Recapture of Sec. 179 Expense Deduction for Passthrough Entities

Editor: Michael D. Koppel, CPA, PFS

The new extended dollar limitation under Sec. 179 allows a taxpayer to elect to expense up to $250,000 of the cost of qualifying property placed in service during a tax year. Practicing CPAs who prepare tax returns are relatively knowledgeable about how to report the Sec. 179 expense deduction. There is one area of Sec. 179, however, that can be tricky and is not well understood: how to report the recapture of Sec. 179 expense for passthrough entities at both the entity and owner levels. This item addresses how S corporations and partnerships that have a Sec. 179 recapture event should report the event to their owners and how a tax return preparer of an individual who receives a Schedule K-1 with supplemental Sec. 179 recapture information should report the recapture on Form 1040, U.S. Individual Income Tax Return.

For passthrough entities, recapture of the Sec. 179 expense deduction information is required when the entity disposes of an asset for which the entity passed through Sec. 179 expense to its owners on a Schedule K-1 (Sec. 1245(a); Regs. Sec. 1.179-1(e) (3)). Recapture of Sec. 179 expense deduction information is also required when there is a decline in business use that triggers recapture. If property for which a Sec. 179 expense deduction was claimed ceases to be used more than 50% in business at any time before the end of the property’s recovery period, partial recapture of the deduction is required (Secs. 179(d)(10) and 280F(b)(2); Regs. Sec. 1.179-1(e)).

Entity Reporting for an Asset Disposition

When preparing Form 1120S, U.S. Income Tax Return for an S Corporation, or Form 1065, U.S. Return of Partnership Income, if a passthrough entity disposed of Sec. 179 property during the tax year, the amount of the Sec. 179 expense previously passed through to its owners on a Schedule K-1 is treated as depreciation and must be recaptured under Sec. 1245 to the extent of any gain realized on the disposition at the owner level. The tax gain or loss on disposition of Sec. 179 assets will not be reported on page 1 of Form 1120S or Form 1065, will not be reported on Schedule K, and will not be included on the Form 4797, Sales of Business Property, prepared by the passthrough entity. The entity will eliminate net book gain or loss on Sec. 179 assets from taxable income and present it on the entity tax return as a Schedule M-1 adjustment. The information necessary to calculate the tax gain or loss at the owner level will be reported on a Form 1120S, Schedule K-1, in box 17, Other Information, and designated as code K, “dispositions of property with section 179 deductions.” For a partnership the same information will be reported on Form 1065, Schedule K-1, box 20, Other Information, designated as code L. Both codes K and L will refer to a supporting schedule.

Because the passthrough entity must maintain fixed asset depreciation schedules for tax purposes, which includes the Sec. 179 expense deduction, it has the information needed to prepare the supporting schedule necessary for codes K and L items. The instructions to the Schedules K-1 for Forms 1065 and 1120S state that for codes K and L the passthrough entity should provide the owner the following information:

• Description of the disposed property;
• Date acquired and placed in service;
• Date of sale or disposition;
• Owner’s distributive share of sale price;
• Distributive share cost and selling expense;
• Distributive share of depreciation;
• Distributive share of Sec. 179 expense;
• If distribution is due to a casualty or theft, the information necessary for the owner to complete Form 4684, Casualties and Thefts; and
• Installment sale information, if applicable.

Most tax preparation software applications will automatically handle the entity-level reporting of a disposition of a Sec. 179 asset from the information entered on a sale of a business asset screen. However, it is important that tax preparers understand how and where the disposition information is reported and that the tax gain or loss on the disposition of Sec. 179 assets is reported at the owner level.

Owner Reporting for Disposition

As described above, an S corporation will report the information necessary to calculate the tax gain or loss at the owner level on a Form 1120S, Schedule K-1, in box 17, Other Information, designated as code K. A partnership will report the information on Form 1065, Schedule K-1, in box 20, Other Information, designated as code L. In both cases, the entry will refer to a supporting schedule containing detailed information.

On Form 4797, depreciation allowed or allowable includes the Sec. 179 expense deduction actually claimed in prior-year tax returns. If an owner was unable or ineligible to deduct the Sec. 179 expense deduction for a disposed asset, the depreciation reported as allowed or allowable on Form 4797 will include only the Sec. 179 expense deduction actually claimed in prior-year tax returns. Thus, the gain or loss on the disposition of an asset can vary between owners of the same entity. When faced with the task of preparing such a Form 4797, the preparer must review prior-year Forms 1040 to see if all Sec. 179 expense deductions from the passthrough entity have been deducted.

It is important for a preparer to understand that the gain or loss on the disposition of a Sec. 179 asset is reported at the owner level and that the information necessary to compute the gain or loss on Form 4797 is found only in the statement attached to the related Schedule K-1. It would be very easy for a preparer of a Form 1040 to skip this information and thus misreport the income or loss from the passthrough entity. The misreported income or loss could be significant, and the preparer firm would have difficulty explaining why it had not prepared the return correctly.

Entity Reporting: Recapture Due to Decline in Use

The other occurrence that can trigger a recapture of Sec. 179 expense deduction is a decline in business use of property to 50% or less at any time before the end of the property’s recovery period. If this situation occurs, the passthrough entity is required to inform its owners that they may have to recapture a portion of previously distributed Sec. 179 expense deduction, and the entity must provide the information necessary for the owner to determine how much the owner must recapture.

The passthrough entity must first recompute the depreciation on all Sec. 179 assets for which the business use drops to 50% or less. It does this by taking the Sec. 179 expense passed through to the owners and applying the same life and method used for regular tax depreciation for this asset. The accumulated depreciation on the Sec. 179 expense through the end of the current tax year is compared with the Sec. 179 expense passed through to the owners for this asset. The difference is allocated to each owner based upon his or her ownership percentage in the year the Sec. 179 expense was passed through to the owners. An S corporation reports the tentative recapture of Sec. 179 expense on Form 1120S, Schedule K-1, in box 17, Other Information, and designated as code L, “recapture of section 179 deduction.” A partnership reports the same information on Form 1065, Schedule K-1, in box 20, Other Information, designated as code M. The dollar amount of the recapture is listed next to the respective codes.

The passthrough entity is required to attach a supporting schedule to each owner’s K-1 that breaks out the owner’s share of the depreciation that was allowed or allowable on the property and the owner’s share of the Sec. 179 expense that was passed through and the years in which the expense was passed through. The recapture amount will not appear on page 1 of Form 1120S or Form 1065 or on Schedule K.

The passthrough entity is required to complete Part IV of Form 4797, using the amounts computed above. The entity will report the Sec. 179 expense deduction(s) passed through to owners in a prior year on line 33. It will report the recomputed depreciation on the Sec. 179 expense deduction on line 34. The difference between the two amounts is reported on line 35 as the recapture amount. The owners must also complete Part IV of Form 4797 and submit it as part of their 1040 return. The passthrough entity must provide the necessary details in a schedule attached to an owner’s Schedule K-1. The schedule must contain information for each asset subject to Sec. 179 recapture. Specifically, it must contain the year the asset was placed in service, the amount of Sec. 179 expense, the amount of recalculated depreciation, and the recapture amount. Each owner will have to determine how much of the Sec. 179 expense was deducted on the owner’s Schedule E in prior-year Forms 1040 in order to correctly complete Part IV of Form 4797.

Going forward, the passthrough entity must modify its tax depreciation schedules by deleting the Sec. 179 expense deduction, reducing accumulated depreciation by the net recapture amount, and increasing the depreciable basis of the asset by the net recapture amount. The alternative minimum tax and adjusted current earnings depreciation schedules must also be modified.

Example: In 2007 a $20,000 Sec. 179 asset with a five-year life is placed in service, and $15,000 of Sec. 179 expense deduction for this asset is passed through to the owners. The business use percentage of this asset falls below 51% in 2008. The 2007 Sec. 179 expense deduction must be recaptured in 2008.

Assume the asset was depreciated for tax purposes using the modified accelerated cost recovery system (MACRS) and a half-year convention. Prior to recapture, the depreciable base would be $5,000 and the accumulated depreciation through 2008 would have been $17,600 ($5,000 × 52%

+ $15,000 of Sec. 179 expense deduction).The recapture is computed by applying the MACRS two-year accumulated depreciation percentage of 52% to the Sec. 179 expense deduction of $15,000, which equals $7,800. The Sec. 179 expense passed through to the owners in 2007 of $15,000 must be recaptured to the extent it exceeds the accumulated depreciation on the Sec. 179 expense deduction of $7,800 ($15,000 × 52%). The tentative recapture of Sec. 179 expense deduction in 2008 is $7,200 ($15,000 – $7,800). The depreciable base for this asset is increased to $12,200 ($5,000 + $7,200), and the accumulated depreciation through 2008 will be adjusted to $10,400 ($17,600 – $7,200).

Owner Reporting: Recapture Due to Decline in Use

As described above, an S corporation will report the tentative recapture of Sec. 179 expense on Form 1120S, Schedule K-1, in box 17, designated as code L. A partnership will report the information on Form 1065, Schedule K-1, box 20, Other Information, designated as code M. The dollar amount of the recapture will be listed next to the respective codes, and the entry will contain a reference to a schedule providing the required detail information. A preparer must be sure to look for the schedule related to the entry because knowing the recapture amount alone does not provide the information necessary to complete Part IV of Form 4797.

The schedule should contain information for each asset subject to Sec. 179 recapture due to decline in business use to 50% or less. Specifically, it should contain the year the asset was placed in service, the amount of Sec. 179 expense, the amount of recalculated depreciation, and the recapture amount. The preparer will have to determine how much of the Sec. 179 expense was deducted on Schedule E in prior-year Forms 1040 in order to correctly complete Part IV of Form 4797. If the owner did not claim a deduction for the full amount of the Sec. 179 expense in a prior year or years, line 33 of Form 4797 must be adjusted by the unclaimed amount, which will affect the dollar amount of the recapture of Sec. 179 expense deduction.

Note that the recapture of Sec. 179 expense deduction determined in Part IV of Form 4797 is reported as nonpassive income on Form 1040, Schedule E, Supplemental Income and Loss. According to the 2008 instructions for the Form 1040, Schedule SE, the recapture of income resulting from the decline in the business use of Sec. 179 property is subject to self-employment tax (IRS, 2008 Instructions for Schedule SE (Form 1040), Self-Employment Tax, p. SE-3).

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

For additional information about these items, contact Mr. Koppel at (781) 407-0300, or mkoppel@gggcpas.com.