.pdf), and the Internal Revenue Service has recently clarified some of these issues in Revenue Procedure 2011-26.2
Taxpayers in a variety of industries—utilities, oil and gas companies, clean energy companies, health care companies, manufacturers, and other capital intensive businesses—should review this guidance and consider the opportunities for accelerating cost recovery. Bonus depreciation is very favorable in general, but Rev. Proc. 2011-26 provides additional rules and exceptions that allow taxpayers of all types to utilize the rules in a favorable way. Rev. Proc. 2011-26 allows:
- components of larger self-constructed property to be eligible for 100 percent bonus depreciation, even if the larger property was first acquired prior to September 8, 2010
- an election to claim 50 percent bonus depreciation for 2010 qualified property
- election out of bonus depreciation altogether, and
- amended returns and Form 3115, Application for Change in Accounting Method, filings to utilize Rev. Proc. 2011-26 and claim bonus depreciation for taxpayers who had already filed their returns.
The 50 percent bonus depreciation rules generally apply to "qualified property," which is limited to: (i) tangible property with a recovery period of 20 years or less; (ii) the original use of which began after December 31, 2007; (iii) which was acquired by the taxpayer after December 31, 2007 and before January 1, 2013; and (iv) was placed in service before January 1, 2013.3 Special rules exist for certain types of property, such as computer software, water utility property, leasehold improvements, transportation property, and certain aircraft, and extensions of deadlines apply in some instances. Section 168(k)(5) provides that a business placing qualified property in service after September 8, 2010, and before January 1, 2012 (again, with extended deadlines for certain property), may claim 100 percent bonus depreciation on the property.
Section 3.02 of Rev. Proc. 2011-26 sets out the rules for the acquisition, placed in service, and original use requirements for 100 percent bonus depreciation purposes. For placing property in service and original use, Rev. Proc. 2011-26 simply notes the substitution of "after September 8, 2010, and before January 1, 2012," for the deadlines. The acquisition rules, however, are key to the utilization of 100 percent bonus depreciation, and special rules apply.
First, the taxpayer must acquire the qualified property after September 8, 2010, and before January 1, 2012, to meet this element. "Acquisition" for these purposes occurs when the taxpayer pays or incurs the cost of the property, consistent with the taxpayer’s cash or accrual accounting method.
A written binding contract, however, may allow for later "acquisition" of property with continued qualification for 100 percent bonus depreciation. The written binding contract rules in section 3.02(1)(a) provide that entering into a binding contract after September 8, 2010, and before January 1, 2012, to acquire, manufacture, construct, or produce long-production property or certain aircraft is treated as meeting the acquisition requirement. The language here is somewhat inconsistent with the parenthetical in the first sentence, which appears to allow any acquisition of long-production property or certain aircraft before January 1, 2013, even without a binding contract. In planning property acquisitions going forward, taxpayers should note that a Treasury official has stated that long-production property and certain aircraft should not qualify for 100 percent bonus depreciation if no written contract is entered into prior to January 1, 2012.
The binding contract rules for 100 percent bonus depreciation operate differently than the general binding contract rules in Section 168(k)(2). As described by a Treasury official, Section 168(k)(2)(A)(iii) and its binding contract rules are relevant only for the December 31, 2007, cut-off date. Property acquired pursuant to a binding contract entered into prior to December 31, 2007, is not eligible for bonus depreciation. For Section 168(k)(5) purposes, a binding contract prior to September 9, 2010, for property that is actually acquired after September 8, 2010, will not prohibit the taxpayer from claiming 100 percent bonus depreciation, because, as described below, the taxpayer can utilize the component rules to claim 100 percent bonus depreciation.
Components are an important aspect of the acquisition rules in Rev. Proc. 2011-26. Section 3.02(1)(a) provides that a taxpayer acquires property for bonus depreciation purposes if the taxpayer begins constructing, manufacturing, or producing that property itself. In general, Treas. Reg. § 1.168(k)-1(b)(4)(iii)(B) provides specific rules on when manufacturing begins, and it also provides a safe harbor, in which incurring more than 10 percent of the total cost is considered "work of a significant nature" and the beginning of manufacturing. Previously, these rules could operate to prohibit 100 percent bonus depreciation, because the taxpayer would be treated as acquiring property when work began, potentially before September 9, 2010. Rev. Proc. 2011-26, however, expands the acquisition definition to include components of larger self-constructed property and provides very favorable treatment for 100 percent bonus depreciation purposes.
Limited Exception for Self-Constructed Property and Components
Section 3.02(1)(b) provides a limited exception allowing 100 percent bonus depreciation for certain components of larger qualifying property. Under this rule, 100 percent bonus depreciation is available for components despite being unavailable for the property as a whole. Thus, if larger self-constructed property was acquired prior to September 9, 2010, and otherwise meets the placed in service and original use requirements, the taxpayer may elect to treat any acquired or self-constructed component of the larger property as eligible for 100 percent bonus depreciation. Of course, the components must be qualified property and meet the acquisition requirements to be eligible. This "limited exception," as it is described in Rev. Proc. 2011-26, purposefully defines "component" very broadly to encompass "any part used in the manufacture, construction, or production of the larger self-constructed property, which may or may not be the same as the asset for depreciation purposes or the same unit of property for purposes of other Code sections." Importantly, a Treasury official stressed that the component rules apply only for Section 168(k)(5) purposes. The broad definition was designed to cover a great deal of activity and provide an investment incentive, but this component definition has no relation to unit of property definitions in other contexts.
A taxpayer must elect application of 100 percent bonus depreciation to components by attaching a statement to its return indicating whether the taxpayer is treating all or some components under Rev. Proc. 2011-26’s limited exception. Treas. Reg. § 301.9100-2(b) relief is available for taxpayers who have already filed returns for property placed in service on or before April 18, 2011, to re-file claiming 100 percent bonus depreciation.
Two examples illustrate these component rules. Section 3.04(3) Example 3 discusses a taxpayer that began constructing a ship in March 2010. $15 million of the $25 million cost related to components acquired after September 8, 2010, and before January 1, 2013, but acquired pursuant to written binding contracts entered into in March 2010. However, because the taxpayer elected under section 3.02(2)(b) of Rev. Proc. 2011-26 to treat the acquired components as qualified property, the taxpayer is allowed 100 percent bonus depreciation with respect to the $15 million paid for the components.
Section 3.04(4) Example 4 uses the same facts, except that the taxpayer does not make the section 3.02(2)(b) election. Under those facts, the taxpayer is not entitled to 100 percent bonus depreciation, because it began construction prior to September 9, 2010, and it fails the acquisition requirement.
As the examples show, a taxpayer must elect to claim 100 percent bonus depreciation for components and also attach a statement to its return. For this reason, taxpayers must consider these requirements and follow the rules closely to ensure they are entitled to and properly document their elections claiming 100 percent bonus depreciation.
Electing Bonus Depreciation: Elections for 50 Percent Bonus Depreciation or No Additional First Year Depreciation
In general, a taxpayer must elect out of bonus depreciation if it does not want or need the bonus depreciation. If a taxpayer previously chose not to deduct 50 percent bonus depreciation, it would not be eligible for 50 percent or 100 percent bonus depreciation for that class of property.
Section 4 allows another "limited exception" for qualified property. For administrative convenience, Rev. Proc. 2011-26 allows a taxpayer to elect out of 100 percent bonus depreciation and elect 50 percent bonus depreciation for all qualified property in a given class and placed in service in the tax year that includes September 9, 2010. Difficulties in tracing assets and determining placed in service and acquisition dates necessitated this special rule, but it only applies for the tax year that includes September 9, 2010. The election is made on Form 4562, and, again, Treas. Reg. § 301.9100-2(b) relief is available if the taxpayer has already filed its return for the year that includes September 9, 2010. The JCT Bluebook provides that relief similar to that in section 4.02 may also be allowed for the 2011 tax year, but a Treasury official noted a technical correction would be necessary for this relief.
Section 5 also provides special rules for taxpayers that did not claim 50 percent bonus depreciation and allows them to elect bonus depreciation for the relevant periods. If a taxpayer did not claim 50 percent bonus depreciation, the taxpayer may claim 50 percent bonus depreciation through an amended return or Form 3115, Application for Change in Accounting Method. Furthermore, if the taxpayer had filed Form 4562 electing not to apply the 50 percent bonus depreciation rules, section 5.03 grants consent from the Commissioner to revoke that election and claim bonus depreciation.
Finally, section 5.04 provides rules for taxpayers with short years or tax years that ended early in 2010. A taxpayer that timely filed its 2009 or 2010 short year return is treated as making an election not to deduct 50 percent bonus depreciation if the taxpayer deducted depreciation but did not claim bonus depreciation amounts and does not file an amended return or Form 3115. This deemed election will apply for both 2009 and 2010 qualified property, and, as such, that class of property would not be eligible for 50 percent or 100 percent bonus depreciation.
Other Special Rules
Rev. Proc. 2011-26 provides some special rules for 100 percent bonus depreciation and its interaction with other Code Sections and laws.
One key area involves section 1603 of the American Recovery and Reinvestment Tax Act of 2009.4 This section provides for Treasury payments to eligible persons who place in service certain energy property. The property must be used in a trade or business or held for the production of income, and section 1603 was designed to reimburse the applicants for a portion of the property’s expense.
The 100 percent bonus depreciation rules make section 1603 an attractive option for taxpayers. Section 1603 provides that an applicant may receive 10 percent or 30 percent of the basis of the energy property as a credit, but the adjusted basis of the property is only reduced by 50 percent of the credit. Rev. Proc. 2011-26 indicates that taxpayers should calculate basis in a project by first computing the credit under section 1603 and the basis reduction under those rules and then claim 100 percent bonus depreciation on the reduced adjusted basis of the qualified property. These rules result in tax savings in certain circumstances.
Code Section 280F also has specific guidance. In general, Section 280F provides a limitation on depreciation deductions for luxury automobiles. The excess of 100 percent bonus depreciation over the allowed depreciation under Section 280F is treated as "unrecovered basis." This unrecovered basis is deductible in the year following the end of the recovery period. Rev. Proc. 2011-26 provides a safe harbor method of accounting and special calculations to "mitigate the anomalous result" that may occur under the 100 percent bonus depreciation rules. Taxpayers subject to these rules should review section 3.03(5)(c) and the examples in sections 3.04(5) and (6) closely.
Rev. Proc. 2011-26 also provides special rules and clarifications for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property under Section 168. There was some uncertainty regarding these types of property and their eligibility for bonus depreciation. A technical correction provided that all this property is eligible, and section 3.03(3) explicitly states that such property is eligible, assuming the other Section 168(k) requirements are met. Importantly, only improvements are eligible for 100 percent bonus depreciation, but a new building, for example, is not eligible.
Several questions are still unanswered. As noted above, the acquisition rules for long-production property and the written binding contract rules are somewhat inconsistent in section 3.02(1)(a). In addition, a Treasury official noted that the written binding contract rules and their application to property which is at a particular stage of production when acquired by a taxpayer may present certain complexities not covered by Rev. Proc. 2011-26. Finally, no changes were made to the accounting method change procedures, and taxpayers with issues under examination who cannot otherwise qualify for automatic accounting method changes must continue to seek consent for bonus depreciation method changes.
Advice on the correct filing of returns and elections, explanatory statements to ensure proper 100 percent bonus depreciation deductions for components, documentation of when assets are acquired and placed in service, application of the written binding contract rules, automatic accounting method changes, and consent for accounting method changes are all issues that taxpayers will face with 100 percent bonus depreciation deductions and Rev. Proc. 2011-26. Pepper Hamilton is prepared to assist you with these matters, and we will continue to follow these rules and guidance as they develop further.