Background

President Trump signed into law the Tax Cuts and Jobs Act (the “TCJA”) on December 22, 2017. Included in the TCJA were amendments to IRC §168(k), which permits taxpayers to expense 100% of the costs of certain qualified property acquired after September 27, 2017 and placed in service through December 31, 2022. Bonus depreciation at the 100% level is eventually phased down 20% each year for qualified property that is placed in service after December 31, 2022, and before January 1, 2027. 

Qualified property was previously defined as property the “original” use of which began with the taxpayer. However, the definition of qualified property was expanded to also include “initial use” property, which includes new and used property that was not previously used by the taxpayer or a predecessor at any time prior to the taxpayer’s acquisition of the property.  Qualified property also must meet certain requirements that disqualifies property acquired from related parties or having a “carryover” basis such as property contributed to a partnership in a non-recognition transaction or “substituted” basis such as property acquired in a liquidation transaction. 

With the expansion of the definition of qualified property to include “initial use” property, questions arose as to whether basis step-ups for qualified property under IRC §734(b) or §743(b) could be fully expensed and how other partnership principles would be applied. On August 3, 2018, U.S. Department of the Treasury released proposed regulations for amendments to IRC §168(k), which address some of these important issues (the “Proposed Regulations”). Taxpayers may choose to apply the Proposed Regulations to qualified property acquired and placed in service after September 27, 2017, for taxable years ending on or after September 28, 2017. 

Acquisition of Energy Partnership Interests 

If a partnership has filed an election under IRC §754 (“754 Election”), the basis of partnership property shall be adjusted in the case of a transfer of a partnership interest (“Over the Top Transaction”) as provided under IRC §743 (“743(b) Adjustment”). The Proposed Regulations take an aggregate view of partnership taxation (i.e., each partner owns a proportional interest in partnership property) with respect to adjustments made to partnership property under IRC §743(b) so that qualified “initial use” property begins with a transferee partner. Therefore, the portion of the positive 743(b) Adjustment is treated as newly placed in service property eligible for bonus depreciation. However, any portion of a 743(b) Adjustment that relates to remedial allocation made under IRC §704(c) still must be recovered over the same remaining recovery period.

The Proposed Regulations do not require the partnership to fully expense the property acquired. A partner shall be able to expense all or a part of its 743(b) Adjustment if the partnership elects out of the bonus depreciation rules. 

Revenue Ruling 99-5 

Revenue Ruling 99-5 presents two scenarios when a disregarded entity becomes a partnership. In Situation 1, B sells 50% of the interests in the disregarded entity to A (“Rev. Rul. 99-5 Transaction”). The Internal Revenue Service (IRS) held that A is treated as purchasing an undivided interest in each of the assets of LLC and then A and B are treated as contributing all the assets to a new partnership in a non-recognition transaction under IRC §721.  

The Proposed Regulations treat A as acquiring newly purchased assets eligible for bonus depreciation immediately before formation of the partnership. B’s portion of the assets are not eligible for bonus depreciation as B holds a carry-over basis in the assets. Also, due to the prohibition against disposing and reacquiring an interest in depreciation property, B is not entitled to bonus depreciation. 

Partnership Contributions, Distributions and Step-In the Shoes Rules

Contributions

Treasury took more of an entity view of partnership taxation for contributions of property to a partnership and distributions of property to a partner. For non-recognition transactions under IRC §721, the partnership will generally receive a carryover basis in the property it receives and have a corresponding IRC §704(b) or “book” basis equal to fair market value. If the property’s book basis is greater than tax basis, the built-in gain is amortized using one of three methods: traditional, curative or remedial.  

Under the remedial method, the built-in gain is amortized as if the property is newly purchased partnership property. The Proposed Regulations deny bonus depreciation application to remedial allocations for otherwise qualified property of a partnership because the partnership fails the no “carryover basis” requirement and the partnership already commenced first use of such property at the time the remedial allocation is made. This rule also applies in the case of a partnership revaluation where the partnership would allocate “reverse” remedial deductions to its partners.  

The Proposed Regulations also deny application of bonus depreciation for partnership property having zero tax basis as it would not be considered a reasonable method because built in gain may be shifted to non-contributing partners. 

Distributions

As for partnership distributions, the Proposed Regulations, taking an entity view, deny application of the bonus depreciation to otherwise qualified property. If a partnership has a 754 Election in effect, a positive basis adjustment under IRC §734(b) to otherwise qualified property fails the “original use” and “initial use” requirements under IRC §168(k) because of the partnership’s current ownership of the property. The Proposed Regulations also do not permit application of bonus depreciation to basis created by a partnership distribution of property under IRC §732, as the partner receives a “carryover” or “substituted” basis in the property distributed by the partnership. 

Step-In the Shoes Rules

There are also special “step-in the shoes” rules whereby if qualified property is transferred in a non-recognition transaction and the transferor previously placed the property in service in the same taxable year, the transferred property is treated as originally placed in service on the date the transferor placed in service the qualified property. The transferee partner or partnership is then eligible for bonus depreciation. However, if the property is later disposed in the same taxable year, bonus depreciation is not permitted. 

Financial Statement Impact

Generally, there is no financial statement impact to U.S. domestic partnerships other than entity-level taxes such as the Texas Margins Tax. However, the Proposed Regulations may have financial statement impact for corporations acquiring partnership interests in an Over the Top Transaction. Generally, deferred tax assets, subject to valuation allowance determination, are recorded when a partnership has a 754 Election in effect and a 743(b) Adjustment is specially allocated to the corporate partner. If the corporate partner does not elect out of bonus depreciation, the current tax liability of the corporate partner would be reduced for bonus depreciation on the 743(b) Adjustment related to qualified property. If the corporate partner was in a net operating loss position a deferred tax asset would be recorded, subject to valuation allowance determination. 

Application to Energy Partnerships

The Proposed Regulations favor Over the Top Transactions and Rev. Rul. 99-5 Transactions. On the other hand, contributions of partnership property and distributions of cash or property from a partnership to a partner will not be able to take advantage of bonus depreciation under IRC §168(k).  

Midstream, downstream and oilfield service companies acquiring qualifying property in an Over the Top Transaction or Rev. Rul. 99-5 Transaction have the most to gain under the Proposed Regulations. These industries in an “Up-C” structure will also greatly benefit from 743(b) Adjustments made in sell-down transactions and when tax receivable agreement payments are made. Any tax amortizable goodwill or customer intangibles, however, is not qualifying property under IRC §168(k) and not eligible for bonus depreciation. 

Upstream partnerships can also take advantage of the Proposed Regulations to the extent of surface equipment that is qualifying property. However, any interests in oil and gas properties shall not qualify for bonus depreciation.