The recently issued bonus depreciation regulations should influence – but not control – how we structure certain partnership contributions and distributions. These transactions include partnership mergers and divisions.
Bonus depreciation generally allows a taxpayer to expense a used capital asset, but only if the purchaser did not previously have a depreciable interest in the property. When a partner’s interest is liquidated (redeemed) or purchased, the basis of partnership property may be adjusted for some or all partners as though those assets were “purchased”. We call these transactions “basis adjustment transactions”. The bonus depreciation regulations establish which of those basis adjustment transactions can result in bonus depreciation deductions.
The bonus depreciation regulations also establish when property acquired by or from a partnership can be eligible for bonus depreciation.
Treasury declined to apply one rule to all basis adjustment transactions. For this reason, selecting one form of a basis adjustment transaction over another can result in a significant economic benefit – or detriment.
No bonus depreciation for contributed property. Property contributed to a partnership is not eligible for bonus depreciation, whether or not the tax basis of the property equals the property’s fair market value. Some thought that bonus depreciation might apply to the spread between value and basis of contributed property if the partnership applied the “remedial allocation method” to mitigate the effects of something called the ceiling rule. Remedial allocations are notional items on the contributed property determined as if that property were acquired by the partnership. However, constructively acquiring the property for remedial allocation purposes does not change the fact that the property was actually contributed to the partnership. So, no bonus depreciation on account of remedial allocations.
The absence of bonus depreciation for contributed property should be considered in rollover transactions involving partnerships. Often in these transactions, acquiror purchases a percentage of the interests in an LLC from the sole owner. The balance of the interests is retained by the seller/business owner (sometimes, an S corporation). In this transaction, the purchaser is deemed to purchase some of the assets and then contribute those assets to a new partnership. While the purchaser is able to use bonus depreciation to any eligible property deemed acquired, the partnership to which they are contributed cannot. It did not acquire them by purchase. However, there are ways to re-structure this transaction to avoid this result. But then, in most of these transactions, goodwill is a significant asset in the deal. Goodwill is not eligible for bonus depreciation, even if not subject to anti-churning rules. So, maybe the bonus depreciation won’t matter so much in these transactions. However, restructuring the transaction has benefits as to amortizing the goodwill as well. So, even where goodwill comprises substantially all of the assets, careful planning can still improve returns.
Bonus depreciation is available as to some partnership basis adjustments. When a partner’s interest is partly or wholly redeemed (more accurately, liquidated), the partnership can increase the basis of its assets by (roughly) the amount of gain the departing partner realizes on the redemption. The remaining partners get to recover that basis over the useful life of the partnership’s properties. However, since the basis adjusted is the common basis of partnership property, and that property was already placed in service by the partnership, there is no bonus depreciation for that adjustment.
The basis of partnership property is also adjusted when a person acquires an interest from another partner. Again, the amount of a positive adjustment is roughly the gain realized by the selling partner. In this transaction, unlike the redemptive transaction, bonus depreciation can be available for a portion of the basis adjustment, but only if the purchaser (or purchaser’s predecessor) did not have a depreciable interest in the property during the five-year period ending on the purchase date. Proposed bonus depreciation regulations provide that a partner is treated as having a depreciable interest in a “proportionate share” of partnership property. The proportionate share is that partner’s share of total depreciation in the property. So, if the purchaser is/was a partner with a share of depreciation in partnership property, bonus depreciation will not be allowed on the basis adjustment. Notably, if bonus depreciation is allowed, the acquiring partner can apply bonus depreciation for a class of property even if the partnership has elected out of bonus depreciation for that class.
The disparity in treatment between redemptions and interest purchases creates a planning opportunity, in the right cases. Business interests, property types, and other factors should be taken into account, even where the opportunity is available.
No bonus depreciation for distributed property. Sometimes a partnership distributes property to a partner. When that happens, that partner’s basis in the property can differ from the partnership’s basis in that property. Regardless of any basis difference, that partner cannot recover the cost of that property using bonus depreciation.
Bonus depreciation is not allowed on transactions between a partnership and certain partners or former partners. Used property is eligible for bonus depreciation only if acquired from by a person who did not have a depreciable interest in that property during the five-year lookback period. Under the proposed regulations, each partner in a partnership as having a depreciable interest in a portion of the property. That portion equals that partner’s (or partner’s predecessor’s) share of depreciation allocations over the five-year lookback period. So, for example, if a person who was a partner in a partnership acquires property from a partnership, bonus depreciation will not be allowed if that partner (or partner’s predecessor) was a partner with a share of depreciation in that property during the five-year lookback period (the five tax years ending before the current year, plus the expired term of the current tax year).
Mergers, divisions, disguised sales, partnership terminations. As noted above, bonus depreciation should be considered (with many other issues) in partnership mergers and divisions. Bonus depreciation also should be a factor in analyzing disguised sales of property, and the now rare transactions that cause a partnership to terminate.