Frequently Asked Questions on Bonus Depreciation

Background
As discussed in Bonus Depreciation Questions Answered, in March 2011, the IRS and Treasury issued Rev. Proc. 2011-26 to provide guidance for taxpayers on claiming 50 versus 100 percent bonus depreciation. Specifically, in order to be eligible for 100 percent bonus depreciation, the qualified original use property must be acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012. With respect to longer production period property¹ and certain aircraft,² an additional year is provided to acquire and place in service such assets. Rev. Proc. 2011-26 provides additional requirements for acquired and self-constructed assets with respect to when property is deemed to be acquired. It also provides a special election for taxpayers to claim 100 percent bonus depreciation on eligible components when the larger self-constructed asset is not eligible for 100 percent bonus depreciation. In addition, Rev. Proc. 2011-26 favorably clarifies that leasehold improvements that meet the definition of both qualified leasehold improvement property and either qualified restaurant property or qualified retail improvement property are eligible for 100 percent bonus depreciation, and provides a safe harbor method of depreciating luxury automobiles eligible for 100 percent bonus depreciation. Taxpayers also now have the option to elect 50 percent bonus depreciation for all of a tax year that includes Sept. 9, 2010, rather than parsing out 50 percent versus 100 percent bonus depreciation based on when eligible assets were acquired and placed in service during the year. Rev. Proc. 2011-26 also provides avenues for fiscal- or short-year taxpayers that failed to elect out of bonus depreciation for years ending in 2010 to elect into or out of bonus depreciation. Although Rev. Proc. 2011-26 overall provides taxpayer-favorable guidance, there are many nuances in the rules that have raised various questions regarding what exactly is eligible for 100 percent bonus depreciation. Fortunately, at the recent ABA Tax Section May meeting in Washington, D.C., Brandon Carlton, Attorney-Advisor with Treasury, addressed many of these questions, as discussed below.

Discussion
Rev. Proc. 2011-26 provides that qualified property is “acquired” when amounts have been “paid or incurred” for the property, however it does not cross-reference the regulations under section 461. Carlton clarified that Treasury intended the phrase “paid or incurred” to be consistent with the current section 168(k) regulations,³ which leverage off of the section 461 principles. As a result, when a taxpayer is performing the “paid or incurred” analysis, it should look to section 461 and the regulations thereunder (i.e., property will be acquired when the cost is “paid” for by cash method taxpayers or “incurred” by accrual method taxpayers).

3 ½-month rule for accrual method taxpayers

When looking to the rules under section 461 for an accrual method taxpayer, the interplay of the 3 ½ month rule with the bonus depreciation provisions becomes important. Specifically, under Treas. Reg. section 1.461-4(d)(6), a taxpayer “may” treat property as provided to it if the delivery of the property is expected to be made within 3 ½ months of payment (i.e., rather than having to wait to treat the cost as having been incurred when the property is actually delivered, which is the general rule). The use of the 3 ½ month rule generally constitutes a method of accounting, and a change to use it generally constitutes an advance consent method change request.⁴ In addressing whether the use of the 3 ½ month rule may be established on an asset-by-asset basis for purposes of bonus depreciation, Carlton verified that Treasury did not intend to change the operation of the 3 ½ month rule, i.e., an accrual method taxpayer should apply its established method of accounting under section 461 for determining when an amount is paid or incurred. Thus, if a taxpayer has an established method of using the 3 ½ month rule when it prepays for the cost of property to be provided to it, it should continue the use of such method. Treasury did not intend to change the operation of the 3 ½ month rule or create a new 3 ½ month rule for purposes of bonus depreciation.

By leveraging off of the current section 168(k) and 461 regulations, Treasury intended for those rules to operate as they currently exist. There is no special asset-by-asset 3 ½ month rule election or method that taxpayers can use. Carlton also noted that he is not aware of any consideration being given to issuing automatic consent provisions allowing taxpayers to automatically change to use the 3 ½ month rule for self-constructed assets. In responding to the question of whether a taxpayer who presently uses the 3 ½ month rule for services would be bound by that method for purposes of applying the paid or incurred rule for property provided to the taxpayer, he noted that taxpayers should properly apply the current policy of the IRS National Office.

Acquisition date of self-constructed assets

With respect to self-constructed assets, many accrual method taxpayers use the 10 percent safe harbor for determining when construction begins.⁵ This raises the issue of eligibility for 100 percent bonus depreciation when progress payments are made to contractors. When asked when self-constructed assets would be deemed to be “acquired” if progress payments are being made to a contractor constructing property for an accrual method taxpayer more than 3 ½ months prior to the taxpayer’s receipt of the property, Carlton noted that the rules of section 461 would apply. Thus, for a taxpayer who has established the use of the 3 ½ month rule, if the property related to the progress payment is not delivered within 3 ½ months of payment, then it would not be acquired for purposes of bonus depreciation (assuming no benefits and burdens of ownership during construction). This can be favorable on the front-end (i.e., progress payments made pre-Sept. 9, 2010) but unfavorable on the back-end (i.e., progress payments made during 2011 and property delivered during 2012). Carlton noted that Treasury tried to spell out the procedures as clearly as possible and to provide bright-lines for taxpayers to know when they have acquired property for purposes of 100 percent bonus depreciation.

Rev. Proc. 2011-26 provides that the term “component” is “intended to refer to 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 as the unit of property for purposes of other Code sections.” Carlton noted that Treasury’s intent with this provision was to provide a very generous rule allowing taxpayers to claim the 100 percent bonus depreciation for components that are acquired within the 100 percent bonus depreciation dates. One of the reasons for including this language was to ensure that taxpayers have the freedom to include all of the components that met/meet the 100 percent bonus depreciation dates as they review the components that were/are acquired during the relevant dates. The intent was not to change the definition of the term “component,” but rather to clarify that the term “component” is not just one level down from the larger unit of property, i.e., any part can be a component. In addition, the term “component” can also include the costs of installation of the larger asset. For example, if self-constructed property is delivered pre-Sept. 9, 2010, but is installed post-Sept. 8, 2010, the post-Sept. 8, 2010 installation costs could be eligible for the component election. However, taxpayers do need to maintain a sufficient level of detail to support their carve out of components for bonus depreciation purposes.

With respect to the written requirement for making the component election, Carlton noted that the taxpayer needs to adequately describe which components are being taken into account, i.e., the taxpayer must indicate whether 100 percent bonus depreciation is being claimed for all or some of the components. A general description of the property and the approach taken should suffice. However, it will be up to examiners to determine if additional detail will need to be provided by the taxpayer.

Additional year to acquire longer production period property and certain aircraft

Rev. Proc. 2011-26 also provides that there is no basis limitation rule for longer production period property placed in service in 2012 for purposes of applying the 100 percent bonus depreciation rules. This is consistent with the statutory language of section 168(k) as it applies to 100 percent bonus depreciation, but seems inconsistent with Congressional intent.⁶ Carlton stated that the language used in Rev. Proc. 2011-26 was meant to be consistent with current statutory language, as it is drafted. Such language allows taxpayers to claim 100 percent bonus depreciation on basis incurred during 2012 related to longer production period property and certain aircraft.⁷

Implications
The 100 percent bonus depreciation provisions are extremely favorable for taxpayers, and the intent and spirit of the rules provide many planning opportunities for taxpayers in determining when costs have been incurred, when property has been acquired, and whether to claim (or not claim) 50 versus 100 percent bonus depreciation. Such determinations can have a significant impact on a taxpayer’s current tax position (e.g., creation of a net operating loss, reduction of section 199 benefit, state and local tax impact, etc.) and, thus, should be made in conjunction with tax advisors to ensure that none of the nuances or intricacies are overlooked.

Natalie Tucker, Director, Washington National Tax

² Section 168(k)(2)(C) (qualified aircraft is generally aircraft that (i) is not used in the trade or business of transporting persons or property (other than for agricultural or firefighting purposes), (ii) has a required payment of a nonrefundable deposit at the time of purchase of the lesser of 10 percent or $100,000, (iii) has an estimated production period exceeding four months, and (iv) has a cost exceeding $200,000).

³See Treas. Reg. section 1.168(k)-1(b)(4)(iii)(B)(2).

⁴ See, e.g., Rev. Proc. 2006-37.

⁵ See Treas. Reg. section 1.168(k)-1(b)(4)(iii)(B)(2).

⁶See footnote 1597 to the General Explanation of Tax Legislation Enacted in the 111th Congress (JCS-2-11)

⁷ See section 3.02(1)(a) of Rev. Proc. 2011-26.