Article republished with permission of our Joint Business Relationship partner, PwC.
Many companies with active like-kind exchange (LKE) programs are trying to understand how the new 100% bonus rules will impact their LKE benefits, and may even be considering suspending their programs for 2011 due to the enhanced bonus deduction. Since a program suspension could potentially create new tax and business process issues, it is important to look at more than just the Federal tax benefit when considering the suspension of a LKE program. Other factors to consider include:
- Impact of state decoupling from Federal "bonus" rules
- State NOL considerations
- Federal Alternative Minimum Tax ("AMT") considerations for individual owners of S-Corporations and partnerships
- Ability to utilize used property as replacement property to maximize LKE and bonus benefit
- Bonus depreciation sunset planning opportunities
- Utilizing LKE service providers for fixed asset tax compliance and reporting
- Time and resources needed to "de-institutionalize" a company's LKE processes
A more detailed overview of each consideration is listed below.
The Federal tax impact of 100% bonus - with and without a LKE program
On December 17, 2010, President Obama signed HR 4853, the "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010" (the "Act"). The Act increases the bonus depreciation deduction from 50% to 100% for qualifying property acquired and placed in service after September 8, 2010 and before January 1, 2012. In addition, it also extends a 50% "bonus" depreciation deduction for property acquired and placed in service in 2012. In order to qualify for "bonus" depreciation, the property must be new and it must have a tax recovery period of 20 years or less.
The impact of 100% bonus depreciation on companies with and without LKE programs is illustrated in the following example where an asset is sold for a gain and the replacement property qualifies for 100% bonus depreciation. In this example, a five year The current method of accelerated asset depreciation in the United States is known as the Modified Accelerated Cost Recovery System (MACRS). MACRS divides all assets into classes which dictate the number of years over which an asset's cost will be recovered. MACRS asset acquired in 2009 is sold for $15,000 with a tax basis of $4,800, resulting in realized gain of $10,200. A like kind asset is acquired for $25,000. Since gain deferred by LKE reduces the depreciable basis of replacement property acquired as part of an exchange, it also reduces the amount of the 100% bonus depreciation allowed in regard to that property.
While it's clear from the example above that there is no Federal tax benefit derived from an LKE program during the period of 100% bonus depreciation (September 9, 2010 to December 31, 2011), only considering the Federal impact fails to address a number of other important factors. Failure to do so could result in significant additional Federal and state taxes in both the current and future tax years.
Impact of states decoupling from Federal "bonus" rules
In the current economic environment, many states are experiencing significant fiscal challenges that prevent them from adopting generous Federal bonus depreciation rules (100% bonus or otherwise). Approximately 80% of the states have not adopted previously enacted Federal bonus depreciation rules. These states are likely to continue this trend and others may join. In states that decouple from the Federal bonus depreciation rules, the suspension of a company's LKE program could result in an additional 2011 state tax liability equal to the company's forgone LKE deferral multiplied by the state's highest marginal tax rate. Depending on the state, that tax bill could amount to as much as 11% of the foregone LKE deferral.
To illustrate, let's assume the same asset is sold as in the previous example. In this instance, let's also assume that the relevant state has decoupled from Federal bonus depreciation. For state purposes, a gain of $5,400 would be realized (sales proceeds of $15,000 less state tax basis of $9,600).
This example illustrates the potential state tax savings from the sale of one asset. While individual company situations will vary, we expect that state tax savings will be significant for many companies if they are filing in states that have decoupled from bonus depreciation. Please contact us if you would like more information on the states that have decoupled. As more fully explained below, a reduction in state taxes can also reduce the alternative minimum tax ("AMT") for owners of closely held companies.
State Net Operating Loss (NOL) considerations
Many states have Net Operating Loss (NOL) carryback and carryforward provisions that are more restrictive than the "2 years back and 20 years forward" provisions under Federal law. In addition, for the same budgetary reasons mentioned above, some states have suspended or eliminated NOL carrybacks and carryforwards. Where NOLs are restricted, taxpayers need to closely examine their own facts and circumstances to determine the impact of bonus depreciation on their taxable income.
AMT considerations for individual owners of S-Corporations and partnerships
As explained above, maintaining LKE can result in a reduction of state taxes since most states did not allow bonus depreciation. Because individual taxpayers are not allowed to deduct state income taxes in calculating their Federal Alternative Minimum Tax (AMT), LKE will generally reduce the state tax preference item which may either decrease or eliminate AMT. However, if a taxpayer suspends its LKE program, its state tax liability will increase, increasing the state preference item, and possibly result in additional AMT.
In addition, AMT resulting from lost state tax deductions is not allowed in the calculation of AMT credits that are typically allowed to offset certain regular tax liabilities in future tax years. Accordingly, for those taxpayers who incur additional state income tax as a result of suspending their LKE program and who are also subject to AMT, suspending their LKE program may result in additional AMT that can not be recouped in future years.
AMT can be influenced by a number of factors and is taxpayer specific. We are available to help you better understand the AMT benefits that may be achieved with your LKE activity.
Ability to utilize used property as replacement property to maximize LKE and bonus benefits
Used property does not qualify for bonus depreciation. However, LKE allows used property to be used as replacement property to complete an exchange. In addition, LKE safe harbor rules provide taxpayers flexibility in matching relinquished and replacement properties to complete exchanges. This flexibility presents a planning opportunity for companies to complete exchanges with "used" replacement property acquisitions that do not qualify for bonus depreciation rather than new property acquisitions that would otherwise qualify for 100% bonus depreciation. For companies who acquire used property, this can be an important consideration in evaluating the benefit of LKE activity in 2011.
Bonus depreciation sunset planning opportunities
LKE rules give taxpayers who "identify" potential replacement property up to 180 days to acquire identified replacement assets. Consequently, assets sold after July 1, 2011 can be exchanged for assets acquired after December 31, 2011 which are not eligible for 100% bonus depreciation. In this way, taxpayers can take advantage of the 100% bonus depreciation deduction for assets acquired in 2011 while still achieving a benefit for gains deferred from assets sold in the second half of 2011.
Careful planning in this area may significantly increase the amount of Federal and state NOLs available to offset income which can be used to reduce taxes in past and future years through carryback and carryforward provisions.
Utilizing your LKE Service provider for fixed asset tax compliance and reporting
Most companies use their LKE provider to periodically calculate and report tax depreciation on LKE, and in some cases, non-LKE assets. For these companies, suspending their LKE programs might not result in a significant cost savings since they would need to develop and implement alternative processes to calculate and report tax depreciation, or continue to use their LKE provider for this service.
Time and resources needed to "de-institutionalize" a company's LKE processes
The requirements of an LKE program necessitate changes to operational business processes in order to institutionalize LKE for asset dispositions and acquisitions. Designing and implementing these operational changes requires significant time and resources from company professionals in a variety of areas including treasury, accounting, tax, procurement, remarketing, legal, and customer and vendor communications.
Suspending an LKE program may require amendments to the company's exchange agreements, modifications of the company's cash processes and account structures, or require changes to communications that the company makes to its customers and vendors. All of these changes require time, effort and expense to modify. These costs and changes to institutionalized business processes must be considered relative to the benefits of suspending an LKE program for a relatively short period of time.
As discussed above, only considering the Federal tax benefits of 100% bonus depreciation does not provide a complete analysis of the issues that should be considered when deciding to maintain or suspend an LKE program during 2011. While the long term advantages of an LKE program are clear, the short term benefits during periods of 100% bonus depreciation require a careful evaluation of all relevant factors to determine the best overall tax position and course of action for the company.
LKE programs represent an effective tool that companies can use for Federal and state tax planning, and streamlining their fixed asset processes. In addition, if 100% bonus depreciation is utilized, an LKE strategy becomes even more important when bonus expires, as a company's tax basis in its fixed assets will be reduced to zero which ultimately will lead to large tax gains unless deferred through an LKE program.