Federal Tax Law Changes Abound More bonus depreciation and deductions affect leasing.

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1 Leasing Law Federal Tax Law Changes Abound More bonus depreciation and deductions affect leasing. President Bush pushed through Congress the $350 billion Jobs and Growth Tax Relief Reconciliation Act of 2003 on May 28, 2003 (Growth Act), granting tax relief to American taxpayers. Created to boost the economy and capital investment, the Growth Act could generate stimulus of $210 billion for the economy in the next two years-about one percent of the expected gross national product over that period. To encourage investment, the Growth Act provides for speedier bonus depreciation with respect to qualifying business investments, and it allows small businesses to take larger immediate deductions for certain business investments. How does current tax law relating to depreciation work under the Growth Act and do these incentives benefit leasing? The Growth Act increases existing first-year bonus depreciation deductions from 30 percent to 50 percent for qualifying property acquired and placed in service between May 5, 2003 and January 1, October 2003

2 Bonus Depreciation The Growth Act increases existing firstyear bonus depreciation deductions from 30 percent to 50 percent for qualifying property acquired after May 5, 2003 and, in most cases, placed in service before January 1, Separate legislation, the Job Creation and Worker Assistance Act of 2002 (Workers Act), created bonus depreciation, an accelerated first year write-off equal to 30 percent of the cost of qualifying property. (See the sidebar for a full explanation.) Like the Workers Act, the Growth Act provides taxpayers/lessors with a onetime depreciation benefit arising under the Modified Accelerated Cost Recovery System (MACRS). In the first year that Figure 1. qualifying property is placed in service, the taxpayer/lessor can take a 50 percent benefit under MACRS. For example, using the same example as appears in Side Bar and assuming property is used only in the U.S., here is how the benefit works. A taxpayer/lessor of qualified 5-year property (such as a $1,000,000 drilling rig) can claim a first-year deduction of 50 percent ($500,000) plus 20 percent of the remaining $500,000 basis of the property in the first year. Thereafter, the taxpayer/lessor takes the regular depreciation for the remaining years needed to fully depreciate the leased property. The math works as follows: $1,000,000 x 50 percent bonus depreciation of the original equipment cost = $500,000 in bonus depreciation write-offs. The remaining basis to depreciate equals $500,000 ($1,000,000 minus $500,000 bonus depreciation). Then, a taxpayer/lessor takes the regular depreciation of 20 percent on the $500,000 adjusted basis = $100,000 ($500,000 x 20 percent). Finally, a taxpayer/lessor can add the $100,000 regular depreciation to the $500,000 bonus depreciation for a total of $600,000 of first year depreciation (which is 60 percent of $1,000,000). For years 2 through 6, a taxpayer/lessor depreciates the balance of the equipment cost by applying the applicable depreciation percentages to the portion of the basis to which bonus depreciation did not apply ($500,000 in the example). The years of depreciation may, therefore, be summarized as shown in Figure 1. Taxpayers may elect out of the 50 percent additional first-year bonus depreciation for any class of qualified property and use the existing 30 percent bonus depreciation. A taxpayer may also elect not to take any additional first year depreciation. Depreciation Depreciation Depreciable Depreciation Year Percentage Basis of Property Allowed Year 1 Bonus Percent $1,000,000 (drilling rig cost) $500,000 Year 1 Regular Percent 500,000 (50% of cost) $100,000 Year Percent 500, ,000 Year Percent 500,000 96,000 Year Percent 500,000 57,600 Year Percent 500,000 57,600 Year Percent 500,000 28,800* Total Percent $1,000,000 *Half-year or so that carries over into year 6 due to the half-year convention. Property will qualify for 50 percent bonus depreciation only if it is eligible property that meets certain timing tests. The timing tests are as follows: October

3 Lessors should consider the timing and value of using bonus depreciation they may be trading accelerated tax relief today against increased taxes in later years. The original use of the property must commence with the taxpayer after May 5, 2003; The property must be acquired by the taxpayer after May 5, 2003, and before January 1, 2005, but not pursuant to a binding contract which was in effect before May 6, 2003; and The property must be placed in service before January 1, 2005 (or January 1, 2006, in case of certain property with a recovery period of at least 10 years or certain transportation property, including certain aircraft). To be eligible for the January 1, 2006 placed in service date, the property must generally cost more than $1 million and take at least a year to produce or must take over two years to produce. If a taxpayer manufactures or constructs property for its own use the acquisition-date requirement described above will be treated as met if construction or manufacturing begins after May 5, 2003, and is completed before January 1, In the case of property to which the January 1, 2006, sunset applies, bonus depreciation applies only to the portion of the basis attributable to manufacture, construction or production before January 1, Property eligible for the 50 percent bonus depreciation consists of most tangible personal property, including leased property with a tax recovery (depreciation) life of 20 years or less, water utility property, and qualified leasehold improvement property. The Growth Act also extends the before September 11, 2004 sunset or expiration dates for 30 percent bonus depreciation to before January 1, As a result of this change, in applying the 30 percent bonus depreciation rules for property that is eligible if placed in service before January 1, 2006, bonus depreciation will apply to the portion of the basis attributable to manufacture, construction or production before January 1, 2005 (as opposed to September 11, 2004). 14 October 2003

4 Clarifications on Sale-Leasebacks and Syndications The Treasury Department and IRS issued temporary regulations, effective September 8, 2003, that answer significant leasing industry questions concerning, among other issues, the availability of bonus depreciation in sale-leaseback and syndication transactions. Visit js703.htm for the press release and text of the regulations. The regulations generally apply to 50 percent bonus depreciation starting on or after May 6, Lessors may use bonus depreciation as prescribed by the regulations for a sale-leaseback, a syndication or a sale-leaseback followed by a syndication, as described below and in Section 1.168(k)-1T(b)(3)(iii) (original use) and Section 1.168(k)-1T(b)(5)(ii) (placed in service) of the regulations: Sale-Leasebacks A lessor taxpayerleased property will be treated as having been originally placed in service not earlier than the date of the leaseback if: (1) the property qualifies for 50 percent bonus depreciation, (ii) is originally placed in service by a person after May 5, 2003, and (iii) is sold to a taxpayer-lessor and leased back to a user-lessee within 3 months after being originally placed in service by such lessee. In other words, the property is treated as if the lessor placed it in service not earlier than the date on which the lessee first used the property under the sale-leaseback. If the user-lessee can not take bonus depreciation, neither can its lessor. Syndications If qualified property is placed in service by a lessor after May 5, 2003 and the lessor subsequently sells (syndicates) the property to a purchaser, the purchaser in the last sale is considered the original user if: (1) the property is sold to the subsequent purchaser within three months after the date the property was originally placed in service by the taxpayer-lessor, and (2) the user-lessee remains the same during the three-month period. However, the placed in service date would not be earlier than the date of the last sale during that three-month period. Sale-Leaseback Followed by Syndication If a syndication transaction occurs after sale-leaseback and both transactions meet the requirements for sale-leasebacks and syndications described above, the syndication rules determine the original use of the property. As a result, it now appears the last purchaser of property can take the bonus depreciation for property in a syndication transaction that occurs up to six months after the property was originally placed in service. That is, the last purchaser receives the benefit of both of the two three-month periods in the sale-leaseback and syndication rules. The bonus depreciation provisions are intended to provide October

5 An Explanation of the Workers Act On March 9, 2002 President Bush signed The Job Creation and Worker Assistance Act of 2002 (Workers Act).The Workers Act provides federal tax incentives that encourage new capital investment and turn net operating losses (NOLs) into found money. Basic Concept: The Workers Act generally permits taxpayers to write off 30 percent of the original cost of certain new equipment acquired after September 10, 2001 for regular and alternative minimum income tax purposes. It also allows taxpayers to carry back a NOL from a tax year ending in 2001 or 2002 to the five preceding tax years. Depreciation Bonus Rule: Here s a basic breakdown of bonus depreciation. Taxpayers/lessors can, subject to the changes in the Growth Act, do the following: 1. Expense (currently deduct) 30 percent of the adjusted basis (which is generally the original equipment cost) of qualified property; 2. Take the bonus in the year the property is placed in service ; and 3. Depreciate the remainder of the adjusted basis (the original equipment cost reduced by depreciation) according to existing depreciation percentages each tax year. Example: A taxpayer/lessor of qualified five-year property (such as a $1,000,000 drilling rig) used exclusively in the U.S. can claim a first-year deduction of 30 percent ($300,000) plus 20 percent of the remaining $700,000 basis of the property in the first year.thereafter, a taxpayer/lessor takes the regular depreciation for the remaining years needed to fully depreciate the property as follows: $1,000,000 x 30 percent bonus depreciation of the original equipment cost = $300,000 in bonus depreciation write-off.the remaining basis to depreciate is $700,000 ($1,000,000 minus $300,000 bonus depreciation).then, a lessor can take the regular depreciation of 20 percent on the $700,000 basis = $140,000 ($700,000 x 20 percent). Finally, a lessor can add the $140,000 regular depreciation to the $300,000 bonus depreciation for a total of $440,000 of first year depreciation (which is 44 percent of $1,000,000). For years two through six, a taxpayer/lessor depreciates the balance of the equipment cost by applying the applicable depreciation percentages to the portion of the basis to which bonus depreciation did not apply ($700,000 in the example).the years of depreciation may, therefore, be summarized as follows: Requirements To Take Depreciation. Bonus depreciation is available only if the property meets eligibility, original use, acquisition date, and placed-in-service date requirements. See Section 168(k) of the Code and Section 1 of the Workers Act for the requirements. Property Eligible for Bonus: The following property is eligible for the bonus write-offs: Property that is eligible for MACRS depreciation under section 168 of the Code and has a cost recovery period of 20 years or less; Certain computer software; Water utility property; and Qualified leasehold improvement property (lessee improvements to the interior portion of a nonresidential building if the lessee occupies the building and the improvements are placed in service more than 3 years after the date the building is first placed in service). Certain technical corrections to the Workers Act remain unresolved.these corrections do not change the policy of the law, but are intended to clarify any ambiguities or drafting flaws.to learn more on the Workers Act, read: New Federal Tax Law Changes Can Help Your Business Grow, Business Leasing News (April Depreciation Depreciation Depreciable Depreciation Year Percentage Basis of Property Allowed Year 1 Bonus Percent $1,000,000 (drilling rig cost) $300,000 Year 1 Regular Percent 700,000 (30% of cost) 140,000 Year Percent 700, ,000 Year Percent 700, ,400 Year Percent 700,000 80,640 Year Percent 700,000 80,640 Year Percent 700,000 40,320* Total Percent $1,000,000 *Half-year or so that carries over into year 6 due to due to the half-year convention. 2002) at /newsletters/bln/release/bln_2002_04.htm #1 For more on possible corrections and actions by the ELA in Congress on tax matters, including bonus depreciation, visit the ELA Federal relations web page at /Federal/bonusdep.htm. October

6 an immediate investment stimulus by increasing the previously existing rate of depreciation. Businesses that invest for growth and expansion will benefit from this provision. However, lessors should consider the timing and value of using bonus depreciation. Lessors may be trading accelerated tax relief today against increased taxes in later years. Bonus depreciation does not increase the amount of overall tax benefits. It does, however, enable lessors to take the tax benefits earlier, which can significantly enhance their after-tax yield on a lease investment, depending upon the depreciation class of the property. Lessors have in some cases been reluctant to use or pass on the benefits of bonus depreciation because of the uncertainties of taxable income and deal volume. Lessors should be prudent with tax planning to assure that they receive the maximum economic and after-tax benefit from bonus depreciation. Small Business Expensing Prior to passage of the Growth Act, a taxpayer could elect to deduct up to $25,000 (for taxable years beginning in 2003 and thereafter) of the cost of qualifying tangible property placed in Some lessors are concerned that small businesses will simply buy qualifying property to use these deductions. Others feel that small businesses still need the capital and pricing lessors offer. service for the taxable year in lieu of standard depreciation. The $25,000 amount would be reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. A taxpayer electing to expense these items could revoke the election only with the consent of the IRS. In general, taxpayers could not elect to expense off-the-shelf computer software, as it constituted non-qualifying intangible property. The Growth Act makes several business-friendly changes. It increases small business expensing for new investments. The amount of investment that may be currently deducted by small businesses has been increased from $25,000 to $100,000. Certain computer software now qualifies for the write-off. The amount of investment qualifying for this immediate deduction begins to phase out for small businesses with investments in excess of $400,000 (increased from $200,000). Both parameters are indexed for inflation beginning in These changes are effective for property placed in service in taxable years beginning in 2003, 2004 and As under prior law, taxpayers may elect to use these benefits or not to use them. Under the Growth Act, a taxpayer electing the benefits of small business expensing may now revoke the election without the consent of the IRS. Once revoked, however, the revocation cannot be changed. The impact of these accelerated deductions have drawn diverse reactions. While some lessors have expressed concern that small businesses will simply buy qualifying property to use these deductions, other lessors apparently feel that small businesses still need the capital and pricing that lessors can offer. With the enhanced bonus depreciation and small business deductions, lessors should actively plan how to best use existing tax benefits under the Growth Act and the Workers Act. While not all lessors use these benefits, they can boost a lessor s yield and help make lease pricing very attractive for small, middle and large-ticket transactions. ELT thanks David G. Mayer, business transactions partner in the Dallas office of the law firm of Patton Boggs LLP for this month s column. 18 October 2003