Part IV: Night at the Roxbury—TCJA Changes to Section 168(k)
Open the door to the full expensing club for some, leaving others out in the cold

Since 2001, Section 168(k) of the Internal Revenue Code has offered companies accelerated recovery for the costs of capital assets through “bonus depreciation.” Over the years, bonus depreciation has been regularly modified, changing both the amount of bonus depreciation as well as its application. Once again, as part of P.L. 115-97 (commonly referred to as the Tax Cuts and Jobs Act, or TCJA), the bonus depreciation provisions have been modified. Immediately following the TCJA’s enactment, the headline for Section 168(k) was that it offered taxpayers a bonanza, including an expanded amount of, and scope of, bonus depreciation. Although the statute does expand both amount and scope, what has become apparent is that some companies (notably capital-intensive businesses and M&A purchasers) may benefit significantly from the new bonus, whereas other businesses (for example, companies in a loss position, certain real estate entities, utilities, and companies with qualified improvement property) are finding that the bonus depreciation provisions may not offer any real bonus. Because the full expensing club does not benefit everyone, it is critical that companies fully understand the provision to determine the value of seeking entrance … and whether to do so at all.

Background

As part of the TCJA, Section 168(k) now allows full expensing (i.e., a 100% depreciation deduction) for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023.¹ The bonus depreciation rate decreases by twenty percent each calendar year until the provision expires in 2027.² “Qualified property” includes Modified Accelerated Recovery System (MACRS) property with a recovery period of twenty years or less; certain computer software; water utility property; certain qualified film, television, or theater productions; and specified plant property.³ Importantly, qualified property includes such property when the original use of the property begins with the taxpayer or the acquisition of the property meets the requirements of Section 168(k)(2)(E)(ii).⁴

Unfortunately, due to a drafting error, qualified improvement property (QIP) was inadvertently removed from the definition of qualified property. QIP includes interior improvements to existing nonresidential real property, and, although the Conference Report accompanying the TCJA makes clear the intended treatment and recovery period for QIP, such property was eliminated from qualified property due to an oversight that failed to provide QIP with a MACRS recovery period of twenty years or less. In addition, to reflect the requirements of Section 163(j), also excluded from qualified property is property used in public regulated utilities and companies with floor plan financing.

Irrespective of the QIP quagmire, compared to prior law, the TCJA did expand Section 168(k) in several important ways: 1) it increased the amount of bonus depreciation from fifty percent to 100 percent; 2) it expanded the scope of qualifying property to include film, television, and theater productions; and 3) it allowed certain used property to qualify for full expensing.⁵ At the same time, the TCJA narrowed the scope of bonus depreciation, making it unavailable to 1) certain utilities; 2) companies with floor plan financing; and 3) companies with QIP (e.g., companies refreshing or updating facilities such as restaurants, retailers, and companies making improvements to plants or facilities).

On August 3, 2018, proposed regulations implementing Section 168(k) were released,⁶ and although the proposed regulations address a number of issues created by these amendments, a number of open items remain.

“In Da Club”: Which Companies Benefit From the New Bonus Depreciation Provisions?

Not unlike the patrons enjoying bottle service in the club’s VIP section, the companies that benefit from bonus depreciation seem pretty obvious. With the increase in bonus depreciation from fifty percent to 100 percent, the beneficiaries are generally taxpayers acquiring capital assets. Purchasers acquiring used property may also benefit. The proposed regulations clarify which used property is eligible for bonus depreciation and the related effect of the used property rules on stock sales that are treated as asset sales under Section 338 or Section 336(e) and on partnership basis adjustments under Section 743. These nuances should be considered to ensure that no foot fault occurs that results in a company being barred from the full-expensing club and left out in the cold.

Prior Property Usage May Affect Bonus Eligibility

The TCJA expands Section 168(k)’s previous definition of qualifying property, which limited bonus depreciation to new property.⁷ Now, however, certain used property qualifies for 100 percent bonus depreciation and admission to the full-expensing club. However, as with any club, with this more welcoming environment comes greater scrutiny at the door. To secure full expensing, companies acquiring used property must be able to demonstrate they did not use the property prior to acquiring it, the property was acquired in an arm’s-length transaction with an unrelated party, and the property’s basis was not determined with reference to the adjusted basis of the property in the hands of the transferor.⁸

Generally, property is treated as used if the taxpayer or the predecessor had a depreciable interest in the property prior to acquisition, regardless of whether the taxpayer or predecessor claimed depreciation deductions.⁹ Thus, if a taxpayer leased property and did not obtain a depreciable interest in the property, it would not be treated as used and would be eligible for full expensing upon subsequent purchase.¹⁰ For consolidated groups, the proposed regulations treat the group as a single taxpayer and treat all members of the group as having a previously depreciable interest in the property.¹¹ In a series of transactions, the transfer of property will be treated as transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee is tested immediately after the last transaction in the series.¹² It will be important for companies claiming bonus depreciation to develop and maintain the necessary support for such positions.

Stock Sales That Are Treated as Asset Sales

Claiming full expensing for used property enables companies considering a reorganization or purchase of assets, including a business acquisition, to potentially expense the full cost of acquired property.¹³ Acquiring companies that can structure their stock transactions as asset purchases under Section 338 or Section 336(e) will also benefit from this expansion to the definition of qualified property.

Acquisitions involving used property qualify for full expensing if 1) there is no relationship between the acquirer and transferor that would result in the disallowance of losses under Section 267; 2) the acquirer and transferor are not component members of the same controlled group; 3) the acquirer’s basis in the property cannot be determined by reference to the transferor’s adjusted basis in the property; 4) the acquirer and transferor are not related as provided in Section 179(d)(3); and 5) the acquirer has not used the property prior to the acquisition.¹⁴

A deemed Section 338 transaction should readily fulfill the first four requirements, because the used property in question is treated as having been acquired by a new, fictional corporation. A somewhat more challenging question may be whether the assets have been used previously by an acquirer. Presumably, this requirement is satisfied with unrelated parties, because the target is a newly formed entity. However, this determination could become more complicated in a transaction involving an intragroup transaction.

Even though a taxpayer may have done everything right to work its way through the line and into the full-expensing club, sometimes those lingering friends still force you to wait outside.

Partnership Basis Adjustments

In certain circumstances, such as in connection with the acquisition of a partnership interest or the distribution of partnership property, the basis of partnership property is permitted to be adjusted, and the amount of the adjustment is generally treated as newly purchased property for depreciation purposes.¹⁵ Prior to the TCJA, the Treasury and the Internal Revenue Service viewed these partnership basis adjustments as ineligible for bonus depreciation and kept such amounts waiting outside in the cold, since such adjustments were made with respect to used partnership property and thus failed to satisfy the original use requirement.¹⁶ In light of the expanded scope of what qualifies as used property, partnership basis adjustments under Section 743(b), which generally are permitted in connection with a person’s acquisition of a partnership interest from a partner, may be considered used property eligible for bonus depreciation, provided that the used property requirements above are met.¹⁷ To determine whether the property has previously been used by a partner, each partner is treated as having owned and used the partner’s proportionate share of the partnership property.¹⁸

In contrast, other partnership basis adjustments are not eligible for full expensing. Partnership basis adjustments under Section 734(b), which generally are permitted in connection with partnership distributions to a partner (including distributions in complete or partial liquidation of the partner’s partnership interest), and remedial allocations under Section 704(c) are not eligible for bonus depreciation, because these adjustments are maintained for the benefit of all partners in a partnership and thus cannot meet the used property requirements of Section 168(k)(2)(E)(ii), since the partnership used the property prior to the event giving rise to the adjustment.¹⁹ Unlike Section 743(b) adjustments, which now satisfy the broader criteria for used property to get past the statutory bouncer, adjustments made under Sections 734(b) and 704(c) are relegated to waiting in the cold, since such adjustments cannot meet the used property requirements of Section 168(k)(2)(E)(ii), again because the partnership used the property prior to the event giving rise to the adjustment.²⁰

Not unlike a bouncer’s finicky decisions made at the Roxbury door, this approach results in economically similar partnership transactions being treated differently under Section 168(k), depending on structure. For example, the purchase of partnership interest from a partner may result in a partnership basis adjustment for the benefit of the purchaser under Section 743(b) that is eligible for bonus depreciation, whereas the partnership’s redemption of a partner’s interest may result in a partnership basis adjustment under Section 734(b) that is not eligible for bonus depreciation. With this in mind, taxpayers entering into partnership transactions yet still seeking entrance to the full-expensing club need to pay careful attention to the transaction structure and its federal income tax treatment.

Companies also need to treat transactions with partnership basis adjustments under Section 743(b) no differently than a group would treat gaining admission to a club. Only the portion of the Section 743(b) adjustment that is allocated to qualified property of the partnership will be eligible for bonus depreciation under Section 168(k) and gain admission; therefore, taxpayers need to think carefully about the manner in which the partnership allocated the Section 743(b) adjustment among its assets to ensure that no part of the adjustment is left hanging at the door.

“This Is the Coat Room”: Which Companies Find Bonus Depreciation Less Beneficial?

Although many companies are eager to take advantage of full expensing, certain companies find themselves stuck in the coatroom or, even worse, waiting out in the cold, unable to take advantage of Section 168(k). These companies include 1) taxpayers carved out of full expensing (and those that elect out of Section 168(k)); 2) taxpayers with current-year losses (unable to use any full-expensing deductions); 3) companies with QIP; and 4) companies that entered into a binding written contract for qualified property prior to the changes in Section 168(k).

Never Stood a Chance: Companies Excluded From Full Expensing

Bonus depreciation is not available for property used in a trade or business that is exempt from the interest limitation under Section 163(j).²¹ Thus, businesses involving real property or farming face a real decision: to claim bonus depreciation subject to Section 163(j) limitation or to elect out of Section 163(j).

Beyond gaining admission to the full-expensing club, companies must evaluate additional depreciation considerations. If a real property trade or business or farming business elects to be exempt from Section 163(j), the business must depreciate certain property using the alternative depreciation system (ADS), which results in a longer recovery period for certain property and makes the property ineligible for full expensing.²² As a practical matter, this election extends the recovery period for nonresidential real property, residential rental property, and QIP.²³ For an electing farming business, the recovery period extends ten years or more.²⁴ Additionally, under Rev. Proc. 2019-8, an electing real property trade or business or electing farming business must depreciate this property according to ADS, including any of its existing property.

Thus, taxpayers should consider whether they have the ability to elect out of Section 163(j), and if so, whether such an election will be a net benefit for the taxpayer, balancing: 1) a business’ benefit from bonus depreciation under Section 168(k) and avoiding the use of ADS; and 2) the potential denial of interest deductions under Section 163(j), keeping in mind that the election to be exempt from Section 163(j) is irrevocable while bonus depreciation eventually sunsets.

Not for Me: Electing Out of Section 168(k)

Two elections are available to companies that cannot use full expensing under Section 168(k). For example, loss companies may elect out of bonus depreciation, especially in light of the eighty percent limitation to net operating losses (NOLs) included in the TCJA. First, companies may elect to exclude bonus depreciation altogether, which is applied to a specific class of property.²⁵ Second, companies may elect to deduct fifty percent, instead of 100 percent, of qualified property acquired during the taxpayer’s first taxable year ending after September 27, 2017.²⁶ This second election cannot be made on a class-by-class basis and must be made with respect to all qualified property.²⁷ As with any election, care should be exercised, since any changes or modifications will require IRS approval.

Legislative Inconsistencies Regarding QIP Recovery Period

In an effort to streamline club admission and provide uniform tax treatment of different types of leasehold improvements, the TCJA also consolidated several types of property into a single category of property, “qualified improvement property” (QIP). For many years, three categories of property generally were allowed favorable tax treatment (e.g., accelerated depreciation of fifteen years rather than the traditional thirty-nine years for buildings): 1) qualified leasehold improvement; 2) qualified retail improvement property; and 3) qualified restaurant property. In 2015, a fourth category, qualified improvement property, was added.²⁸ Although the aim of the TCJA was simplification, the result in this area has been confusion. Congress consolidated the four categories into one, qualified improvement property, but then failed to assign QIP its previous fifteen-year recovery period. Thus, such property is subject to the thirty-nine-year recovery period and ineligible for full expensing, even though the Conference Report provides that QIP is eligible for full expensing.²⁹

Treasury and the IRS argue that the matter cannot be resolved administratively,³⁰ and taxpayers with large amounts of QIP are forced to wait for a technical correction to secure full expensing.³¹ Until the technical corrections occur, companies may accelerate QIP depreciation deductions by carefully reviewing repair costs, which are immediately deductible, and performing cost segregation studies, which may allow portions of a property to be depreciated using a shorter recovery period.

Stuck Waiting for Your Friend: Effect of Binding Contracts on Acquisition Dates

Even though a taxpayer may have done everything right to work its way through the line and into the full-expensing club, sometimes lingering friends still force you to wait outside. The acquisition date is critical to determining a property’s eligibility for full expensing; specifically, only property acquired and placed in service after September 27, 2017, will be eligible for bonus depreciation. For Section 168(k), the property’s acquisition date is the date that the taxpayer entered into a binding written contract with respect to the property, even if the taxpayer would receive the property at a later date.³²

This definition is generally more restrictive than prior guidance, under which if an entity created property for a taxpayer under a binding written contract that was executed prior to the creation of the property, the acquisition date was the date the taxpayer acquired the property, rather than the date of the contract.³³ Additionally, under the proposed regulations, companies that entered into written binding contracts for qualified property prior to September 27, 2017, fell outside the scope of full expensing, as the acquisition date occurred prior to the implementation of full expensing.

Last Call: Business Considerations

The full-expensing club may offer significant benefits to its patrons; however, it may not benefit all taxpayers. It is important to consider the implications of claiming bonus depreciation or electing out of it; in fact, modeling may be necessary to quantify the value of bonus depreciation and a night at the Roxbury. This will be especially significant in comparing full expensing and ADS for real property trades or businesses that are considering whether to elect out of Section163(j).

Additionally, nontax considerations are important, such as if a taxpayer is considering future acquisitions that may be structured as an asset sale under Section 338 or Section 336(e) to claim bonus depreciation. Basis adjustments under Section 743 should be carefully allocated to qualifying property so that the adjustments qualify for bonus depreciation and aren’t excluded with the Section 734(b) and 704(c) adjustments. For QIP, monitoring Congress is required to determine whether technical corrections allow bonus depreciation treatment.

Ellen McElroy is a partner at Eversheds Sutherland (US) LLP.

Endnotes

1. Section 168(k)(1).
2. Section 168(k)(6)(A).
3. Section 168(k)(2).
4. Section 168(k)(2)(A). In order to satisfy the requirements of Section 168(k)(2)(E)(ii) regarding acquisition of property, such property must not have been used by the taxpayer at any time prior to such acquisition, and the acquisition of such property must meet the requirements of Sections 179(d)(2)(A)-(C) and 179(d)(3).
5. Section 168(k)(7).
6. Prop. Treas. Reg. Section 1.168(k)-2.
7. Former Section 168(k).
8. Section 168(k)(2)(E)(ii).
9. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iii)(B)(1).
10. Id.
11. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iii)(B)(3)(i).
12. Id.
13. Section 168(k) references the limitations for used property established in Section 179(d), which means bonus depreciation does not apply when property is acquired: 1) from a related party; 2) from a component member of a controlled group; or 3) in a transaction that results in a carryover basis.
14. Id.
15. Sections 734 and 743.
16. 83 Fed. Reg. 39295.
17. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iv)(D).
18. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iv)(D)(1)(i).
19. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iv)(A), (C).
20. Prop. Treas. Reg. Section 1.168(k)-2(b)(3)(iv)(A), (C).
21. Section 168(k)(9)(A)-(B). Section 163(j) generally limits a taxpayer’s net interest expense to thirty percent of its adjusted taxable income.
22. Section 168(g)(1)(G), (8); Section 168(k)(2)(D).
23. Section 168(g)(2).
24. Section 168(k)(g)(1)(G).
25. Section 168(k)(7); Prop. Treas. Reg. Section 1.168(k)-2(e)(1)(i).
26. Prop. Treas. Reg. Section 1.168(k)-2(e)(3).
27. 83 Fed. Reg. 39294.
28. Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113, 129 Stat. 3040 (2015), www.gpo.gov/fdsys/pkg/PLAW-114publ113/pdf/PLAW-114publ113.pdf.
29. Joint Explanatory Statement of the Committee of Conference at 205.
30. Nathan J. Richman, “Treasury: Qualified Improvement Property Needs Technical Correction,” Tax Notes (Oct. 9, 2018), www.taxnotes.com/tax-notes-today/tax-cuts-and-jobs-act/treasury-qualified-improvement-property-needs-technical-correction/2018/10/09/28hbq?highlight=qualified%20improvement%20property %20technical%20correction.
31. Additional First Year Depreciation, 83 Fed. Reg. 39293 (Aug. 8, 2018).
32. Section 168(k)(2)(B)(i)(III); Prop. Treas. Reg. Section 1.168(k)-2(b)(5)(ii), (iii)(A).
33. Treas. Reg. Section 1.168(k)-1(b)(4)(iii)(A).