While many states use a fixed-date conformity approach (i.e., a state adopts Internal Revenue Code changes at a certain date) to disallow bonus depreciation, North Carolina's scheme imposes a unique depreciation method without reference to the Code's methods of cost recovery. Instead, North Carolina law calls for adjustments to a taxpayer's income, which can cause challenges when planning for and reporting recognition and nonrecognition events. However, with proper planning, noncorporate taxpayers have the ability to determine how unused future bonus depreciation deductions are used when transferring assets in a nonrecognition or "basis carryover" event.
While tracking yearly addbacks and deductions of bonus depreciation for corporations, individuals, partnerships, and S corporations is reasonably straightforward, tracking addbacks and deductions for trusts, estates, and beneficiaries can be complicated. Careful recordkeeping and planning will allow taxpayers to maximize deductions while ensuring accurate reporting.
North Carolina General Statutes Section 105-153.6(a) (for individuals, fiduciaries, and passthrough entities) and Section 105-130.5B(a) (for corporations) state that "a taxpayer who takes a special accelerated depreciation deduction for that property under section 168(k) or 168(n) of the [Internal Revenue] Code must add to the taxpayer's federal taxable income or adjusted gross income, as appropriate, . . . 85% . . . of the amount taken for that year under those Code provisions." For tax years before 2012, the taxpayer must add the amount to the taxpayer's federal taxable income. For tax year 2012 and after, the taxpayer must add the amount to the taxpayer's adjusted gross income. In the five years subsequent to the addback, the statute allows the taxpayer a deduction for 20% of the amount previously added back.
Example 1: ABC Co. claims $100,000 of bonus depreciation on its 2015 federal return. For 2015 through 2020, the company has the following North Carolina adjustments to adjusted gross income:
- 2015: Addback of $85,000.
- 2016-2020: Deductions of $17,000 each year.
The net effect of the addback and deduction is a $15,000 deduction in 2015 with deductions of $17,000 each subsequent year until the asset is fully depreciated. Allowing for an immaterial difference in the initial year, North Carolina's convention for bonus depreciation is essentially straight-line depreciation over six years, regardless of the modified accelerated cost recovery system (MACRS) recovery period.
For corporate and noncorporate entities, there is no adjustment to future deductions when an asset that had an associated prior-year addback is transferred in a recognition event. The transferor continues to take deductions for amounts added back to income in prior years. Deductions do not transfer to the transferee, and there is no adjustment to the disposal gain or loss reported for federal tax purposes.
The same treatment results when members in a passthrough that reported a prior-year addback sell their membership interests. In these cases, both the selling members and the members remaining in the passthrough are entitled to take on their North Carolina tax returns the future deductions resulting from the prior-year addbacks. Future bonus depreciation deductions as reported at the passthrough level could exceed the sum of all bonus depreciation deductions as reported on the members' North Carolina Schedules K-1 (N.C. Dep't of Rev. Announcement, "Bonus Depreciation Deduction for Pass-through Entities" (March 1, 2006)).
In a nonrecognition or "basis carryover" event, the rules for corporations and individuals differ. For corporations involved in a nonrecognition event, such as a Sec. 351 contribution, North Carolina General Statutes Section 105-130.5B(e) states that "[i]n the event of an actual or deemed transfer . . . wherein the tax basis of the asset carries over . . . for federal income tax purposes . . . the transferor is not allowed any remaining future bonus depreciation deductions associated with the transferred asset." Instead, the transferee adds to the basis the transferor's remaining unused deductions and then depreciates it over the remaining life of the asset according to the asset's MACRS convention (N.C. Dep't of Rev. Announcement, "Bonus Asset Basis" (Feb. 21, 2014)).
The future North Carolina deductions taken by the transferee are based upon the appropriate federal depreciation convention. In no instance will the future deductions in the hands of the transferee be the same as the deductions would have been in the hands of the transferor. If the asset has no remaining life, as may be the case with three-year property, any remaining unrecovered amounts are fully deducted by the transferee in the year of transfer. In addition, Section 105-130.5B(g) requires that the transferee have a North Carolina adjustment for gain or loss if the asset is sold before it is fully depreciated or amortized.
Section 105-153.6(e), which applies to individuals, passthroughs, estates, and trusts, provides flexibility for a transferor. In the event of a nonrecognition or "basis carryover" transfer, such as a gift, distribution from an estate, or Sec. 721 contribution, the transferor has latitude either to keep the future deductions or to relinquish them to the transferee. If the transferor chooses to keep the deductions, the transfer is treated similarly to a sale: The transferor continues to take the annual deductions associated with the prior-year addback, while the transferee has no separate North Carolina basis in the asset. If the transferor chooses to allow the transferee to have the deductions, then the rules for corporate carryover basis transfers apply. The statute requires that the transferor "certif[y] in writing to the transferee" that "the transferor or owner in a transferor will not take any remaining future depreciation deduction associated with the transferred asset."
As a general rule, a taxpayer that included a bonus depreciation addback in a prior year retains the right to take the future deductions. However, in situations whereby the transferor will be unable to use the future deductions, consideration should be given to forgoing the future deductions and allowing the transferee the additional basis for depreciation. From the transferee's perspective, the value of any remaining deductions would depend upon the remaining life and depreciation convention of the asset. This transfer rule specifically provides an opportunity for estates or trusts prior to the final distribution of assets. Because the taxpayer will cease to exist, the tax benefits of future deductions can be passed on to the beneficiaries so long as a properly certified letter is executed. Failure to pass the deductions on to beneficiaries or survivors results in the loss of future deductions, which would have yielded a tax benefit at the current statutory rates. The North Carolina statutory rates for 2016 are 5.75% for individuals and trusts and 4% for corporations.
Once future bonus depreciation deductions are identified, they should be tracked from year to year to ensure the proper annual benefit is realized. However, tracking deductions for estates and trusts can be complicated. When complex trusts and estates distribute less than 100% of distributable net income, North Carolina General Statutes Section 105-160.2 requires the fiduciary to distribute any North Carolina adjustments using the same allocations used for distributing income. This requires fiduciaries and beneficiaries to allocate their addbacks between bonus depreciation addbacks, which become deductions in later years, and non-bonus depreciation addbacks (e.g., an addback related to the domestic production activities deduction), which do not become deductions in later years.
For fiduciaries, businesses, and individuals, determining the portion of any addbacks or deductions that is related to bonus depreciation can be especially challenging when the North Carolina K-1 does not clearly identify the components of the addbacks and deductions that are being reported. In these instances, tax preparers should contact the preparer of the passthrough entity's return for clarification.
Another complexity is that in years subsequent to addbacks, beneficiaries of complex trusts and estates may end up reporting two distinct layers of bonus depreciation deductions that were created by a single addback.
Example 2: ABC Trust is a complex trust that reported $1,000 of bonus depreciation on its 2015 federal return. On the 2015 North Carolina fiduciary return, the trust reports an addback of $850, $400 of which is apportioned to the fiduciary and $450 of which is apportioned to the beneficiary. In 2016, the trust distributes less than 100% of distributable net income. The beneficiary will have two layers of bonus depreciation deductions to report in 2016. The first layer is $90 ($450 × 20%) and is a result of the 2015 addback that the beneficiary reported on its tax return. The second layer will be apportioned to the beneficiary from the trust. This layer will be a percentage apportionment of the 20% deduction that the trust is entitled to, based on the trust's share of the 2015 add-back. The percentage apportioned to the beneficiary will depend upon how much income was distributed to the beneficiary in 2016. No carryforward schedule can be created for the deduction apportioned to the beneficiary because it depends on a future unknown variable—namely, the distribution of future income.
While the Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113, extended federal bonus depreciation through 2019 (decreasing from 50% to 40% in 2018 and then to 30% in 2019), North Carolina Session Law 2016-6, signed by Gov. Pat McCrory on June 1, 2016, extended the current state treatment of bonus depreciation through 2017. Whether the North Carolina General Assembly will extend the regime of bonus depreciation addbacks and subsequent deductions to tax years 2018 and 2019 remains to be seen.
Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.