Placed-in-Service Decision Requires Careful Planning

By Ananth Seetharaman, Ph.D., CA, Saint Louis University, St. Louis, MO, and Greg Carnes, Ph.D., CPA, University of North Alabama, Florence, AL (Neither Affiliated with PKF North American Network)

Editor: Kevin F. Reilly, J.D., CPA
Sec. 167(a) allows a depreciation deduction for assets used in the taxpayer’s trade or business or held for the production of in-come (e.g., rental income). Regs. Sec. 1.167(a)-10(b) provides that the period for depreciation of such an asset begins when it is placed in service and ends when the asset is retired from service. The placed-in-service date is important for tax planning purposes because optimally chosen placed-in-service dates can accelerate depreciation deductions and make available any additional deductions or tax credits. A delay in the placed-in-service date should not, per se, affect the total amount of the depreciation deduction over the asset’s life; that amount is limited by the asset’s tax basis. However, an earlier placed-in-service date is, as a general rule, preferred by taxpayers and opposed by the Service due to time value of money considerations. Not surprisingly, therefore, the placed-in-service date is contentious in many situations. For example:
  • When should depreciation begin for a building under construction?
  • If a factory building is intended to house machinery, can the building be placed in service before the machinery is installed?
  • Is operational use of a machine or a manufacturing facility a prerequisite for it being deemed placed in service, or is it sufficient that the property is ready for use?
  • If equipment is acquired during the tax year but it is not practicable to use the equipment in the business until the following year, when was the equipment placed in service?
  • If a production facility is moved or relocated, does the placed-in-service date change?

This item analyzes the various tax law sources to provide a framework for answering these types of questions. In some instances, the IRS and the courts have narrowly interpreted the placed-in-service requirement only to reverse course and apply a broader interpretation in other instances. Until the issuance of further guidance, taxpayers would be well advised to exercise caution in determining when an asset is placed in service.

Treasury’s Interpretation

Regs. Sec. 1.167(a)-(11)(e)(1)(i) provides that property is considered to be placed in service when it is “first placed in a condition or state of readiness and availability for a specifically assigned function” (emphasis added). If a building is specifically constructed to house machinery and equipment, as a general rule, the building will be deemed placed in service on the date it is ready and available to house the machinery and equipment. Note that, per the regulations, the building’s state of readiness and availability should be assessed without regard to whether the machinery or equipment that the building is intended to house have been placed in service. However, the regulations also state that in an appropriate case (for example, when the building’s use is so inextricably related to the machinery or equipment it is intended to house that the building can be expected to be retired when the property it houses is retired), the building’s readiness or availability is determined by taking into account the readiness and availability of such machinery or equipment.

Interpretation of Placed in Service by the IRS and Courts

Notwithstanding the seemingly liberal interpretation of the Sec. 167(a) placed-in-service provision in Regs. Sec. 1.167(a)-(11)(e)(1)(i), the Service has often interpreted this provision narrowly, requiring full actual operational use, not merely availability for use, of an asset before it is deemed placed in service. FSA 199916040, for example, dealt with a taxpayer that purchased, sold, and transported natural gas. The taxpayer owned and operated an integrated pipeline system, which connected gas supply sources from several states to gas markets in other states. Because compressors were required to maintain gas pressure in the pipelines, the taxpayer bought both new and used compressors. These compressors were repaired if necessary and were placed into warehouses for storage until needed. On their delivery to storage, the taxpayer treated the compressor as having been placed in service for depreciation purposes, presumably on the ground that the machines were ready and available for their assigned function. In advising against depreciation until the time the compressors were installed in the pipelines, the Chief Counsel noted that the Service has applied Regs. Sec. 1.167(a)(11)(e)(1)(i) generally to require actual operational use in the trade or business, citing Consumers Power Co., 89 TC 710 (1987), and Oglethorpe Power Corp., TC Memo 1990-505, to support this conclusion. In Consumers, the Tax Court implicitly adopted the argument that an asset or facility is not placed in service until it is operating at rated capacity. Relying on Consumers, the court in Oglethorpe stated that an electricity-generating unit should not be deemed placed in service because it was not available for its specifically assigned function, which the court defined as consistently sustaining generation levels near its rated capacity.

The IRS has also taken positions in several revenue rulings consistent with the idea that full operational use of an asset is a prerequisite for it to be considered as placed in service. Rev. Rul. 79-98, for example, states that a nuclear electric generating facility was placed in service when “the unit was able to operate at its rated capacity without failure.” Similarly, in Rev. Rul. 73-518, the taxpayer, an electric utility company, deducted depreciation on a transmission line in year 1, on the ground that the line was ready and available for its assigned function. The Service, however, ruled that the transmission line was not placed in service in year 1 because substations, which were necessary to put the lines into operation, were not completed and made available for service until year 2.

Liberal Interpretation of Placed in Service

The Service and the courts have, however, often adopted a less restrictive placed-in-service stance, thereby muddying the waters. In Rev. Rul. 76-238, the IRS responded to a request for advice as to the proper placed-in-service dates for depreciating (1) a building constructed to house manufacturing facilities and (2) the individual items of production machinery and equipment that were to be housed within the building. The Service considered the building to be placed in service on the date its construction was completed and it was made available for installation of machinery and equipment. Similarly, the Service considered the machinery that was installed in the building over a period of months to have been placed in service when the “entire production line was available for the production of an acceptable product...notwithstanding later testing to eliminate defects which prevented attainment of planned production levels or the meeting of acceptable quality control parameters.” In other words, “availability for a specifically assigned function” in the case of machinery does not necessarily mean that the machinery be put to actual operational use.

Following the principle in Rev. Rul. 76-238, several other revenue rulings have concluded that actual operation use or operation at rated capacity is not a prerequisite for an asset to be deemed placed in service (see, e.g., Rev. Ruls. 76-256 and 84-85). More recently, Letter Ruling 200334031 responded to a request for a ruling as to when each of several wind turbine generators was placed in service for depreciation allowance purposes and for the renewable energy production credit under Sec. 45. The Service ruled that the turbines should be considered placed in service for purposes of the allowance for depreciation deductions and the renewable energy production credit, notwithstanding any temporarily limited capacity or output. The ruling cited Regs. Sec. 1.46-3(d)(2), which provides examples of when property is in a condition of readiness. One example covers equipment acquired for a specifically assigned function that is operational but undergoing tests to eliminate any defects. Another example involves operational farm equipment acquired and placed in service in a tax year even though it was not practical to use such equipment for its specifically designed function in the taxpayer’s business of farming until the following year.

In addition to revenue rulings, several court cases also appear to disregard the IRS-imposed general requirement that actual operational use or operation at rated capacity is a precondition for an asset to be deemed placed in service. For instance, in Sealy Power, 46 F3d 382 (5th Cir. 1995), the court held that minimal operation of an electricity generating plant fueled by burning trash is sufficient for the plant to be deemed placed in service. Likewise, in both Northern States Power Co., 151 F3d 876 (8th Cir. 1998), and Connecticut Yankee Atomic Power Co., 38 Fed. Cl. 721 (1997), the courts allowed depreciation for nuclear fuel assemblies in the year received. The courts reasoned that they were “ready and available” for immediate use on delivery even though the fuel assemblies were not actually installed and supplying power to the reactors until months after delivery in the following fiscal year. In Sears Oil Co., 359 F2d 191 (2d Cir. 1966), the court concluded that “depreciation may be taken when depreciable property is available for use ‘should the occasion arise,’ even if the property is not in fact in use” (emphasis added). Relying on Sears, the court in SMC Corp., 675 F2d 113 (6th Cir. 1982), held that a fully operational crane and shredder installed by a taxpayer had been placed in service even though a utility company had not yet completed the electrical lines needed to power the equipment. Thus, the Court of Federal Claims and the Second, Fifth, Sixth, and Eighth Circuits, among others, appear to reject an “actual operation” requirement in this context and to adopt a more expansive standard whereby depreciation may be taken when depreciable property is available for use “should the occasion arise,” even if the property is not in fact in use.

In Livingston, TC Memo 1966-49, the Service argued that depreciation is not allowable on a building under construction that is not yet being used in a business operation. The court rejected this argument, holding that depreciation is allowable on portions of the building from the date such portions became completed for use in petitioner’s business, even if the entire building project is not yet complete.

Other Important Issues Related to Placed-in-Service Date

Would the relocation of a facility result in a new placed-in-service date? Letter Ruling 200708005 deals with a taxpayer wanting to claim a credit under Sec. 45K for producing fuel from a non-conventional source—a credit available only if the facility is placed in service within certain specified dates. The issue was whether the facility’s relocation to produce the fuel would result in a new placed-in-service date. The Service ruled that relocation did not produce a new placed-in-service date unless this was considered to be a “new” asset as provided by the fair market value requirements of Rev. Rul. 94-31. Under Rev. Rul. 94-31, relocation will not result in a new placed-in-service date unless, following the relocation, the original property’s fair market value is less than or equal to 20% of the facility’s total value (the new property’s cost plus the original property’s value).

Sec. 446 and Regs. Sec. 1.446-1(e) provide that a taxpayer must secure the Commissioner’s consent before changing a method of accounting for federal income tax purposes. Regs. Sec. 1.446-1(e)(2)(ii)(d)(3)(v) provides that if a taxpayer changes the placed-in-service date of a depreciable or amortizable asset because the taxpayer incorrectly determined the date on which the asset was placed in service, this change is not a change in accounting method. Rather, the taxpayer can correct such a change by making adjustments in the applicable tax year.

The placed-in-service date issue also arises in a taxable asset acquisition or a stock acquisition followed by a Sec. 338(h)(10) election. The IRS ruled in Letter Ruling 200434007 that in a taxable sale of assets, the purchaser does not “step into the shoes” of the seller. As a result, the purchaser receives a new basis and placed-in-service date for the property, which determine the availability and the amount of any additional depreciation or tax credits that the purchaser may claim for the acquired property. Similarly, per Letter Ruling 200434007, when Buyer acquires the stock of Seller, and Buyer and Seller make a joint election under Sec. 338(h)(10), resulting in a deemed taxable sale of assets by Old Target to New Target, New Target does not step into the shoes of Old Target. Therefore, New Target receives a new tax basis in, and a new placed-in-service date for, the assets deemed purchased from Old Target.

Summary and Conclusion

Taxpayers should examine their particular circumstances to determine when eligible property is considered placed in service because optimally chosen dates can maximize current deductions or tax credits for federal income tax purposes. In general, property is placed in service in the tax year the property is placed in a condition or state of readiness and availability for a specifically designed function. Facts and circumstances need to be examined to determine placed-in-service dates, but there is increasing support for the position that an asset is deemed placed in service when it is ready and available for use should the occasion arise.

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