Understanding the Jobs and Growth Tax Relief Reconciliation Act of 2003

Before amendment by the 2003 Tax Act, Section 179 of the Code permitted taxpayers (other than estates, trusts, and certain noncorporate lessors) that purchased qualifying tangible depreciable property, such as equipment, to elect to deduct the cost of the property in the year it is placed in service. The equipment may be new or used. The deduction may be taken in lieu of taking depreciation deductions totaling the same amount over the equipment's recovery period. Before amendment, Section 179 permitted a deduction of $25,000 of the cost of qualifying equipment placed in service in 2003. The amount of this deduction was reduced, dollar for dollar, if the taxpayer purchased more than $200,000 of property during the year.

The 2003 Tax Act increases the amount of the allowable Section 179 deduction to $100,000, a four-fold increase, and increases the phase-out amount to $400,000. For example, a qualifying equipment lessor purchasing $100,000 of equipment in 2003 (at any time after January 1, 2003) may deduct the full cost of the purchase against the lessor's taxable income. On the other hand, if the lessor purchases $450,000 of equipment this year, then the allowable Section 179 deduction would be reduced to $50,000.

The amount of the Section 179 deduction may not exceed the lessor's taxable income derived from its business for the taxable year. Disallowed deductions may be carried forward and deducted against future years' taxable income.

The Act also expands the category of property that may be expensed under Section 179 to include off-the-shelf computer software.

The expansion of the allowable deduction under Section 179 is effective for 2003, 2004, and 2005, after which the limits return to their pre-Act amounts ($25,000 deduction, phased out for equipment acquisitions of greater than $200,000).

Both the $100,000 allowable de-duction, and phase-out threshold of $400,000, will be adjusted for inflation after 2003.

Section 179 is not available for certain non-corporate lessors, such as partnerships or limited-liability companies, unless:

• The equipment subject to the lease has been manufactured or produced by the lessor, or
• The term of the lease (taking into account options to renew) is less than 50% of the class life of the property and, for the period consisting of the first 12 months after the date on which the equipment is transferred to the lessee, the sum of the deductions with respect to such property that are allowable to the lessor (other than rents and reimbursed amounts) exceeds 15% of the rental income produced by the property.

The purpose of this limitation is to make the Section 179 deduction available to partnerships and other pass-through entities that operate as businesses rather than as purely investment vehicles.

Increase in Extension of Bonus Depreciation

The Bush Administration's first inducement for capital formation through bonus depreciation was the Jobs Creation and Worker Assistance Act of 2002 (the '2002 Tax Act'), which created a 30% first-year depreciation allowance for qualifying property under the modified accelerated cost recovery system, commonly referred to as 'MACRS'. The 30% bonus depreciation is in addition to the depreciation allowable under MACRS. Under the 2002 Tax Act, qualifying property acquired before September 11, 2004, and placed in service before January 1, 2005 (January 1, 2006, for certain self-produced property or 'transporta-tion property') is entitled to a 30% additional first-year depreciation allowance.

Unlike the Section 179 deduction, which is available for the purchase of new and used property, bonus depreciation is available only with re-spect to new property with a recovery period of 20 years or less. However, property purchased in a sale/leaseback transaction qualifies as new property, if the taxpayer claiming bonus depreciation purchased the property within three months after the original purchaser/user placed the property in service.

The 2003 Tax Act increases the additional first-year depreciation allowance from 30% to 50%. To qualify for the higher percentage, the property must be acquired after May 5, 2003 and placed in service before January 1, 2005 (January 1, 2006, for self-produced property and certain 'transportation property'). The 2002 Tax Act's requirement that the property be acquired before September 11, 2004 has been eliminated.

Unlike the Section 179 deduction, the bonus depreciation rules do not limit the amount of depreciation by the taxable income of the taxpayer. This means that, for taxpayers who are eligible to utilize net operating losses (and assuming no other loss limitation rule applies), if the amount of bonus depreciation available exceeds the lessor's taxable income, then the resulting loss may be carried back and/or forward to reduce other years' taxable income under the net operating loss ('NOL') rules of Code Section 172.

Bonus depreciation is claimed on the cost of the property after reduction by the Section 179 deduction. Regular deductions under MACRS are claimed on the cost of the equipment, after reduction by the Section 179 allowance and bonus depreciation.

The IRS has published tables specifying the percentages applicable to various property in determining its depreciation allowance under MACRS. The table to the right assumes application of the half-year convention, modified for the 2003 Tax Act's provisions on first-year bonus depreciation.

The taking of bonus depreciation is optional with the taxpayer; indeed, a taxpayer may elect bonus depreciation for qualifying property of 50%, 30%, or not at all.

While the Code Section 179 allowance precludes estates, trusts, and certain noncorporate lessors from utilizing the provision, the 2002 and 2003 Tax Acts have no such limitation on the taking of the first-year bonus depreciation.

Bonus depreciation is allowed in full for alternative minimum tax purposes (carrybacks and carryforwards of net operating losses generally may offset alternative minimum taxable income of up to 90% of such income).

While Congress, through the 2002 and 2003 Tax Acts, has acted to provide incentives for the purchase of capital equipment, most states (including California, Illinois, New York, and Texas) have not followed suit and have not conformed their tax laws to permit bonus depreciation as allowed by the 2002 Tax Act (and are unlikely, in light of the current dearth of tax revenues, to follow the 2003 Tax Act's expansion of bonus depreciation).

Primary Beneficiary of the 2003 Tax Act's Expensing and Depreciation Provisions: Corporate Lessors

With the reduction in interest rates and, until recently, the decline in the stock markets, equipment leasing pass-through entities have experienced a revival in investor interest. This interest is likely to continue, as the memory of the debacle in the partnership syndication market of the 1980s and early 1990s fades. But this revived interest should be for economic and not tax motivated reasons. Large partnership and LLC equipment lessors are likely to exceed the Code Section 179 threshold, thus making the new Section 179 deduction amount unavailable. The availability of MACRS depreciation on equipment that qualifies as three- or five-year equipment is sufficient, during the early years of a pass-through equipment lessor's economic life, to shelter in whole or in substantial part the lessor's equipment leasing income. Because of the operation of the passive activity loss rules of Code Section 469 and the at-risk rules of Code Section 465, individual limited partners of limited partnerships and individual members of LLCs cannot use their allocable share of the taxable losses of pass-through entities to offset their 'active' ordinary income or their portfolio income, such as interest and dividends (the passive activity rules), or use their allocable share of taxable losses against any other income to the extent such losses exceed the amount they have 'at risk' in the pass-through entity (the at-risk rules). The 2003 Tax Act's provisions substantially increasing the first-year deductions for equipment purchases should not, therefore, prove to be a boon to pass-through entity equipment lessors.

The equipment lessors that should benefit from the 2003 Tax Act's capital equipment provisions are corporate lessors. While large corporate lessors will not be able to utilize the expanded Code Section 179 deduction, these lessors (other than certain closely-held C corporations) are not subject to the passive activity loss rules or the at-risk rules and, therefore, generally may be able to utilize losses generated by additional equipment depreciation to offset current and, under the NOL rules, prior or future years' taxable income. So while the 2003 Tax Act should stimulate the equipment leasing business, in all of the forms in which that business is conducted, it provides special inducements for corporate lessors

James F. Fotenos is a partner with Greene Radovsky Maloney & Share LLP, San Francisco, where he specializes in corporate finance and pass-through entities. The author would like to acknowledge the assistance of his colleagues Joseph S. Radovsky and Ian O'Donnell in the preparation of this article.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the '2003 Tax Act' or, simply, the 'Act'), signed by President Bush into law on May 28, 2003, provides strong inducements for the purchase of capital equipment. Together with record-low interest rates, the Act's 'tax subsidies' for the purchase of equipment should reduce the costs of equipment to equipment lessors and make them more competitive with asset-based lenders.

The 2003 Tax Act's inducements for the purchase of capital equipment are the increase in the maximum dollar amount of the cost of equipment that may be expensed under Internal Revenue Code ('Code') Section 179 from $25,000 to $100,000 for qualifying small businesses, and an increase from 30% to 50% together with an extension through 2004 (December 31, 2005 in certain cases) of the additional first-year depreciation that may be taken for qualifying equipment. In combination, these two measures can dramatically accelerate the deductions available for the year equipment is purchased and placed in service.

Increased Expensing Under Code Section 179

Before amendment by the 2003 Tax Act, Section 179 of the Code permitted taxpayers (other than estates, trusts, and certain noncorporate lessors) that purchased qualifying tangible depreciable property, such as equipment, to elect to deduct the cost of the property in the year it is placed in service. The equipment may be new or used. The deduction may be taken in lieu of taking depreciation deductions totaling the same amount over the equipment's recovery period. Before amendment, Section 179 permitted a deduction of $25,000 of the cost of qualifying equipment placed in service in 2003. The amount of this deduction was reduced, dollar for dollar, if the taxpayer purchased more than $200,000 of property during the year.

The 2003 Tax Act increases the amount of the allowable Section 179 deduction to $100,000, a four-fold increase, and increases the phase-out amount to $400,000. For example, a qualifying equipment lessor purchasing $100,000 of equipment in 2003 (at any time after January 1, 2003) may deduct the full cost of the purchase against the lessor's taxable income. On the other hand, if the lessor purchases $450,000 of equipment this year, then the allowable Section 179 deduction would be reduced to $50,000.

The amount of the Section 179 deduction may not exceed the lessor's taxable income derived from its business for the taxable year. Disallowed deductions may be carried forward and deducted against future years' taxable income.

The Act also expands the category of property that may be expensed under Section 179 to include off-the-shelf computer software.

The expansion of the allowable deduction under Section 179 is effective for 2003, 2004, and 2005, after which the limits return to their pre-Act amounts ($25,000 deduction, phased out for equipment acquisitions of greater than $200,000).

Both the $100,000 allowable de-duction, and phase-out threshold of $400,000, will be adjusted for inflation after 2003.

Section 179 is not available for certain non-corporate lessors, such as partnerships or limited-liability companies, unless:

• The equipment subject to the lease has been manufactured or produced by the lessor, or
• The term of the lease (taking into account options to renew) is less than 50% of the class life of the property and, for the period consisting of the first 12 months after the date on which the equipment is transferred to the lessee, the sum of the deductions with respect to such property that are allowable to the lessor (other than rents and reimbursed amounts) exceeds 15% of the rental income produced by the property.

The purpose of this limitation is to make the Section 179 deduction available to partnerships and other pass-through entities that operate as businesses rather than as purely investment vehicles.

Increase in Extension of Bonus Depreciation

The Bush Administration's first inducement for capital formation through bonus depreciation was the Jobs Creation and Worker Assistance Act of 2002 (the '2002 Tax Act'), which created a 30% first-year depreciation allowance for qualifying property under the modified accelerated cost recovery system, commonly referred to as 'MACRS'. The 30% bonus depreciation is in addition to the depreciation allowable under MACRS. Under the 2002 Tax Act, qualifying property acquired before September 11, 2004, and placed in service before January 1, 2005 (January 1, 2006, for certain self-produced property or 'transporta-tion property') is entitled to a 30% additional first-year depreciation allowance.

Unlike the Section 179 deduction, which is available for the purchase of new and used property, bonus depreciation is available only with re-spect to new property with a recovery period of 20 years or less. However, property purchased in a sale/leaseback transaction qualifies as new property, if the taxpayer claiming bonus depreciation purchased the property within three months after the original purchaser/user placed the property in service.

The 2003 Tax Act increases the additional first-year depreciation allowance from 30% to 50%. To qualify for the higher percentage, the property must be acquired after May 5, 2003 and placed in service before January 1, 2005 (January 1, 2006, for self-produced property and certain 'transportation property'). The 2002 Tax Act's requirement that the property be acquired before September 11, 2004 has been eliminated.

Unlike the Section 179 deduction, the bonus depreciation rules do not limit the amount of depreciation by the taxable income of the taxpayer. This means that, for taxpayers who are eligible to utilize net operating losses (and assuming no other loss limitation rule applies), if the amount of bonus depreciation available exceeds the lessor's taxable income, then the resulting loss may be carried back and/or forward to reduce other years' taxable income under the net operating loss ('NOL') rules of Code Section 172.

Bonus depreciation is claimed on the cost of the property after reduction by the Section 179 deduction. Regular deductions under MACRS are claimed on the cost of the equipment, after reduction by the Section 179 allowance and bonus depreciation.

The IRS has published tables specifying the percentages applicable to various property in determining its depreciation allowance under MACRS. The table to the right assumes application of the half-year convention, modified for the 2003 Tax Act's provisions on first-year bonus depreciation.

The taking of bonus depreciation is optional with the taxpayer; indeed, a taxpayer may elect bonus depreciation for qualifying property of 50%, 30%, or not at all.

While the Code Section 179 allowance precludes estates, trusts, and certain noncorporate lessors from utilizing the provision, the 2002 and 2003 Tax Acts have no such limitation on the taking of the first-year bonus depreciation.

Bonus depreciation is allowed in full for alternative minimum tax purposes (carrybacks and carryforwards of net operating losses generally may offset alternative minimum taxable income of up to 90% of such income).

While Congress, through the 2002 and 2003 Tax Acts, has acted to provide incentives for the purchase of capital equipment, most states (including California, Illinois, New York, and Texas) have not followed suit and have not conformed their tax laws to permit bonus depreciation as allowed by the 2002 Tax Act (and are unlikely, in light of the current dearth of tax revenues, to follow the 2003 Tax Act's expansion of bonus depreciation).

Primary Beneficiary of the 2003 Tax Act's Expensing and Depreciation Provisions: Corporate Lessors

With the reduction in interest rates and, until recently, the decline in the stock markets, equipment leasing pass-through entities have experienced a revival in investor interest. This interest is likely to continue, as the memory of the debacle in the partnership syndication market of the 1980s and early 1990s fades. But this revived interest should be for economic and not tax motivated reasons. Large partnership and LLC equipment lessors are likely to exceed the Code Section 179 threshold, thus making the new Section 179 deduction amount unavailable. The availability of MACRS depreciation on equipment that qualifies as three- or five-year equipment is sufficient, during the early years of a pass-through equipment lessor's economic life, to shelter in whole or in substantial part the lessor's equipment leasing income. Because of the operation of the passive activity loss rules of Code Section 469 and the at-risk rules of Code Section 465, individual limited partners of limited partnerships and individual members of LLCs cannot use their allocable share of the taxable losses of pass-through entities to offset their 'active' ordinary income or their portfolio income, such as interest and dividends (the passive activity rules), or use their allocable share of taxable losses against any other income to the extent such losses exceed the amount they have 'at risk' in the pass-through entity (the at-risk rules). The 2003 Tax Act's provisions substantially increasing the first-year deductions for equipment purchases should not, therefore, prove to be a boon to pass-through entity equipment lessors.

The equipment lessors that should benefit from the 2003 Tax Act's capital equipment provisions are corporate lessors. While large corporate lessors will not be able to utilize the expanded Code Section 179 deduction, these lessors (other than certain closely-held C corporations) are not subject to the passive activity loss rules or the at-risk rules and, therefore, generally may be able to utilize losses generated by additional equipment depreciation to offset current and, under the NOL rules, prior or future years' taxable income. So while the 2003 Tax Act should stimulate the equipment leasing business, in all of the forms in which that business is conducted, it provides special inducements for corporate lessors

James F. Fotenos is a partner with Greene Radovsky Maloney & Share LLP, San Francisco, where he specializes in corporate finance and pass-through entities. The author would like to acknowledge the assistance of his colleagues Joseph S. Radovsky and Ian O'Donnell in the preparation of this article.