Sec. 179D and Passthrough Entities

Expenses & Deductions

Sec. 179D was added to the Code in 2005 by the Energy Tax Incentives Act of 2005, P.L. 109-58, effective for property placed in service after December 31, 2005. Originally scheduled to expire December 31, 2007, it has been extended twice and now expires for property placed in service after December 31, 2013. The committee report noted that the provision provides a deduction “equal to energy-efficient commercial building property expenditures made by the taxpayer” (Joint Committee on Taxation, Description and Technical Explanation of the Conference Agreement of H.R. 6, Title XIII, the “Energy Tax Incentives Act of 2005” (JCX-60-05), p. 79 (July 28, 2005)). The conference agreement limited the deduction amount to $1.80 per square foot, with a partial deduction allowed for building subsystems. The Sec. 179D deduction reduces the adjusted basis in the property for depreciation purposes.

Recognizing that depreciation deductions provide no tax incentive for a public entity’s ownership of a building, the committee report noted that “the Secretary shall promulgate regulations that allow the deduction to be allocated to the person primarily responsible for designing the property in lieu of the public entity” (id. at 80). Consequently, architects qualify for the Sec. 179D deduction that otherwise would be provided to the building owner. This provision was codified at Sec. 179D(d)(4).

Notice 2008-40, Section 3.06, provides that the designer does not include any amount in income on account of the Sec. 179D allocation, nor is the designer required to reduce future deductions, even though such a reduction in deductions would comport with how Sec. 179D benefits nonpublic building owners.

This provision has unexpected consequences for partnership and S corporation designers. For firms structured as passthrough entities, the deduction at the entity level reduces the owners’ aggregate tax basis in the entity interest. This deduction, however, does not consume cash. (Consider it a “free” deduction.) The entity has the same cash available for distribution to its owners, but the owners’ tax bases in the entity have been reduced due to the passthrough deduction. Ultimately, the owners will have capital gain from receiving distributions in excess of tax basis (Sec. 704(d) for partnerships and Sec. 1366(d) for S corporations). The effect of Sec. 179D: A “free” current ordinary deduction is provided to the designer at the cost of a future capital gain. Sec. 179D provides a benefit to the designer, but it is not as much of a benefit as it initially appeared.

For designers structured as S corporations, the possibility exists that the S corporation has accumulated earnings and profits from a C corporation year. The Sec. 179D deduction reduces the accumulated adjustments account, thereby causing cash distributions to be dividends to the extent of accumulated earnings and profits.

The IRS Office of Chief Counsel released legal memorandum AM 2010-007 on December 23, 2010, discussing the issue. The memorandum states:

We understand that a growing number of [owners of passthrough entities] . . . have taken the position that this deduction is available to the [owners] without regard to the basis limitation rules contained in §§ 704(d) and 1366(d), either on the theory that the deduction is a partner or shareholder level deduction, or because the basis limitations of §§ 704(d) and 1366(d) and basis adjustment rules of §§ 705(a) and 1367(a) simply do not apply with respect to the §179D deduction.

The memorandum proceeds to give the Office of Chief Counsel’s position with respect to such arguments, stating that the Sec. 179D deduction, “like any other partnership or S corporation item of deduction,” reduces the owner’s tax basis in the ownership interest. Examples of the effect are provided.

Other Code provisions provide “free” deductions, notably Sec. 199. However, the Sec. 199 deduction is computed at the owner level (see Sec. 199(d)(1)(A)(i)). Consequently, the entity does not pass through the deduction; it passes through the information necessary for the owner to compute the deduction. It is a distinction with a difference.

Since Sec. 179D is scheduled to expire for property placed in service after 2013, it is not likely that Congress will modify Sec. 179D to “cure” this issue, if indeed Congress did not intend this result.