S Corps should beware how elections are made
IRC section 179 (Election to Expense Certain Depreciable Business Assets) is an example of legislative grace given taxpayers by Congress. It allows taxpayers to elect to expense the cost of certain types of tangible personal property that would otherwise be capitalized and depreciated over a number of years. This can be very beneficial to taxpayers seeking to accelerate deductions. For example, a taxpayer may enjoy a particularly profitable year in 1996, but expect losses in future taxable years. In this case, the election to write off otherwise depreciable property in 1996 would benefit the taxpayer more than by spreading the deduction over a number of years. Even in the case where the taxpayer expects constant taxable income and stable tax rates, the election provides a benefit simply due to the time value of money (i.e., it is better to save tax dollars today rather than tomorrow). Another advantage of electing IRC section 179 benefits is that the expense does not give rise to an alternative minimum tax adjustment normally triggered by depreciation deductions under an accelerated method. Section 179 does not apply to estates and trusts.
A section 179 election is subject to three limitations. The first limitation (“dollar limitation”) limits the aggregate cost of property which may be expensed in a taxable year to $17,500 (The Small Business Job Protection Act, as passed by Congress August 2, 1996, and recently signed by President Clinton, increases the limitation in incremental amounts starting in 1997: By 2003 the dollar limitation will be $25,000). The second limitation (“reduction limitation”) reduces the dollar limitation by the amount by which the cost of qualifying property placed in service exceeds $200,000. For example, if a taxpayer purchases $210,000 of qualifying property, the dollar limitation is reduced by $10,000 ($210,000-$200,000) to $7,500 ($17,500-$10,000). Effectively, if a taxpayer purchases $217,500 or more of qualifying section 179 property, no election is available to that taxpayer. The third limitation (“taxable income limitation”) limits the section 179 deduction to the taxpayer’s aggregate taxable income for the taxable year from all of its actively conducted trades or businesses. Any amount limited by the taxable income limitation may be carried over to future taxable years indefinitely. No such carry forward is available for amounts limited by the dollar limitation.
For an S corporation (the rules are similar for partnerships), section 179 is elected at the corporate level and limited at the corporate and shareholder levels. Accordingly, an S corporation may pass through to its shareholders up to $17,500 (subject to the other limitations) of section 179 expense. After receiving their Schedules K-1 from the S corporation, the shareholders must determine their deductible amount of section 179 expense based on the dollar, reduction, and taxable income limitations. For purposes of computing the reduction limitation, the cost of section 179 property placed in service by entity is not attributed to the owner.
Any section 179 expense which is passed through from the S corporation must reduce the basis of the S corporation property with respect to which the election is made even if the shareholders are limited as to the amount they can deduct. In addition, the shareholder must reduce his basis in his stock by the amount of section 179 expense passed through to him pursuant to IRC section 1367 (even if the expense becomes nondeductible as a result of the dollar or other limitations).
Shareholders in S corporations (and partners in partnerships) face a potentially costly problem if they own stock in more than one S corporation (or if they hold interests in partnerships in addition to their S corporation). Since the deduction is limited at the corporate and shareholder levels, it is possible for an individual to have section 179 expense passed through from all his K-1s which in aggregate exceed the $17,500 limitation. Since the statute does not provide for a carry forward of amounts subject to the dollar limitation, the taxpayer has effectively wasted a deduction to the extent the total section 179 expense passed through exceeds $17,500. Also, the S Corporation which passed through the expense must reduce the basis in the assets for which the election is made and the shareholder must reduce his basis in his stock for the amount of the expense passed through. This result is obviously unfavorable since upon disposition of the property by the corporation or the stock by the shareholder, the adjusted basis will have been reduced by a deduction for which no benefit was received.
Example. Mrs. Brown owns 100% of the stock of the Pink Corporation and 50% of the stock of the White Corporation. Both corporations have December 31 year ends. During 1996, the Pink Corporation elects to expense $17,500 of section 179 property and the White Corporation elects to expense $10,000 of section 179 property. As a result, Mrs. Brown’s K-1 from the Pink Corporation shows $17,500 of section 179 expense and her K-1 from the White Corporation shows $5,000 ($10,000 x 50%) of section 179 expense for a total of $22,500. Mrs. Brown, however, is limited to a $17,500 deduction on her 1996 personal tax return although her basis in the stock of the two corporations is reduced in the aggregate by $22,500. In addition, the Pink and White Corporations must reduce their basis in the property for which the section 179 election was made.
This harsh result can easily be avoided if the shareholder has input into the preparation of the corporate tax returns or if one tax preparer prepares all of the corporate returns in which the taxpayer has an interest. Accordingly, it is important for the taxpayer or the tax preparer to recognize this potential problem and act accordingly. For example, if John Smith owns all the stock of two S Corporations and Joe CPA prepares both the corporate tax returns and the individual tax returns and John holds no other interests in pass-through entities, then Joe CPA can easily avoid the problem by making sure that no more than $17,500 in the aggregate is expensed by the two S Corporations under Section 179. If, however, John Smith holds other interests in pass-through entities, then he must attempt to avoid the problem by communicating with other entities (to the extent he can) or by simply not making the election (or at least not to the maximum amounts) for his two S Corporations.
In addition, if a tax preparer is preparing an S corporation return for a corporation which has shareholders whose tax positions he is not familiar with, he should seriously consider not electing the section 179 benefits since by doing so he could be doing the shareholders a disservice. Of course, the preparer, before making this decision, should make an attempt (if feasible) to ascertain whether or not the election would benefit all the shareholders.
In cases where a taxpayer or tax preparer discovers that too much Section 179 expense has been passed through to the taxpayer by an S corporation, the corporation can attempt to revoke the election. However, the election can only be revoked with permission of the IRS and then only in extraordinary circumstances.
Passive investors in S corporations (or other flow-through entities) can also lose out on Section 179 benefits due to the taxable income limitation. The expense deduction cannot exceed the taxpayer’s aggregate taxable income derived from his or her active conduct of a trade or business–the limitation applies at the entity level as well as to each owner. An S corporation shareholder who does not meaningfully participate in the company does not include the company’s pass-through income in computing the taxable income limitation; absent other “active” income (e.g., wages, pass-through entities in which the taxpayer meaningfully participates), no deduction is currently available. Note: Whether or not a taxpayer actively conducts a trade or business is determined based on facts and circumstances. *