Internal Revenue Code (IRC) Section 179 allows eligible taxpayers to elect to expense the cost of certain depreciable property in the tax year the property is placed in service. Basically, property that is eligible for the Section 179 deduction privilege includes most depreciable tangible personal property and software used in an active trade or business. However, certain types of depreciable tangible personal property become ineligible in certain circumstances.
As is typical in the construction industry and other industries, an equipment-intensive business will set up an entity to purchase the equipment and then lease this equipment to the operating company. While this business model is sound from an overall liability perspective, the set-up and operation of the equipment leasing company can make the equipment purchased in the equipment leasing company ineligible for Section 179 benefits.
When The Restriction Doesn’t Apply
Generally, non-corporate lessors, which would include partnerships and LLCs taxed as partnerships, are prohibited from claiming Section 179 deductions for the cost of property that is leased to other parties, including related parties. However, this restriction does not apply in the following two circumstances:
- The non-corporate lessor manufactured or produced the leased property in question, or
- Under a two-pronged test:
- The term of the lease (counting options to renew) is less than 50 percent of the class life of the leased property as defined by IRC Sec. 168(i), and
- For the first 12 months after the property is transferred to the lessee, the lessor’s deductions allowed solely by IRC Sec. 162 with respect to the leased property exceeds 15 percent of the rental income produced by the leased property. Since depreciation expense is allowed under IRC Sec. 167, taxes, under IRC Sec. 164, and interest expense under IRC Sec. 163, they are not included as expenses for purposes of the “more-than-15%-of-rental-income” test.
Putting This Into Layman’s Terms
So how exactly does this all work? Here’s an example. Let’s say the Lessor Partnership (LP) is in the equipment leasing business. All of LP’s equipment is leased under short-term, 1-year leases, the terms of which are less than 50 percent of the Section 168(i) class lives of the property. Therefore, the first prong of the preceding test is passed.
The second prong of the test is passed when, in the first 12 months after the equipment is transferred to lessees, LP’s Section 162 expenses allocable to leased equipment exceed 15 percent of the rental income.
In this example, LP’s rental income is $100,000. If LP’s Section 162 expenses exceed $15,000, then the second prong of the test is met. LP’s Section 162 expenses amount to $20,000 and include maintenance of the equipment, rent for the storage of the equipment, insurance, licenses and tags, and other allocable general and administrative expenses. Since both prongs of the test are passed for such equipment, the non-corporate lessor restriction on Section 179 deductions does not apply to such equipment.
Be sure to consult your tax advisor if you are a non-corporate taxpayer in the active trade or business of leasing equipment or other personal property, whether to third parties or to your operating company. The operation of this leasing business can impact whether you are eligible to expense the cost of certain depreciable property under IRC Sec. 179.
By Doug Houser, MBA, CEPA (Zanesville office)