With the Section 179 deduction raised to a maximum of $500,000 this year and next, it’s going to be a big part of many tax lives. But an Eastern Iowa farm couple yesterday was tripped up by an obscure limit on the deduction.
The Section 179 deduction allows taxpayers to fully deduct property in the year it is placed in service; otherwise it would be capitalized and depreciated over several tax years. Only a few years ago, the Section 179 deduction was limited to $15,000 per year, per taxpayer. “Stimulus” bills have raised it drastically in recent years.
The farmers put property in service in 2004, 2005 and 2006. They purchased the property in their own names. But the farm operations were actually run in a corporation called “Circle T.” The farmers leased the property to their farm corporation and to “C & A, Inc.,” an unrelated corporation. Here’s where things got messy.
The tax law restricts Section 179 deductions of non-corporate taxpayers when their property will be rented out. Such leased property is normally ineligible for the Section 179 deduction, unless two requirements are met. The Tax Court explains (my emphasis):
Non-corporate lessors may expense the cost basis of section 179 property by meeting a two-prong test. First, the term of the lease, taking into account options to renew, must be less than 50 percent of the class life of the leased property. Sec. 179(d)(5)(B). Second, petitioners’ section 162 business expenses for the leased property claimed during the initial 12-month period following the transfer of the property to the lessee must exceed 15 percent of the rental income produced by such property.
The first test allows very short-term leased property to get Section 179 treatment; the second test requires that there be significant non-rental expenses in the business. Unfortunately, the Tax Court found that the taxpayers failed to adequately document their lease agreements:
Petitioners assert that they satisfied the first prong because they annually renewed the terms of the leases of their farm-related property with Circle T and C & A. Petitioners therefore contend that the lease term is a year long so as to be less than 50 percent of the class life of the farm-related property. Respondent argues the lease terms are indefinite and therefore petitioners cannot satisfy the first prong. We agree.
All lease agreements between petitioners and Circle T and C & A were oral, and none of the farm-related property lease agreements was memorialized in writing. Moreover, petitioners have not presented any evidence regarding the terms for the leased farm-related property. The failure of a party to introduce evidence, which, if true, would be favorable to that party gives rise to the presumption that the evidence would be unfavorable if produced.
The Tax Court found that the lease terms weren’t one-year renewable leases, but were instead “indefinite”; as a result, the court said that it could not conclude that the leases were for less than 50% of the useful life of the property. That made the property fail the non-corporate lessor rules, so its cost has to be recovered over a period of years through depreciation. Adding insult to injury, the court imposed the 20% “accuracy-related penalty” for the tax understatement, saying that the taxpayers failed to show any evidence of their tax preparer’s qualifications.
The moral: Beware the non-corporate lessor rules, and document your related-party transactions carefully.
Cite: Thomann, TC Memo 2010-241
UPDATE, 11/3: Paul Neiffer has more.