United States

Bonus depreciation allowable for certain stepped-up basis transactions

Buyers of some partnership interests after Sept. 27, 2017 may benefit

TAX ALERT  | 

Bonus depreciation, which is tantamount to full expensing, is available only for certain tangible assets, and not for intangible assets like goodwill. In many cases, however, the benefits can be quite substantial for a prospective purchaser of an interest in – or the assets of – an existing business entity holding substantial amounts of tangible assets.

Before the 2017 tax changes, “used” assets were not eligible for bonus depreciation – bonus depreciation was only available for an asset’s “original use.” The 2017 tax law changed this rule to allow bonus depreciation for outright purchases of previously used assets. But no one knew how this change would apply to the acquisition of an interest in an existing partnership holding previously used assets, to the distribution of such assets from an existing partnership, or to similar transactions. On August 8, 2018, the IRS will publish in the Federal Register proposed regulations clarifying these issues (see REG-104397-18). This Alert explains the rules of the proposed regulations relating to such acquisitions. For a more general discussion of how the new bonus depreciation rules apply to purchases of new or used assets, see our other alert

The new bonus depreciation rules generally apply to transactions that occur on or after September 28, 2017. Thus, the new rules may apply to some closed and completed transactions that will be reported on tax returns filed in 2018. In addition, many transactions that have closed in 2018 or are in the planning stages may be affected by these proposals. In that regard, although the new proposed rules will be effective only when finalized, the proposal clarifies that certain portions of the proposed rules applicable to basis step-ups under Section 743 of the tax code can be relied upon immediately.[1]

In summary, purchases of interests or assets that give rise to a recognition of gain by the seller of a partnership interest, the seller of property, or the seller of interests in a disregarded entity, are generally eligible for first year expensing – if the purchaser is not considered a prior user of the property. Purchases that generally do not give rise to the recognition of gain by the seller do not give rise to bonus depreciation benefits for the purchaser.

More specifically, the proposed regulations clarify how the new bonus depreciation rules will apply to a wide variety of transactions involving partnerships or disregarded entities holding assets that are otherwise eligible for bonus depreciation – such as a used truck or machine, or certain components of other used property. Technically, all of the facts and circumstances are relevant to the ultimate treatment, but the following are the general guidelines for the most typical transactions.

  1. If an existing interest in an existing partnership is purchased by a new party directly from an existing owner – and there is an election in effect under Section 754 to adjust the basis of the purchaser’s share of the partnership’s asset basis under Section 743 – bonus depreciation benefits will be available for that purchasing partner’s share of the partnership’s assets, based on their newly determined fair market value. Note that bonus depreciation will only be available, however, to the portion of asset basis that is stepped-up above the partnership’s inside tax basis in the assets prior to the transaction.
  2. If one partner of an existing tax partnership with two or more partners (or two or more members if the legal entity is an LLC) purchases all of the other interests in the partnership, resulting in the entity becoming a disregarded entity for federal income tax purposes, bonus depreciation may be available for the portion of the partnership assets that the purchasing partner is deemed to have purchased from the selling partner or partners.[2]
  3. If all of the interests in an existing partnership for tax purposes are purchased by a single new party who is not currently a partner (or member if the entity is an LLC), the partnership becomes a disregarded entity and the transaction is treated as an outright purchase of assets by the new party acquiring 100 percent of the interests in the entity. As a result, the normal bonus depreciation rules for outright asset purchases are applied. The entity is disregarded, for purposes of the new party, and bonus depreciation is generally available.
  4. In some transactions, acquired assets are owned by a single-member LLC that is treated as a disregarded entity not distinct from its owner for tax purposes. If 100 percent of the interests in that entity are purchased by a new party, it is treated as an outright asset purchase and the normal bonus depreciation rules apply. The disregarded entity is disregarded for all purposes, and bonus depreciation is generally available.
  5. If only a portion of the interests in a disregarded entity is acquired by another party, giving it two or more owners, the entity will become a partnership for tax purposes. Bonus depreciation benefits will turn on how the acquisition is structured.
    1. If the interest is acquired in exchange for money or property that is either transferred directly to the existing owner, or that is contributed to the entity and distributed to the owner, the transaction will be treated as if a portion of the existing assets had been directly acquired by the new party, receiving a new basis equal to their fair market value, and then contributed to a newly formed partnership. Bonus depreciation will be available for the assets the new party is treated as purchasing and contributing to the newly formed partnership – as if it had purchased the assets outright and contributed them to a partnership.
    2. If the cash (or property) contributed to the previously disregarded entity is not distributed to the existing owner, the transaction will be treated as if the new partnership were formed first, followed by a contribution of cash (or property) by the new party to the partnership. Although the new party may get special allocations of other depreciation benefits under the rules of Section 704(c), there would be no bonus depreciation benefits for that party’s share of the partnership assets.
  6. As implied by the previous example, if cash (or property) is contributed to an existing partnership in exchange for an interest – and the transaction is not treated as the purchase of another partner’s existing partnership interest because the cash (or property) is not distributed to any of the existing partners – the acquiring partner may enjoy some depreciation allocation benefits under Section 704(c), but there will be no bonus depreciation benefits because no property is treated as having been acquired. The partnership’s property did not change hands, and there is no sale of a partnership interest that would be permitted to be treated (under Section 743) in a manner resulting in bonus depreciation eligibility as described above.

Additional Details of Proposed Regulations

Technically, the proposed regulations consider all of the facts and circumstances in determining whether a step-up in basis – on account of a transaction treated as an outright purchase or on account of a transaction subject to Section 743 – will qualify for additional first year deprecation. One of the key items the proposed regulations note is that the previously used property requirements will generally be satisfied if the partner acquiring the interest has not used their portion of the partnership property to which the step-up relates at any time prior to the acquisition – notwithstanding the fact that the partnership may have previously used the property.[3] The proposed regulations go on to address several other factors that must be considered when making the determination as to whether bonus deprecation will apply to a step-up, including the prohibited relationship requirements and certain basis determination requirements.

Accordingly, while it may be possible for certain taxpayers to utilize bonus depreciation with respect to step-ups, the proposed regulations demand a review of all of the relevant facts and circumstances.

In the case of the purchase of a disregarded entity that becomes a partnership, the regulations provide additional guidance regarding the allocation of the bonus depreciation deductions. Prior to the issuance of the proposed regulations, rules in place to deal with other situations might have allowed some of the bonus depreciation to be allocated back to a seller maintaining a rollover interest. The proposed regulations would clarify that this does not occur. No portion of the bonus deprecation may be allocated to a partner that previously held an interest in the property. Accordingly, under the proposed regulations, the bonus depreciation deductions would be allocated entirely to the buyer.

Proposed regulations highlight differences between outright asset purchases, Section 743 step-ups upon the purchase of partnership interests, and special allocations of depreciation benefits under Section 704(c) upon the contribution of cash (or property) to an existing partnership

The proposed regulations highlight and magnify the distinction between the bonus depreciation benefits of an outright asset purchase, the bonus depreciation benefits of the purchase of an interest giving rise to a stepped-up inside basis for the purchasing partner under Section 743, and a contribution of money (or property) to a partnership -- which may give rise only to an increased allocation of otherwise existing partnership depreciation benefits under Section 704(c).

For example, under one of the permissible allocation methods under Section 704(c) (the remedial method), the investing partner’s allocable share of depreciation on existing assets is calculated by reference to “any” recovery period and deprecation method available to the partnership for newly purchased property. This formulation presented the question of whether the partnership would be able to assume 100 percent bonus depreciation in making this allocation of existing depreciation benefits to the contributing partner, giving a cash investor, for example, a large initial year deduction. The proposed regulations provide a “no” answer to this question, as they state that allocations under the remedial method would not be computed assuming a hypothetical use of bonus depreciation.

Distributions of cash or property from a partnership will not create eligible deductions for the partnership or for the partner receiving the property.

In certain cases, the distribution of cash or property to a partner may trigger a step-up in basis for the assets of the partnership. Where a Section 754 election is in effect, and distributions give rise to gain for a distributee partner – or the recipient partner adjusts the basis of the property received – Section 734(b) will cause the partnership to step-up the basis of its remaining assets by a calculated amount. The proposed regulations clarify that this type of basis step-up is not eligible for bonus deprecation for the partnership.

If the partnership distributes property, either as a current distribution or in complete liquidation of a partner’s interests, the partner may be required to step-up (or step-down) the basis in the property received. The proposed regulations clarify that property distributed – whether or not in complete liquidation of a partner’s interest in the partnership – will not qualify for bonus depreciation in the hands of the distributee partner.

Certain corporate stock purchases treated as asset acquisitions will be eligible for first-year expensing

Certain taxpayers can elect for federal income tax purposes to treat corporate stock purchases and sales as if they were asset acquisitions or dispositions. For federal income tax purposes, the taxpayer is deemed to have purchased or sold the assets of the corporation, not its shares.

The proposed regulations provide that property deemed to be acquired as a result of either of these two provisions – either a Section 338 election or a Section 336(e) election – would be considered to be acquired by purchase. Accordingly, the stepped-up tax basis of property acquired in this manner would be eligible for bonus depreciation.

Special rules for consolidated corporate groups

Consolidated groups of corporations are groups of corporate taxpayers that file a consolidated federal tax return each year. The proposed regulations contain special rules intended to apply the first use requirement for bonus depreciation to such consolidated groups. The rules generally would disallow bonus depreciation where a particular corporate member is making its first use of a tangible asset, but the asset was previously used by another member of the group. For example, if one consolidated group member sold an asset to a buyer outside of the group, and a second member of the consolidated group bought the same asset from that outside purchaser, the asset would not be eligible for bonus depreciation.  

Conclusion

Taxpayers considering taxable acquisitions or other transactions that will generate a step-up in the basis of assets potentially eligible for bonus depreciation, or could be restructured to generate such a step-up, should pay particular attention to these proposed regulations. Each proposed transaction and its alternatives should be analyzed to determine whether and to what extent expensing is available, as well as the tax consequences to the seller. In addition, some transactions that have already closed, but which are subject to the new bonus depreciation rules, should be reviewed to ensure that the optimum allowable tax treatment is obtained.
 

[1] In particular, the IRS notice explains, “a partnership may rely on the last three sentences in paragraph (j)(4)(i)(B)(1) of this section in these proposed regulations for transfers of partnership interests that occur on or after September 28, 2017, and ending before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

[2] See footnote 3 for additional discussion regarding Rev. Rul. 99-6 transactions.

[3] Although this clarification was directed at Section 743, if applied to Rev. Rul. 99-6 transactions where a buyer is also an existing partner, it allays concerns that practitioners had in regard to whether a purchasing partner had “used” the portion of the assets they were deemed to have purchased.  Instead, this clarification suggests that the purchasing partner is only treated as having used the portion of any assets deemed to have been distributed in redemption of its partnership interest, and not the portion treated as distributed in redemption to the other partners and then purchased.

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