As a result of RRA '93, a taxpayer may now deduct up to $17,500 for purchases of eligible property under IRC Sec. 179. Here's a new look at the rules and how to maximize the benefits and avoid recapture of the deduction.

RRA '93 increased the annual limit for an eligible taxpayer's IRC Sec. 179 deduction from $10,000 to $17,500. Congress' generosity to small business provides an opportunity for additional tax savings. However, the new limit significantly increases the necessity for vigilance and documentation during the depreciable life of property on which an IRC Sec. 179 deduction is taken. A variety of transactions could trigger recapture of part or all of the deduction.

Overview

IRC Sec. 179 allows a taxpayer other than an estate or trust to deduct up to $17,500 of qualifying property. In general, assets eligible for the IRC Sec. 179 deduction are depreciable equipment, vehicles, furnishings, and certain storage facilities and single purpose agricultural or horticultural structures. The property must be acquired by purchase and used in the active conduct of a trade or business.

To meet the "purchase" requirement, property cannot be acquired -

* from a person related to the taxpayer under IRC Sec. 267 or IRC Sec. 707(b) in such a way that losses would be disallowed,

* by one component member of a controlled group from another component member,

* in a transaction, such as a gift, that determines the taxpayer's basis for the property in whole or in part by reference to the previous owner's basis, or

* as an inheritance.

Property used both for trade or business and for other purposes, such as income production, qualifies for IRC Sec. 179 treatment, but only if more than 50% of the property's use for the tax year is in the trade or business. Only the portion of the cost attributable to the trade or business may be expensed under IRC Sec. 179.

Certain property that a taxpayer owns as a lessor qualifies for IRC Sec. 179, but IRC Sec. 179(d)(5) specifically excludes property owned by a noncorporate lessor unless -

* the lessor manufactured or produced the property, or

* the property's class life is more than double the lease term, including options to renew, and the sum of business expense deductions (IRC Sec. 162) exceed 15% of rental income on the property during the first 12 months of the lease.

Presumably, property that meets either test is not held merely for the production of income.

The portion of a property's basis eligible for deduction under IRC Sec. 179 does not include any amount determined by reference to the basis of other property the taxpayer has owned. Property acquired in like-kind exchanges and other tax-deferred transactions may be eligible only for a limited IRC Sec. 179 deduction, if any.

Annual LImits

A year's maximum deduction is reduced dollar-for-dollar to the extent by which a taxpayer places in service IRC Sec. 179 property in excess of $200,000 for the year. For example, a taxpayer who places $217,500 of such property in service during a tax year is not eligible for any deduction in that year. A taxpayer approaching $200,000 of eligible purchases for a tax year should consider postponing additional purchases.

Also, the deduction for a tax year cannot exceed the total taxable income a taxpayer derives from the active conduct of trades or businesses during the year. Taxable income from all such trades or businesses is aggregated. Taxable income from investments is excluded. To the extent it exceeds such taxable income, a year's IRC Sec. 179 deduction is carried over and allowed in later tax years, subject to limits in those years.

For this purpose, taxable income includes IRC Sec. 1231 gains and losses from a trade or business and interest earned on its working capital. Taxable income is computed before deductions for IRC Sec. 179, one-half of self-employment taxes, NOLs, and suspended deductions, such as those subject to at-risk or passive activity loss rules.

An individual who is employed and also owns a sole proprietorship may deduct a greater amount under IRC Sec. 179 than the sole proprietorship's taxable income alone might permit. The reason is an employee is considered to be engaged in the active conduct of the trade or business of his or her employment. Salary, wages, tips, and other compensation before reduction by unreimbursed employee business expenses are included in the employee's taxable income from the active conduct of trades or businesses.

Husband and wife filing separately are treated as separate taxpayers in determining taxable income. Further, each spouse is limited to $8,750 of deduction per tax year unless the couple elects to share the $17,500 differently. They also are treated as one taxpayer for purposes of the $200,000 threshold. If one spouse purchases $217,500 of IRC Sec. 179 property during a year, neither is entitled to any IRC Sec. 179 deduction.

A taxpayer who purchases more than $17,500 of eligible property in a tax year should select and record those purchases to which IRC Sec. 179 applies and how any carryover will be apportioned among them. A taxpayer who fails to make the selection must apportion the carryover equally among the items of IRC Sec. 179 property elected to be expensed for the tax year.

Limits for Corporations and Partnerships

To determine the limit for a C corporation, taxable income is computed before any NOL deduction or special deductions (such as the dividends- received deduction) and excludes items not derived from trades or businesses the corporation actively conducts.

Partnership and S corporation taxable income takes into account the aggregate amount of items described in IRC Secs. 702(a) and 1366(a), respectively, excluding credits, tax-exempt income, and compensation payments to partners or shareholder-employees. Deductions and losses are treated as negative income. The limitations of IRC Secs. 702(a) and 1366(a) used in computing a partner's or shareholder's taxable income are disregarded.

The component members of a controlled group are treated as one taxpayer for purposes of IRC Sec. 179. In defining a controlled group, the phrase "more than 50%" is substituted for "at least 80%" in IRC Sec. 1563(a)(1). Component members may allocate the annual limit in any manner to which they agree, except the portion allocated to any member may not exceed the cost of IRC Sec. 179 property the member purchases and places in service during the year.

The dollar and taxable income limits for partnerships and S corporations are applied both at the entity level and at the partner or shareholder level. Thus, a partner or a less-than-100% S corporation shareholder may be unable to derive the full $17,500 of IRC Sec. 179 deductions from the entity during a tax year, even if the partnership or S corporation is below the $200,000 threshold and has sufficient taxable income.

Example. Hayward Associates, a partnership, purchases $60,000 of IRC Sec. 179 property during the tax year and elects to deduct the maximum $17,500. Alex Hayward, a 40% partner, takes $7,000 of the deduction on his Form 1040. Alex may add to this amount an additional $10,500 of IRC Sec. 179 deductions from other sources.

Because the deduction is limited to the income derived from the active conduct of a trade or business, a partner or S corporation shareholder must meaningfully participate in the trade or business to derive any such taxable income from it. This prevents a passive investor from deducting IRC Sec. 179 expenses against taxable income from that trade or business. In general, the owner must participate in the management or operations of the business, although regulations under IRC Sec. 179 do not provide objective criteria for participation.

Example. Gladys Weintraub operates a sole proprietorship and is a passive investor in a partnership. Weintraub's 1994 taxable income from the sole proprietorship was $13,500. Her share of tax able income from the partnership was $4,000. Weintraub's 1994 limit on IRC Sec. 179 expense was $13,500, assuming the $200,000 threshold is inapplicable.

Adjustments to Depreciable Basis

The depreciable basis of property is reduced by any amount deductible under IRC Sec. 179 even if the deductible amount is carried over because of the taxable income limitation. Similarly, the depreciable basis of partnership or S corporation property generally is reduced even if a partner or shareholder is currently unable to deduct all of the IRC Sec. 179 amount allocated to the partner or shareholder. An exception is made for any IRC Sec. 179 deduction allocated to a trust or estate that is a partner or shareholder. Since trusts and estates are ineligible for IRC Sec. 179 deductions, amounts allocated to them do not reduce the basis of partnership or S corporation property.

Example. During 1995, Broadway Partnership purchases $24,000 of IRC Sec. 179 property. Broadway elects to expense $17,500 of the property. However, Broadway is 20%-owned by Ralph Broadway Children's Income Trust. Accordingly, 20% of the $17,500, or $3,500, is not deductible under IRC Sec. 179, and the property's depreciable basis is reduced by only $14,000 ($17,500 less $3,500). Broadway partnership applies MACRS to $10,000 of the property's cost ($24,000 less $14,000).

If property is disposed of, any IRC Sec. 179 carryover relating to the property is added to the property's basis immediately before the transfer. The carryover is no longer available for deduction.

Maximizing Total Deductions

A taxpayer that purchases more than $17,500 of eligible property in a tax year may select the properties for which the election is made and/or the portion of each property's cost to be deducted. To maximize deductions, a taxpayer typically applies IRC Sec. 179 to the properties with the longest MACRS recovery periods. This yields the highest total of IRC Sec. 179 and MACRS deductions in the early years of the properties' ownership, although it lengthens the taxpayer's expose to IRC Sec. 179 recapture.

In some situations, a taxpayer's choice of property might depend on the dates various items are purchased during a tax year. If more than 40% of non-real property is placed in service during the last quarter of the year, the mid-quarter convention applies and acquisitions are grouped by quarter for MACRS computations. However, the IRC Sec. 179 deduction is determined without reference to the period of time eligible property has been in service during the tax year. By expensing late acquisitions, IRC Sec. 179 may be used to sidestep the mid-quarter convention and increase the deductions allowable for property purchased near year-end.

If possible, taxpayers may also want to avoid electing to expense listed property under IRC Sec. 280F(d)(4). As discussed below, any recapture of deductions that results from failure to maintain predominantly trade or business use generally is more severe for listed property than for other property.

IRC Sec. 179 applies regardless of the length of the tax year in which the property is placed in service. Thus, IRC Sec. 179 should be added to the list of tax planning options for a business' first (often short) tax year and for a short year caused by a change in tax year or other occurrence. The $17,500 limit might make a significant difference in taxable income and could be one of the factors determining the timing of asset purchases. IRC Sec. 179 should be used carefully, however, since the election is revoked only with IRS consent.

A small manufacturer might shift income between tax years with IRC Sec. 179. The reason is that uniform capitalization rules do not apply to IRC Sec. 179 deductions. While depreciation must be capitalized until inventory is sold, IRC Sec. 179 deductions reduce taxable income in the year they are taken. This advantage is felt primarily by small manufacturers since UNICAP rules do not apply to wholesalers and retailers of personal property with gross receipts of $10 million or less.

Triggering Recapture

To avoid recapture, a taxpayer must use IRC Sec. 179 property more than 50% in a trade or business until the end of the property's recovery period.

Events that trigger recapture include -

* Use of the property at least 50% for personal purposes in any year of the recovery period;

* Conversion of the property from use in a trade or business to use in the production of income during that period;

* A transfer, such as a gift of the property, that would trigger recapture of rehabilitation credit under IRC Sec. 47; and

* In general, disposition of the property, if recapture does not occur under IRC Sec. 1245(a).

The amount recaptured generally is the difference between the IRC Sec. 179 deduction taken on the property and the MACRS deductions that could have been taken on the portion expensed for all tax years through the year of recapture.

Example. Gail Sheridan purchased a $20,000 asset (seven-year property) for her sole proprietorship in 1993. She deducted $17,500 under IRC Sec. 179 and properly applied MACRS to the remaining $2,500 of basis. During 1994, Sheridan's business use of the property was only 40%. MACRS deductions on the $17,500 for 1993 and 1994 would have totaled $4,215, found as follows:

MACRSTradeorIRCSec.179MACRS

PercentBusinessUseAmountDeduction

.1429x100%x$17,500=$2,501

.2449x40x17,500=1,714

Sheridan takes $13,285 into ordinary income, the difference between her $17,500 deduction in 1993 and $4,215 of allowable MACRS deductions for 1993 and 1994.

Taxpayers should especially guard against recapture of an IRC Sec. 179 deduction if the triggering event does not provide cash to pay the resulting tax bill. Assuming she is in the 36% tax bracket, Gall Sheridan's federal income tax liability on the recaptured amount is $4,783.

Recapture occurs even if the amount recaptured did not reduce the taxpayer's tax liability in the year eligible property was placed in service. However, the portion of a year's IRC Sec. 179 deduction not allowed (i.e., carried over) because of the $200,000 threshold or the taxable income limit is not subject to recapture.

Example. The 1993 taxable income from Gall Sheridan's business exceeded $17,500, permitting the entire IRC Sec. 179 deduction. However, NOL carry-overs eliminated her tax liability so that the IRC Sec. 179 deduction provided no tax benefit. Even so, recapture occurs in 1994 as described in the previous example. Presumably, the deduction is part of a 1993 NOL that can offset the 1994 recapture income.

The property's basis is increased by the amount recaptured so that depreciation in later tax years is determined as though the IRC Sec. 179 deduction was never taken. Gaff Sheridan's 1995 MACRS deduction is computed on the full $20,000 cost of her property, with appropriate allowance made for her personal use.

Listed Property

Recapture on listed property is greater than on other property because IRC Sec. 280F(b)(2) takes precedence over Reg. Sec. 1.179-1(e)(1). For listed property, the amount recaptured is the excess of IRC Sec. 179 and MACRS deductions taken to the year of disqualifying use, less deductions that would have been determined under the alternative (straight-line) depreciation system of IRC Sec. 168(g). Depreciation deductions for later tax years are determined with the alternative depreciation system rather than with an accelerated method.

Listed property includes the following:

* Passenger automobiles and other transportation property not used in a transportation business;

* Property used for entertainment, recreation, or amusement;

* Computers and peripheral equipment not used at a regular business establishment (including a qualified home office) and owned or leased by the operator of the establishment; and

* Cellular telephones and similar telecommunications equipment.

Example. Marvin Toomis, a surgeon, keeps his receivables and other business records on a $7,000 computer system in his home office. The office does not qualify under IRC Sec. 280A(c)(1), so the computer system is listed property. Toomis deducts $6,300 under IRC Sec. 179 in 1994 as his business use of the property in 1994 is 90% and personal use is 10%. This is based on the time log he keeps. In 1995, personal use of the computer by Toomis and his family rises to 60% and business use declines to 40%. Accordingly, Toomis recaptures $5,110 of the $7,000 in 1995 ($6,300 less $1,190).

ADSBusinessADS

PercentUsePercentBasisDeduction

10%x90%x$7,000=$630

20%x40%x7,000=560

$1,190

Assuming that Toomis' business use remains at 40% in 1996, his depreciation deduction again is $560, based on the ADS allowance of 20%.

Documentation a Must

Documentation is one of the most important aspects of planning IRC Sec. 179 deductions and avoiding recapture. Especially important is documentation of active participation in a trade or business, time logs demonstrating predominant business use of property, and workpapers identifying and allocating carryovers of IRC Sec. 179 deductions. With the increase in the amount of the deduction to $17,500, it has become more important that the documentation meet IRS requirements.

Joseph R. Oliver, PhD, CPA, is a professor of accounting at Southwest Texas State University.