Anthony J. Balden
The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010,1 signed
into law last December, temporarily increases bonus depreciation
deductions under Section 168(k) from 50 percent to 100 percent. This
immediate recovery of costs for certain qualifying property was designed
to encourage investment and, in connection with the other tax cuts and
provisions in the legislation, to otherwise promote economic growth. We
outlined the new 100 percent bonus depreciation provisions and potential
issues in our January 2011 Tax Update (available online at www.pepperlaw.com/pdfs/TaxUpdate0111.pdf), and the Internal Revenue Service has recently clarified some of these issues in Revenue Procedure 2011-26.2
Taxpayers in a variety of industries-utilities, oil and gas
companies, clean energy companies, health care companies, manufacturers,
and other capital intensive businesses-should review this guidance and
consider the opportunities for accelerating cost recovery. Bonus
depreciation is very favorable in general, but Rev. Proc. 2011-26
provides additional rules and exceptions that allow taxpayers of all
types to utilize the rules in a favorable way. Rev. Proc. 2011-26
The 50 percent bonus depreciation rules generally apply to "qualified
property," which is limited to: (i) tangible property with a recovery
period of 20 years or less; (ii) the original use of which began after
December 31, 2007; (iii) which was acquired by the taxpayer after
December 31, 2007 and before January 1, 2013; and (iv) was placed in
service before January 1, 2013.3
Special rules exist for certain types of property, such as computer
software, water utility property, leasehold improvements, transportation
property, and certain aircraft, and extensions of deadlines apply in
some instances. Section 168(k)(5) provides that a business placing
qualified property in service after September 8, 2010, and before
January 1, 2012 (again, with extended deadlines for certain property),
may claim 100 percent bonus depreciation on the property.
Section 3.02 of Rev. Proc. 2011-26 sets out the rules for the
acquisition, placed in service, and original use requirements for 100
percent bonus depreciation purposes. For placing property in service and
original use, Rev. Proc. 2011-26 simply notes the substitution of
"after September 8, 2010, and before January 1, 2012," for the
deadlines. The acquisition rules, however, are key to the utilization of
100 percent bonus depreciation, and special rules apply.
First, the taxpayer must acquire the qualified property after
September 8, 2010, and before January 1, 2012, to meet this element.
"Acquisition" for these purposes occurs when the taxpayer pays or incurs
the cost of the property, consistent with the taxpayer's cash or
accrual accounting method.
A written binding contract, however, may allow for later
"acquisition" of property with continued qualification for 100 percent
bonus depreciation. The written binding contract rules in section
3.02(1)(a) provide that entering into a binding contract after September
8, 2010, and before January 1, 2012, to acquire, manufacture,
construct, or produce long-production property or certain aircraft is
treated as meeting the acquisition requirement. The language here is
somewhat inconsistent with the parenthetical in the first sentence,
which appears to allow any acquisition of long-production property or
certain aircraft before January 1, 2013, even without a binding
contract. In planning property acquisitions going forward, taxpayers
should note that a Treasury official has stated that long-production
property and certain aircraft should not qualify for 100 percent bonus
depreciation if no written contract is entered into prior to January 1,
The binding contract rules for 100 percent bonus depreciation operate
differently than the general binding contract rules in Section
168(k)(2). As described by a Treasury official, Section
168(k)(2)(A)(iii) and its binding contract rules are relevant only for
the December 31, 2007, cut-off date. Property acquired pursuant to a
binding contract entered into prior to December 31, 2007, is not
eligible for bonus depreciation. For Section 168(k)(5) purposes, a
binding contract prior to September 9, 2010, for property that is
actually acquired after September 8, 2010, will not prohibit the
taxpayer from claiming 100 percent bonus depreciation, because, as
described below, the taxpayer can utilize the component rules to claim
100 percent bonus depreciation.
Components are an important aspect of the acquisition rules in Rev.
Proc. 2011-26. Section 3.02(1)(a) provides that a taxpayer acquires
property for bonus depreciation purposes if the taxpayer begins
constructing, manufacturing, or producing that property itself. In
general, Treas. Reg. § 1.168(k)-1(b)(4)(iii)(B) provides specific rules
on when manufacturing begins, and it also provides a safe harbor, in
which incurring more than 10 percent of the total cost is considered
"work of a significant nature" and the beginning of manufacturing.
Previously, these rules could operate to prohibit 100 percent bonus
depreciation, because the taxpayer would be treated as acquiring
property when work began, potentially before September 9, 2010. Rev.
Proc. 2011-26, however, expands the acquisition definition to include
components of larger self-constructed property and provides very
favorable treatment for 100 percent bonus depreciation purposes.
Limited Exception for Self-Constructed Property and Components
Section 3.02(1)(b) provides a limited exception allowing 100 percent
bonus depreciation for certain components of larger qualifying property.
Under this rule, 100 percent bonus depreciation is available for
components despite being unavailable for the property as a whole. Thus,
if larger self-constructed property was acquired prior to September 9,
2010, and otherwise meets the placed in service and original use
requirements, the taxpayer may elect to treat any acquired or
self-constructed component of the larger property as eligible for 100
percent bonus depreciation. Of course, the components must be qualified
property and meet the acquisition requirements to be eligible. This
"limited exception," as it is described in Rev. Proc. 2011-26,
purposefully defines "component" very broadly to encompass "any part
used in the manufacture, construction, or production of the larger
self-constructed property, which may or may not be the same as the asset
for depreciation purposes or the same unit of property for purposes of
other Code sections." Importantly, a Treasury official stressed that the
component rules apply only for Section 168(k)(5) purposes. The broad
definition was designed to cover a great deal of activity and provide an
investment incentive, but this component definition has no relation to
unit of property definitions in other contexts.
A taxpayer must elect application of 100 percent bonus depreciation
to components by attaching a statement to its return indicating whether
the taxpayer is treating all or some components under Rev. Proc.
2011-26's limited exception. Treas. Reg. § 301.9100-2(b) relief is
available for taxpayers who have already filed returns for property
placed in service on or before April 18, 2011, to re-file claiming 100
percent bonus depreciation.
Two examples illustrate these component rules. Section 3.04(3)
Example 3 discusses a taxpayer that began constructing a ship in March
2010. $15 million of the $25 million cost related to components acquired
after September 8, 2010, and before January 1, 2013, but acquired
pursuant to written binding contracts entered into in March 2010.
However, because the taxpayer elected under section 3.02(2)(b) of Rev.
Proc. 2011-26 to treat the acquired components as qualified property,
the taxpayer is allowed 100 percent bonus depreciation with respect to
the $15 million paid for the components.
Section 3.04(4) Example 4 uses the same facts, except that the
taxpayer does not make the section 3.02(2)(b) election. Under those
facts, the taxpayer is not entitled to 100 percent bonus depreciation,
because it began construction prior to September 9, 2010, and it fails
the acquisition requirement.
As the examples show, a taxpayer must elect to claim 100 percent
bonus depreciation for components and also attach a statement to its
return. For this reason, taxpayers must consider these requirements and
follow the rules closely to ensure they are entitled to and properly
document their elections claiming 100 percent bonus depreciation.
Electing Bonus Depreciation: Elections for 50 Percent Bonus Depreciation or No Additional First Year Depreciation
In general, a taxpayer must elect out of bonus depreciation if it
does not want or need the bonus depreciation. If a taxpayer previously
chose not to deduct 50 percent bonus depreciation, it would not be
eligible for 50 percent or 100 percent bonus depreciation for that class
Section 4 allows another "limited exception" for qualified property.
For administrative convenience, Rev. Proc. 2011-26 allows a taxpayer to
elect out of 100 percent bonus depreciation and elect 50 percent bonus
depreciation for all qualified property in a given class and placed in
service in the tax year that includes September 9, 2010. Difficulties in
tracing assets and determining placed in service and acquisition dates
necessitated this special rule, but it only applies for the tax year
that includes September 9, 2010. The election is made on Form 4562, and,
again, Treas. Reg. § 301.9100-2(b) relief is available if the taxpayer
has already filed its return for the year that includes September 9,
2010. The JCT Bluebook provides that relief similar to that in
section 4.02 may also be allowed for the 2011 tax year, but a Treasury
official noted a technical correction would be necessary for this
Section 5 also provides special rules for taxpayers that did not
claim 50 percent bonus depreciation and allows them to elect bonus
depreciation for the relevant periods. If a taxpayer did not claim 50
percent bonus depreciation, the taxpayer may claim 50 percent bonus
depreciation through an amended return or Form 3115, Application for
Change in Accounting Method. Furthermore, if the taxpayer had filed Form
4562 electing not to apply the 50 percent bonus depreciation rules,
section 5.03 grants consent from the Commissioner to revoke that
election and claim bonus depreciation.
Finally, section 5.04 provides rules for taxpayers with short years
or tax years that ended early in 2010. A taxpayer that timely filed its
2009 or 2010 short year return is treated as making an election not to
deduct 50 percent bonus depreciation if the taxpayer deducted
depreciation but did not claim bonus depreciation amounts and does not
file an amended return or Form 3115. This deemed election will apply for
both 2009 and 2010 qualified property, and, as such, that class of
property would not be eligible for 50 percent or 100 percent bonus
Other Special Rules
Rev. Proc. 2011-26 provides some special rules for 100 percent bonus
depreciation and its interaction with other Code Sections and laws.
One key area involves section 1603 of the American Recovery and Reinvestment Tax Act of 2009.4
This section provides for Treasury payments to eligible persons who
place in service certain energy property. The property must be used in a
trade or business or held for the production of income, and section
1603 was designed to reimburse the applicants for a portion of the
The 100 percent bonus depreciation rules make section 1603 an
attractive option for taxpayers. Section 1603 provides that an applicant
may receive 10 percent or 30 percent of the basis of the energy
property as a credit, but the adjusted basis of the property is only
reduced by 50 percent of the credit. Rev. Proc. 2011-26 indicates that
taxpayers should calculate basis in a project by first computing the
credit under section 1603 and the basis reduction under those rules and
then claim 100 percent bonus depreciation on the reduced adjusted basis
of the qualified property. These rules result in tax savings in certain
Code Section 280F also has specific guidance. In general, Section
280F provides a limitation on depreciation deductions for luxury
automobiles. The excess of 100 percent bonus depreciation over the
allowed depreciation under Section 280F is treated as "unrecovered
basis." This unrecovered basis is deductible in the year following the
end of the recovery period. Rev. Proc. 2011-26 provides a safe harbor
method of accounting and special calculations to "mitigate the anomalous
result" that may occur under the 100 percent bonus depreciation rules.
Taxpayers subject to these rules should review section 3.03(5)(c) and
the examples in sections 3.04(5) and (6) closely.
Rev. Proc. 2011-26 also provides special rules and clarifications for
qualified leasehold improvement property, qualified restaurant
property, and qualified retail improvement property under Section 168.
There was some uncertainty regarding these types of property and their
eligibility for bonus depreciation. A technical correction provided that
all this property is eligible, and section 3.03(3) explicitly states
that such property is eligible, assuming the other Section 168(k)
requirements are met. Importantly, only improvements are eligible for
100 percent bonus depreciation, but a new building, for example, is not
Several questions are still unanswered. As noted above, the
acquisition rules for long-production property and the written binding
contract rules are somewhat inconsistent in section 3.02(1)(a). In
addition, a Treasury official noted that the written binding contract
rules and their application to property which is at a particular stage
of production when acquired by a taxpayer may present certain
complexities not covered by Rev. Proc. 2011-26. Finally, no changes were
made to the accounting method change procedures, and taxpayers with
issues under examination who cannot otherwise qualify for automatic
accounting method changes must continue to seek consent for bonus
depreciation method changes.
Advice on the correct filing of returns and elections, explanatory
statements to ensure proper 100 percent bonus depreciation deductions
for components, documentation of when assets are acquired and placed in
service, application of the written binding contract rules, automatic
accounting method changes, and consent for accounting method changes are
all issues that taxpayers will face with 100 percent bonus depreciation
deductions and Rev. Proc. 2011-26. Pepper Hamilton is prepared to
assist you with these matters, and we will continue to follow these
rules and guidance as they develop further.
1 Pub. L. No. 111-312 (2010).
2 2011-16 I.R.B. (Mar. 29, 2011).
3 Section 168(k)(2)(A).
4 Pub. L. No. 111-5 (2009).
material in this publication was created as of the date set forth above
and is based on laws, court decisions, administrative rulings and
congressional materials that existed at that time, and should not be
construed as legal advice or legal opinions on specific facts. The
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transmission and receipt of it does not constitute, a lawyer-client
article is republished with permission of Pepper Hamilton LLP. Further
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