Expense Method Depreciation and the Non-Corporate Lessor Rules

November 3, 2010 | Roger McEowen

Farmers and other business owners who buy equipment to use in their operation often prefer to deduct the cost of the purchase in the year of purchase to the greatest extent possible.  Under I.R.C. §179, for tangible depreciable personal property, all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer’s trade or business), regardless of the time of year the asset was placed in service.  This is an off-the-top depreciation allowance that may be taken at the taxpayer’s election each year.  The aggregate basis amount eligible for the deduction is $500,000 for 2010 and 2011.  That dollar limit is for all eligible property placed in service during the year, not for each item.  Property that is eligible for expense method depreciation is tangible, depreciable personal property.  However, certain items of tangible depreciable personal property are not eligible for expense method depreciation.  In general, any property that would not be eligible for investment tax credit (under the rules when the investment tax credit was available) is ineligible for expense method depreciation.  Likewise, property acquired by gift, inheritance, by estates or trusts and property acquired from a spouse, ancestors or lineal descendants is not eligible for expense method depreciation.  For property traded in, only the cash boot that is paid is eligible for expense method depreciation.  

For agricultural producers, expense method depreciation is potentially available for a wide array of assets.  For example, not only can expense method depreciation be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins and silos because all of those assets were eligible for investment tax credit when it was available and were classified as “other property” under I.R.C. §1245.  Thus, the expense method depreciation allowance is available for a significant array of assets at the taxpayer’s election.  Taxpayers can select those assets to which they would like to have expense method depreciation apply - and can even make or revoke the expense method election on an amended return for open tax years through 2011.  If it is selected for a particular asset, depreciation cannot be claimed on that portion of the asset’s basis, the basis of the qualifying property must be reduced by the amount of the expensing deduction.

For 2010 and 2011, expense method depreciation is phased out for taxpayers with cost of qualifying property exceeding $2,000,000 per year.  For each dollar of investment in excess of $2,000,000 per year, the allowable expense method amount is reduced by $1.  Thus, at $2,000,000, the full deduction is available, and at $2,500,000 (for 2010 and 2011), nothing is available.  In addition, expense method depreciation can be claimed only to the extent of taxable income from an active trade or business.  

As noted above, certain rules bar expense method depreciation for assets that are acquired in a particular manner.  There are also a couple of rules that come into play when property that is otherwise eligible for expense method depreciation is leased.  One of those rules requires that the property be purchased for the active conduct in the taxpayer’s trade or business.  Normally, that disqualifies from expense method eligibility assets that are cash leased – those assets are not used by the taxpayer in the active conduct of the taxpayer’s trade or business.  Whether a taxpayer is engaged in the active conduct of a trade or business is based on all the facts and circumstances.  But, for expense method depreciation purposes, it basically means that the taxpayer “meaningfully participates” in the management or operations of the business.   So, cash leases don’t work, but crop-share and/or livestock share leases work if there is either material or “meaningful” participation.  In addition, another rule applies to leases of property for which a non-corporate taxpayer wants to make an expense method depreciation election – the non-corporate lessor rule.  That special rule was at issue in a recent Tax Court case.

The taxpayers were a farm couple in southeast Iowa that owned and operated a 504-acre farm.  Sometime around 2000, the couple orally agreed to lease 124 acres of their farmland along with buildings, grain storage bins and equipment to Circle T Farms, Inc., a hog farrow-to-finish business that the couple owned.   Under the oral agreement, the taxpayers would annually receive $70,000 cash rent.  They leased the balance of their farmland to C&A, Inc., an unrelated party, again via an oral lease.  The husband also entered into an oral farming agreement with C&A that was put in writing in 2006 to state that the agreement “covered any future year[‘]s crops, so long as neither party requested a change on or before Sept[ember] 1 of the calendar year.”    In 2004, 2005 and 2006, they purchased property that qualified for expense method depreciation.  On their tax return for 2004, they expensed $52,000 for drainage tile and a fence that was installed on the land that they leased to C&A, and $10,000 for material they purchased to remodel their farm office, including furniture and fixtures.  For 2005, they expensed $63,488 for a grain bin.  For 2006, the expensed $8,467 for a pickup truck and $31,000 for a grain bin and grain dryer.  The bin and dryer (and, presumably, the pickup truck) were orally leased to Circle T Farms – for the $70,000 annual “cash rent.”  The IRS disallowed all of the expense method depreciation deductions for the farm-related property - citing the non-corporate lessor rule.

As for the office equipment, the court agreed with the IRS that the couple didn’t substantiate the deduction on their return and, as such, the court couldn’t determine whether the office material were “other property” under I.R.C. Sec. 1245.  Importantly, the court did not hold that the office materials were not I.R.C. §1245 property, but did hold that the taxpayers failed to present sufficient evidence to allow the court to determine whether the office materials were not “structural components” and would, therefore, be eligible for expense method depreciation.  So, an expense method deduction was denied for those items.  The court did not address the non-corporate lessor rule with respect to the office equipment.  

As for the grain bins, grain dryer, drainage tile, pickup truck and fence, the non-corporate lessor rule was applicable.  That rule can bar an I.R.C. §179 deduction for non-corporate taxpayers that acquire property for leasing purposes.  To get around the rule, a non-corporate lessor must be able to show that the lease (accounting for renewal options) must be less than 50 percent of the class life of the leased property.  Once that rule is satisfied, the claimed business expenses for the first 12 months after the transfer of the property to the lessee must exceed 15 percent of the rental income that the property produces.  The couple claimed that they met the first test because they renewed their leases involving the farm property every year.  So, they claimed, the lease term was a series of one-year leases and was, therefore, less than 50 percent of the class life of the farm-related property.  But, the IRS and the court disagreed.  None of the leases were in writing and the couple didn’t provide any evidence of the actual lease terms.  As a result, the court concluded that the leases were for an indefinite period of time and couldn’t be claimed to have a term of less than 50 percent of the class life of the property.  Since the first part of the test was not satisfied, the second part was immaterial.  The court also imposed an accuracy-related penalty. 

Is the court correct? Yes.  But, the court left some unfinished business.  They decided the case exclusively based on the non-corporate lessor rule.  That is probably because that’s the way the IRS framed the issue.  As mentioned above, cash leased assets don’t qualify to be expensed because they aren’t acquired for use in the taxpayer’s “trade or business.”  But, the court didn’t go there.  Could they have decided the case solely on that ground and come out the same way?  Probably not with respect to the grain bin, grain dryer and pickup leased to the taxpayer’s farrow-to-finish hog operation.  If the taxpayers were materially participating in the hog operation, a Mizell-type argument would lead to the conclusion that the leased assets to their hog operation would qualify for expense method depreciation.  However, the taxpayers would probably still be out of luck with respect to the drainage tile and fences on the land cash leased to the unrelated corporation.  The non-corporate lessor rule wouldn’t have been necessary to deny expense method treatment on those assets.  So, even though the court didn’t address the trade or business requirement, it’s probably not safe to assume that if the non-corporate lessor rules are satisfied, the trade or business rule doesn’t have to be a concern in leasing situations.

The bottom line – get these type of leases in writing and draft the leases carefully with the non-corporate lessor (and trade or business) rules in mind.  Thomann v. Comr., T.C. Memo. 2010-241.