The Treasury and IRS have released a second set of final regulations (T.D. 9916) (2020 final regulations) on the allowance for the additional first-year depreciation deduction under IRC Section 168(k), as amended by the Tax Cuts and Jobs Act, for qualified property acquired and placed in service after September 27, 2017. T.D. 9916 finalizes, with modifications, the proposed regulations released in September 2019. The 2020 regulations also modify the final regulations on IRC Section 168(k) issued in 2019 (2019 final regulations).

Final regulations

Components

The 2020 final regulations adopt the proposed regulations' provisions allowing taxpayers to elect to treat components, acquired or self-constructed after September 27, 2017, of certain larger self-constructed property as eligible for the additional first-year depreciation deduction, regardless of whether the larger self-constructed property is eligible for that deduction under IRC Section 168(k). The election must be made via a statement attached to a timely filed return, indicating the components to which the election applies (or that the election applies to all qualifying components).

Under the proposed regulations, larger self-constructed property was not eligible larger self-constructed property for purposes of the component election if it was placed in service after December 31, 2019. Similarly, larger self-constructed property that was qualified property under the version of IRC Section 168(k)(2)(B) or (C) in effect on the day before the TCJA's enactment was not eligible larger self-constructed property for purposes of the component election if placed in service after December 31, 2020.

The 2020 final regulations expand the definition of larger self-constructed property for purposes of the component election by eliminating the requirement for larger self-constructed property to be qualified property under the version of IRC Section 168(k)(2) in effect on the day before the TCJA's enactment. Instead, the 2020 final regulations require the larger self-constructed property to be (1) MACRS property with a recovery period of 20 years or less, computer software, water-utility property, or qualified improvement property under the version of IRC Section 168(k)(3) in effect the day before the TCJA's enactment, and (2) qualified property under Treas. Reg. Section 1.168(k)-2(b) "determined without regard to the acquisition date requirement in [Treas. Reg. Section] 1.168(k)-2(b)(5), for which the taxpayer begins the manufacture, construction, or production before September 28, 2017."

The 2020 final regulations also retain the rule that qualified film, television and theatrical productions are not eligible for the component election. When both real property and personal property are constructed as part of a project, the 2020 final regulations treat the personal property as larger self-constructed property separate and apart from the real property, which is considered its own larger self-constructed property.

Used property

Five-year safe harbor

The 2019 final regulations provided a safe harbor limiting how many years taxpayers must look back to determine if they or the predecessor had a prior depreciable interest in the acquired property, in which case the additional first-year depreciation deduction would be unavailable.

In response to comments, the 2020 final regulations clarify that the relevant period under the safe harbor (the lookback period) includes the five calendar years immediately before the current calendar year in which the taxpayer places the property in service, and the portion of the current calendar year before the property's placed-in-service date.

The 2020 final regulations also subject the taxpayer and any predecessors to separate lookback periods. If the taxpayer or a predecessor, or both, did not exist for the entire lookback period, only the portion of the lookback period during which the taxpayer, predecessor or both have existed is taken into account for determining whether the taxpayer or the predecessor had a depreciable interest in the property. As discussed later, additional changes were made to clarify that the safe harbor period applies in the context of consolidated groups as well.

Series of related transactions

The 2020 final regulations modify the series-of-related-transactions rules established in the proposed regulations.

Under the 2020 final regulations, the transferee "is treated as related to the immediate transferor or the original transferor if the relationship exists either immediately before the first transfer of the depreciable property in the series or when the transferee acquires the property." The final regulations also adopt special rules under the proposed regulations, which disregard certain parties and transactions for purposes of testing relatedness, including (i) if a party places property in service and disposes of it in the same tax year, or never places it in service, and (ii) most transactions described in IRC Section 168(i)(7).

The final regulations also introduce new special rules. For example, if a transferor ceases to exist during the series of transactions, the transferor is deemed to exist at the time of each relevant step for purposes of testing relatedness. If a transferee acquires depreciable property from a transferor that did not exist before the first transfer of the property in the series, the transferee must test its relationship with the party from which the new transferor acquired the property, as well as the original transferor. Finally, if a transferee acquires property under a series of transactions that include an acquisition of stock meeting the requirements of IRC Section 1504(a)(2), followed by a taxable liquidation of the target under IRC Section 331, any relationship between the parties is disregarded for purposes of these rules.

Consolidated groups

Group prior-use rule and stock and asset acquisition rule

The 2020 final regulations adopt two rules from the proposed regulations with limited changes. Under the group prior-use rule, if a member of a consolidated group acquires property in which the group had a prior depreciable interest, the member is treated as having a prior depreciable interest in that property. The stock-and-asset-acquisition rule treats a member as having a prior depreciable interest in property if the member acquires depreciable property and a corporation that previously had a depreciable interest in the property becomes a group member through a related transaction. In each case, the final regulations clarify that the five-year safe harbor is taken into account when applying these rules by treating a member as having a depreciable interest in property only if the group (or a relevant member) had a depreciable interest in that property within the lookback period, consistent with the safe harbor.

In addition, the 2020 final regulations illustrate, through examples, that the group prior-use rule does not apply when an asset is acquired by a former group member (other than the member that directly held the asset) following termination of a group. A similar example demonstrates that an asset acquisition is eligible for the additional first-year depreciation deduction if a member of a consolidated group acquires an asset, and a corporation that previously had a depreciable interest in the property becomes a member of the same group through an unrelated transaction, (i.e., the stock-and-asset-acquisition rule does not apply).

Consolidated acquisition rules

The 2020 final regulations also include rules to allow a member that buys (or is deemed to buy) eligible property in an intercompany transaction to claim the additional first-year deduction if the buyer leaves the group through a series of related transactions that includes the (actual or deemed) property acquisition. To qualify for the deduction, the member must meet the following criteria:

• The intercompany acquisition must otherwise meet the requirements for used property acquisitions (disregarding the group prior-use rule and certain prohibitions on acquisitions from related parties)
• The transferee (and, for deemed sales under an IRC Section 338 or IRC Section 336(e) election, the target) must both leave the relevant consolidated group and cease to be related to the transferor member
• The acquired property must continue to be eligible property on both the deconsolidation date and the day after

Unlike the 2019 proposed regulations, however, the series of related transactions is not limited to a 90-day period for these rules to apply.

When these consolidated acquisition rules apply, the general rules for a series of related transaction do not apply. In another departure from the 2019 proposed regulations, the 2020 final regulations establish a delayed bonus approach that treats the transferee member as selling the acquired eligible property to an unrelated third party one day after the deconsolidation date for an amount of cash equal to the member's basis in the property. The transferee member is then treated as acquiring identical (but distinct) used property from another unrelated third party for the same amount. The initial intercompany sale is respected as occurring on the date of the actual acquisition and is subject to generally applicable rules. Additionally, the transferee member's deemed sale and purchase of assets under the delayed bonus approach only applies to eligible property, which is generally determined without regard to an election not to claim additional first-year depreciation by the selling consolidated group.

Taxpayers may elect out of the delayed bonus approach for all eligible property acquired through the same series of related transactions. The election generally is made by attaching a statement to a timely filed tax return for the transferee (or target) member's tax year beginning on the day after the deconsolidation date (or the tax year of an acquiring consolidated group that includes that tax year). Taxpayers making the election are deemed to have made the election for all other transactions in the series that would be subject to the delayed bonus approach. The taxpayer may only revoke the election by filing a private letter ruling request and obtaining the IRS's consent.

IRC Section 355 transactions

The Treasury Department and IRS declined to extend the delayed bonus approach previously described to deemed asset acquisitions under qualified stock dispositions described in IRC Section 355(d)(2) or (e)(2) for which an election under IRC Section 336(e) is made. In addition, the Treasury Department and IRS are considering, and request comments regarding, whether the deemed sale and purchase of eligible property under the delayed bonus approach could prevent a transferee member from satisfying the active-trade-or-business requirements of IRC Section 355(b).

Consolidated rules move to IRC Section 1502

The 2020 final regulations move the rules for consolidated groups from Treas. Reg. Section 1.168(k)-2(b)(3)(v) to new Treas. Reg. Section 1.1502-68.

Partnerships

Partnership look-through rule

The proposed regulations established a partnership look-through rule under which a person would have a depreciable interest in a portion of property before acquiring the property if the person was a partner in a partnership at any time the partnership owned the property. The 2020 final regulations withdraw this rule because the complexity of applying the rule would place a significant administrative burden on the taxpayers and the IRS.

Interaction of IRC Section 743(b) basis adjustments and IRC Section 168(i)(7) transactions

The 2020 final regulations decline to provide additional clarification on the operation of IRC Section 168(k) with respect to IRC Section 743(b) adjustments after transfers of partnership interests in IRC Section 168(i)(7) transactions, as described in the 2019 final regulations. As provided in the 2019 final regulations, a taxpayer's purchase of a partnership interest, followed by a transfer of that interest in an IRC Section 168(i)(7) transaction in the same tax year, results in bonus-depreciation eligibility for any IRC Section 743(b) adjustment that is allocated to bonus-eligible property and arises from the initial partnership interest purchase. The bonus depreciation is allocated between the transferor (the purchaser of the partnership interest) and the transferee (the successor partner) on a monthly basis.

Definitions

Qualified improvement property

The 2020 final regulations modify the definition of qualified improvement property set forth in Treas. Reg. Section 1.168(b)-1(a)(5)(i)(A) by requiring that the improvement be made by the taxpayer, effectively aligning the definition in the regulations to that utilized in IRC Section 168(e)(6). The IRS and Treasury explain in the preamble to the regulations "that an improvement is made by the taxpayer if the taxpayer makes, manufactures, constructs, or produces the improvement for itself or if the improvement is made, manufactured, constructed, or produced for the taxpayer by another person under a written contract."

The 2020 final regulations further clarify that nonresidential real property will be qualified improvement property under the following circumstances:

1. The taxpayer acquires nonresidential real property in a carryover basis transaction (e.g., an IRC Section 351 or IRC Section 721 transaction, etc.).
2. An improvement was made by, and placed in service by, the transferor of the property.
3. The improvement is qualified improvement property for the transferor.
4. The improvement is treated as being made by the taxpayer.

As qualified improvement property, the nonresidential real property is subject to a 15-year or 20-year recovery period, depending on whether the general or alternative depreciation system applies, but only for the portion of the taxpayer's basis in the property that does not exceed the transferor's adjusted depreciable basis of the property. With this said, such property will not qualify as used property eligible for bonus depreciation because it will not meet the requirements of IRC Section 179(d)(2)(C); consequently, the taxpayer will not be able to claim the additional first-year depreciation deduction for the property.

Predecessor and class of property

Minor changes were made to the definitions of predecessor and class of property to clarify that "predecessor" applies only to specific property, and "class of property" applies only to IRC Section 743(b) basis adjustments to partnership assets for the benefit of a specific partner. A prior provision, which treated any transferor of an asset to a trust as a predecessor (regardless of whether the transfer involved carryover basis), has been removed.

IRC Section 168(k)(9) property

The 2020 final regulations adopt the proposed regulations' amendments to Treas. Reg. Section 1.168(k)-2(b)(2)(ii)(F) and (G) to allow additional first-year depreciation for otherwise bonus eligible property to a lessor leasing property to a trade or business described in IRC Section 168(k)(9), including certain rate-regulated utilities and trades or businesses with floor-plan financing indebtedness. To qualify for this treatment, the lessor itself may not be a trade or business described in IRC Section 168(k)(9).

For purposes of IRC Section 168(k)(9)(B) and Treas. Reg. Section 1.168(k)-2(b)(2)(ii)(G), the 2020 final regulations amend Treas. Reg. Section 1.168(k)-2(b)(2)(ii)(G) to clarify that a trade or business with floor-plan financing indebtedness "takes into account" interest associated with such indebtedness for the tax year if:

• It incurs that interest within the tax year
• The interest expense (including that interest) exceeds the sum of the amounts calculated under IRC Section 163(j)(1)(A) and (B) (interest income plus the applicable percentage of adjusted taxable income) for the tax year

If the trade or business has taken floor-plan financing interest into account under Treas. Reg. Section 1.168(k)-2(b)(2)(ii)(G) for a tax year, Treas. Reg. Section 1.168(k)-2(b)(2)(ii)(G) applies to any property placed in service by that trade or business in that tax year; as such, the trade or business cannot utilize bonus depreciation on its assets placed in service within that tax year. This does not necessarily preclude a trade or business with floor-plan financing indebtedness from utilizing bonus depreciation in future tax years, provided that the interest associated with the floor-plan financing indebtedness is not "taken into account" (as described previously) in such future tax years.

In the Preamble to the 2020 final regulations, the IRS and Treasury indicate that they plan to publish guidance providing transition relief for taxpayers that:

1. Treated IRC Section 163(j) as providing an option for a trade or business with floor-plan financing indebtedness to include or exclude its floor-plan financing interest expense in determining the business interest expense deduction on the 2018 federal income tax return
2. Have a trade or business with floor-plan financing indebtedness and want to revoke their election to not claim the additional first-year depreciation for property placed in service during 2018

De minimis use

The 2020 final regulations adopt the de minimis use rule established in the proposed regulations. Under the de minimis use rule, a taxpayer may (1) acquire and place in service property for which it did not previously have a depreciable interest, (2) dispose of the property to an unrelated party within 90 calendar days of placing the property in service, and (3) reacquire and again place the property in service. When determining whether the taxpayer or a predecessor used the property at any time before the reacquisition, the taxpayer need not take into account the depreciable interest from the 90-day period when the taxpayer originally held the property. The de minimis use rule does not apply if the taxpayer reacquired and placed the property in service during the same tax year in which it disposed of the property.

The 2020 final regulations add examples to illustrate the application of the de minimis use rule.

Acquisition date for property not acquired under a written binding contract

The 2020 final regulations retain the rule from the proposed regulations defining the acquisition date of property acquired under a contract that does not meet the definition of a written binding contract. Under that rule, the acquisition date is the date on which the taxpayer pays or incurs more than 10% of the total cost of the property, excluding the cost of land and certain preliminary activities.

Mid-quarter convention

The 2020 final regulations specify that the depreciable basis for the tax year in which the taxpayer places qualified property in service "is not reduced by the allowed or allowable additional [first-year] depreciation deduction for that [tax] year" when determining whether the mid-quarter convention applies. In other words, the unadjusted basis of bonus-eligible property is utilized when assessing whether the mid-quarter convention applies in a given tax year.

Effective date

The definition of qualified improvement property applies to depreciable property placed in service after December 31, 2017. The modifications made to Treas. Reg. Section 1.168(k)-2 and Treas. Reg. Section 1.1502-68 as a result of the 2020 final regulations apply to depreciable property acquired after September 27, 2017, and placed in service during or after a taxpayer's tax year that begins on or after January 1, 2021. That said, a taxpayer may apply the modifications to the aforementioned regulations to depreciable property acquired after September 27, 2017, and placed in service after September 27, 2017, by the taxpayer in a tax year ending on or after September 28, 2017, provided that the taxpayer consistently applies all the rules in the regulations.

Alternatively, the 2020 final regulations permit taxpayers to rely on the proposed regulations released in September 2019 for depreciable property acquired and placed in service after September 27, 2017, by the taxpayer during a tax year ending on or after September 28, 2017, and ending before the taxpayer's first tax year that begins on or after January 1, 2021. Taxpayers exercising this option must follow the proposed regulations in their entirety, except for the partnership look-through rule as detailed previously and in the proposed regulations.

Implications

Many of the modifications made by the 2020 final regulations are directionally in line with the prior proposed regulations released in September 2019. They also give taxpayers a framework to apply the bonus depreciation provisions to property acquired and placed in service under the latest iteration of bonus depreciation in the TCJA. How taxpayers implement the 2020 final regulations, particularly those wishing to "early adopt" the provisions of the regulations for years in which a tax return has already been filed, will be the subject of additional procedural guidance (including, for example, method-change rules) that we expect to be forthcoming in the near future.

Regarding the component election attributable to larger self-constructed property, taxpayers may now "break up" property into components and apply 100% bonus depreciation to potentially significant portions of self-constructed property that otherwise would only be eligible at best for pre-TCJA bonus-depreciation percentages. The expansion of this election to property that would not have otherwise been bonus eligible based on its placement in service in a tax year outside the pre-TCJA bonus-depreciation period adds further potential benefit for taxpayers looking to utilize the election. In short, the component election provides an immediate opportunity to assess whether certain components of larger self-constructed property placed in service on or after September 28, 2017, might be eligible for 100% bonus depreciation.

The final series-of-related-transactions rule was intended to take a simplified approach compared to the 2019 proposed regulations and to take into account changing relationships between parties. While the new approach provides some clarity, significant complexity remains as a result of these special rules. The rules require each transferee to obtain significant information regarding the relationships between the other parties, as well as when and whether the other parties placed the property in service, among other information. Such inquiries may span multiple years. In addition, the 2020 final regulations focus solely on relationships at the time of, or prior to, a relevant asset acquisition, failing to take into account relationships that subsequently arise, even those within a short period and under a plan.

The changes to the consolidated group rules from the 2019 proposed regulations generally address many taxpayer concerns, including (i) confirming the availability of the five-year safe harbor in the context of consolidated groups, (ii) removing the 90-day requirement to apply the consolidated acquisition rules, and (iii) limiting the scope of the delayed bonus approach to eligible property. If the nature of the property changes between the intercompany transaction and the day after the deconsolidation event, however, taxpayers should be aware that bonus depreciation may not be available.

Although the deemed-sale approach prevents the transferee from recognizing gain (or loss) on the deemed sale (notwithstanding potential changes in value on the acquired assets), it also disallows the additional first-year depreciation deduction to the extent the selling consolidated group claims cost-recovery deductions after the intercompany transaction. Further, the deemed replacement property is not eligible for federal income tax credits or deductions that only apply to new property because the transferee is treated as acquiring used property. Finally, taxpayers contemplating spin-off transactions under IRC Section 355 should be aware that (i) while the additional first year deduction is not available for qualified stock dispositions under IRC Section 355(d)(2) and (e)(2), structuring options may be available and (ii) the Treasury Department and IRS are studying the potential impact on meeting IRC Section 355(b)'s active-trade-or-business requirement.

The withdrawal of the partnership look-through rule is a welcome change for taxpayers and significantly reduces the complexity of applying the IRC Section 168(k) requirements. Eliminating the partnership look-through rule is consistent with the "entity" approach to partnerships applied in other IRC Section 168(k) requirements (for example, the "relatedness" test under IRC Section 168(k)(2)(E)(ii)(II), which tests the relationship between a buyer and seller of property by reference to IRC Sections 267 and 707(b)).

Certain other partnership-related issues still remain unaddressed. For example, the application of the "acquisition requirements" under IRC Section 168(k)(2)(E)(ii) in the context of certain other partnership-related transactions remains unclear. Specifically, the rule specifying that the transferee's basis in eligible property acquired is not determined in whole or in part by reference to the basis of the property in the transferor's hands creates uncertainty in transactions involving disguised sales of partnership property under IRC Section 707(a)(2)(B), when, for example, the partnership is treated as acquiring part of an asset in a purchase transaction and part of the same asset in a contribution transaction. Consider the following example:

A contributes $150 of cash and B contributes eligible property with a basis of $120 and a value of $200 to partnership AB. Immediately following the contributions, AB transfers $50 to B in order to equalize the partners' capital accounts at $150 each. Assuming no exceptions apply, AB is treated as having acquired 25% of the property and will have a $50 basis in the acquired property. Additionally, B is treated as contributing the remaining 75% of the property to AB in an IRC Section 168(i)(7) transaction, with a value of $150 and a basis of $90. A question is whether the transfer of the property violates the IRC Section 168(k) requirement that the transferee's basis not be determined in whole or in part by reference to the basis of the property in the transferor's hands.

As the 2020 final regulations declined to clarify the operation of IRC Section 743(b) basis adjustments in the context of IRC Section 168(i)(7) transactions, additional guidance may be necessary. For example, the timing of the bonus depreciation deduction's impact on the purchaser's basis in its partnership interest is necessary for determining the successor partner's resulting IRC Section 743(b) adjustment with respect to the transferred partnership interest. Furthermore, the bifurcation of bonus depreciation between the purchaser and the successor partner affects the determination of the successor partner's IRC Section 743(b) basis adjustment (and the allocation of that adjustment to the partnership's assets under IRC Section 755).

———————————————