Tax Accounting
When planning an incorporation or reorganization transaction, taxpayers and their advisers often focus on choice of entity, conservation and preservation of tax attributes, and reducing the tax cost and may not examine in depth the related accounting method and depreciation issues that arise as a result of the transaction. These items may not be addressed until well after the transaction, when either the target company or the acquirer is preparing the post-transaction tax return.
Relevant Transactions
It is important to consider the effects of Sec. 168(i)(7) on transactions described in Secs. 332, 351, 361, 721, or 731 (Sec. 168(i)(7) transactions). These transactions are “step-in-the-shoes” transactions, meaning that post-transaction the acquirer or transferee will follow the target or transferor’s pretransaction methods, and in general no gain or loss is recognized. Separate rules (not addressed in this item) apply with respect to asset acquisitions or deemed asset acquisitions.
Depreciation Rules
Under Sec. 168, depreciation deductions are determined by using the applicable depreciation method, recovery period, and convention. In Sec. 168(i)(7) transactions, the parties to the transaction need to give special consideration to the midquarter convention, related depreciation calculations, and bonus depreciation. Other aspects of calculating depreciation after a Sec. 168(i)(7) transaction are not discussed in this item.
Generally, for most tangible personal property, the applicable convention is the half-year convention. By applying the half-year convention, a taxpayer treats all property placed in service during any tax year as placed in service on the midpoint of that tax year. In certain circumstances, however, the midquarter convention is required. When the midquarter convention is required, the taxpayer treats all property placed in service during any quarter of a tax year as placed in service on the midpoint of that quarter. This convention is required under Sec. 168 if 40% or more of the aggregate bases of certain property are placed in service during the last three months of a taxpayer’s tax year (Regs. Sec. 1.168(d)-1).
Test for Sec. 168(i)(7) Transactions
For purposes of applying the midquarter convention, a special rule applies for taxpayers that have entered into a Sec. 168(i)(7) transaction. If property transferred in a Sec. 168(i)(7) transaction also was placed in service by the transferor in the same tax year as the transaction, for purposes of computing the 40% test, the transferee must treat the property as placed in service on the date of the transaction. Therefore, if a taxpayer enters into a Sec. 168(i)(7) transaction in the last quarter of its tax year, the likelihood of its being required to use the midquarter convention greatly increases (Regs. Sec. 1.168(d)-1(b)(7)(i)).
When a taxpayer is required to use the midquarter convention as a result of a Sec. 168(i)(7) transaction, the recovery period begins (i.e., depreciation starts) on the date the transferor placed the property in service. Therefore, even though the property is treated as placed in service on the date of the transaction for purposes of determining the applicable convention, the original placed-in-service date is used for purposes of determining when the recovery period begins. Further, depreciation on assets placed in service by the transferor during the same tax year of the transaction must be allocated between the transferor and the transferee. The depreciation deduction is allocated between the transferor and the transferee based on the number of months in the transferor’s tax year that each party held the property in service (Regs. Sec. 1.168(d)-1(b)(7)(ii)).
Example 1: During year 1, A , a calendar-year taxpayer, purchased computers for $15,000 and placed them in service in February. On Oct. 1, A transferred the computer equipment to B , a calendar-year partnership, in a transaction described in Sec. 721, which is a Sec. 168(i)(7) transaction. During year 1, B purchased office desks for $15,000 and placed them in service in June. These are the only items of depreciable property placed in service by A and B during year 1.
In applying the 40% test, the taxpayer treats the computers as placed in service by B on Oct. 1. Using this placed-in-service date, the 40% test is met for B because the computer equipment is placed in service during the last three months of B ’s tax year and its basis exceeds 40% of the aggregate basis of property placed in service by B during the tax year ($15,000 ÷ $30,000 = 50%).
In applying the midquarter convention to determine when the computer equipment is deemed to be placed in service, the date on which A placed the property in service is used. Accordingly, because A placed the computer equipment in service during the first quarter of its tax year, the computer equipment is deemed placed in service on Feb. 15, the midpoint of the first quarter of A’s tax year.
Year 1 deduction: The depreciation deduction allowable for year 1, $5,250 ($15,000 × 40% × [10.5 ÷ 12]), is allocated between A and B based on the number of months in A ’s tax year that A and B held the property in service. Thus, because the property was in service for 11 months during A ’s year 1 tax year and A held it for 8 of those 11 months, A is allocated $3,818 ([8 ÷ 11] × $5,250). B is allocated $1,432, the remaining three-elevenths of the $5,250 depreciation deduction for A ’s year 1 tax year.
Year 2 deduction: For year 2, B ’s depreciation deduction for the computer equipment is $3,900, the sum of the remaining 1.5 months of depreciation deduction for the first recovery year and 10.5 months of depreciation deduction for the second recovery year ([$15,000 × 40% × (1.5 ÷ 12)] + [$9,000 × 40% × (10.5 ÷ 12)]).
Impact of Bonus Depreciation
Sec. 168(i)(7) transactions also have implications for bonus depreciation. Similar to the rules described above, if qualified property is transferred in a Sec. 168(i)(7) transaction in the same tax year that the property is placed in service by the transferor, the transferred property is treated as originally placed in service on the date the transferor placed the property in service. Furthermore, the bonus depreciation deduction for qualified property for the transferor’s tax year in which the property is placed in service is allocated between the transferor and the transferee on a monthly basis (Regs. Sec. 1.168(k)-1(f)(1)(iii)).
Example 2: Assume the same facts as Example 1, except that the property was placed in service in a 50% bonus depreciation year. The 50% bonus depreciation deduction allowable for the computers for year 1 of $7,500 ($15,000 × 50%) is allocated between the parties based on the number of months that each held the computers in service.
Thus, because the computers were held in service by A for 8 of 11 months, which includes the month in which A placed the computers in service but does not include the month in which the desks were transferred, A is allocated $5,455 ([8 ÷ 11] × $7,500). B is allocated $2,045, the remaining three-elevenths of the $7,500 bonus depreciation deduction allowable for the computers.
EditorNotes
Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PwC.
