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IRS OKs late ADS depreciation election to utilize NOL generated by alimony payment

May 15, 2018

Although taxpayers generally benefit by using the fastest depreciation method available, there are times where a slower depreciation method is preferable. For example, one taxpayer was advised to elect to use the slower alternative depreciation system (ADS) to get the best tax mileage out of a large alimony deduction. This deduction would generate a net operating loss (NOL), but only if the ADS election was made by affiliated entities he owns. Although the entities did not timely make the necessary election for the tax year at issue, IRS, in a private ruling, granted the taxpayer’s entities an extension of time to remedy the error.

Background on alimony.In general, for divorce or separation instruments executed before Jan. 1, 2019, payments of alimony or separate maintenance made under a divorce or separation instrument are taxable to the payee spouse in the year received (Code Sec. 71(a)Reg § 1.71-1(b)(5)), and are deductible by the payor spouse in the year paid, as a deduction from gross income. (Code Sec. 62(a)(10)Code Sec. 215(a))

Note that for any divorce or separation instrument that’s:

  1. executed after Dec. 31, 2018, or
  2. executed on or before Dec. 31, 2018, and modified after Dec. 31, 2018, if the modification expressly provides for the following treatment,

the deduction for the payment of alimony won’t apply (Code Sec. 215Code Sec. 62(a)(10)), and the inclusion in gross income for the receipt of alimony payments won’t apply. (Code Sec. 71(a))

Background on NOL carryback.In general, for tax years beginning before 2018, an NOL may be carried back two years and forward 20 years. (Code Sec. 172(b)(1)(A)) For NOLs arising in tax years ending after 2017, the general 2-year NOL carryback is repealed.

Background on NOL nonbusiness deduction modification.In computing a noncorporate taxpayer’s NOL ordinary nonbusiness deductions (such as alimony) are allowed only to the extent of nonbusiness income, i.e., gross income not derived from the taxpayer’s trade or business (that is, ordinary nonbusiness income plus any excess of nonbusiness capital gains over nonbusiness capital losses). (Code Sec. 172(d)(4)Reg § 1.172-3(a)(3)(i))

Checkmark Observation: An excess of nonbusiness income over nonbusiness deductions will reduce an NOL.

Expenses from a taxpayer’s profit-oriented activities are ordinarily deductible under either Code Sec. 162 (business expenses) or Code Sec. 212 (expenses of property held for production of income), but Code Sec. 172(d)(4)differentiates between business expenses and income-producing expenses. The characterization of partnership income (loss) as business or nonbusiness income (deduction) is made at the partnership level. Thus, for example, where a partner was in the real estate business and the partnership wasn’t, the partner’s portion of the partnership’s loss was a nonbusiness deduction. (Campbell, William v. U.S., (1987, CA5) 59 AFTR 2d 87-917, affg on this issue (1984, DC TX) 54 AFTR 2d 84-5090)

Background on depreciation deductions.In general, the depreciation allowance for tangible property used in a trade or business is computed using the general depreciation system (GDS, also called MACRS) in Code Sec. 168(a). However, the taxpayer may elect under Code Sec. 168(g)(7) to depreciate property otherwise eligible for GDS using the alternative depreciation system (ADS). In general, ADS, which uses straight-line depreciation, produces a smaller deduction in an assets early year than does GDS.

Code Sec. 168(g)(7) permits a taxpayer to elect for any class of property for any tax year to use the ADS for determining depreciation for all property in that class placed in service during that tax year. However, in the case of nonresidential real property, the election is made separately with respect to each property. Once made, an election to use ADS is irrevocable.

Under Reg. § 301.9100-7T(a)(1)), the election under Code Sec. 168(g)(7) must be made for the tax year in which the property is placed in service. Reg. § 301.9100-7T(a)(2)(i) further provides that this election must be made by the due date (including extensions) of the tax return for the tax year for which the election is to be effective. And Reg. § 301.9100-7T(a)(3)(i) provides that election under Code Sec. 168(g)(7) is made by attaching a statement to the tax return for the tax year for which the election is to be effective.

Background on extension to make election. IRS has discretion to grant a reasonable extension of time to make a regulatory election. (Reg. § 301.9100-1) Requests for extensions of time for regulatory elections that don’t meet the requirements of Reg. § 301.9100-2 (automatic extensions) will be granted when the taxpayer provides evidence to establish to IRS’s satisfaction that the taxpayer acted reasonably and in good faith and granting relief will not prejudice the interests of the government. (Reg. § 301.9100-3)

Facts. Taxpayer is a calendar-year individual who wholly owns a number of affiliated entities that either file either a Form 1065, U.S. Income Tax Return for a Partnership, or Form 1120S, U.S. Income Tax Return for an S Corporation, as applicable, on a calendar year basis and use an accrual method of accounting. The affiliated entities are in an unidentified trade or business.

The affiliated entities used the GDS to depreciate all property placed in service in Tax Year A and reported income to their shareholder/partner, Taxpayer, on Schedule K-1 (1120S/1065), Shareholder’s/Partner’s Share of Income, Deductions, Credits, etc. Taxpayer claimed the depreciation deductions on his Tax Year A Form 1040.

Taxpayer paid an undisclosed amount of alimony during Tax Year A and deducted the alimony payments on his Form 1040. He reported a net loss on the return but was precluded from carrying back or carrying over the net loss as an NOL to the extent the net loss was attributable to the alimony deduction. Taxpayer could have preserved the benefit of the deduction for alimony on his return if the affiliated entities had minimized the depreciation deductions flowing through to Taxpayer and eliminated his net loss. Specifically, the affiliated entities could have elected to depreciate all property placed in service in Tax Year A using ADS on all property placed in service in that year, instead of GDS.

Taxpayer was not advised by the affiliated entities’ in-house tax preparers or his tax return preparer, and he did not know independently, that he could preserve the benefit of the deduction for alimony on the Tax Year A return by having the affiliated entities make the ADS election for all property placed in service by the affiliated entities during that tax year.

After Taxpayer discovered the problem, he was advised by another tax professional regarding potential remedies for the failure to make the ADS election. This professional advised Taxpayer to file a request for relief under Reg. § 301.9100-3.

Relief granted.IRS OK’d an extension of time under Reg. § 301.9100-1 and Reg. § 301.9100-3 to make the Code Sec. 168(g)(7) election to use the ADS method of depreciation for property placed in service in the tax year in question. IRS concluded that the conditions enumerated in these regs were satisfied.

As a result, IRS granted the affiliated entities 60 calendar days from the date of the ruling to make the Code Sec. 168(g)(7) election for all property placed in service by the affiliated entities during the relevant tax year. This election must be made by the affiliated entities filing either an amended Form 1065, U.S. Income Tax Return for a Partnership or Form 1120S, U.S. Income Tax Return for an S Corporation, as applicable, for the Tax Year A, with a statement indicating that the affiliated entities are electing to make the Code Sec. 168(g)(7) election to use the ADS method of depreciation for all property placed in service during that tax year.

References: For when to use or elect ADS, see FTC 2d/FIN ¶ L-9402 ; United States Tax Reporter ¶ 1684.03.

PLR 201818011

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