Sometimes, as tax advisers, we and our clients tend to concentrate so intensely on federal income tax matters that we inadvertently overlook the potential impact of state income tax issues. However, it is crucial to recognize that these state-level considerations can be significant enough to warrant a reevaluation of the optimal choice for a federal return election.

In the case of PLR 202323001,[1] it came to light that the taxpayer, a partnership, was unaware of the substantial adverse consequences on the partners’ state income tax returns resulting from the utilization of bonus depreciation on their federal income tax return. Neither the partnership nor its tax adviser identified this matter until after the tax return had already been prepared and filed.

In this ruling, the taxpayer approached the IRS seeking permission to retroactively make a late election to forego the deduction of additional first-year depreciation. The objective was to rectify the unintended consequences arising from the utilization of such depreciation on their federal income tax return, which had a detrimental impact on the partners’ state income tax returns.

What Could Be the State Issue?

Although the details regarding the state income tax return are not explicitly provided in the PLR, it is plausible that the issue at hand stemmed from the state’s disallowance of the additional first-year depreciation. Consequently, it may be the case that the state tax law requires the inclusion of the excess of bonus depreciation over the depreciation not claiming bonus depreciation in federal taxable income in all cases.

This inclusion of the excess bonus depreciation becomes problematic when the state tax regulations fail to consider that a portion or all of the bonus depreciation was not deducted on the current year’s federal return due to the application of the passive activity loss rules outlined in IRC §469. If the state does not account for this distinction, it can lead to unexpected and arguably unfair consequences for taxpayers.

This author’s home state of Arizona, prior to conforming to federal bonus depreciation rules, had exactly this sort of method of dealing with a depreciation difference in a passive activity—so I’ve seen this exact situation arise.

The Facts of the Ruling

The letter describes the facts of the situation as follows:

Taxpayer is treated as a partnership for federal income tax purposes and files a Form 1065, U.S. Income Tax Return for Partnership Income, on a calendar year basis. Taxpayer’s overall method of accounting is the accrual method.

During the Taxable Year, Taxpayer placed in service property that is classified as 5-year property or 7-year property and is qualified property under § 168(k)(2) of the Code (collectively, classes of property). On its timely filed federal tax return for the Taxable Year, Taxpayer deducted the additional first year depreciation for the classes of property.

Taxpayer engaged Firm to prepare its federal income tax return for the Taxable Year. Taxpayer reviewed this federal income tax return prior to its filing, but was not aware at that time of certain unfavorable state tax implications to one or more partners of Taxpayer stemming from Taxpayer’s deduction of the additional first year depreciation on its federal income tax return for its Taxable Year. These implications were discovered after the Taxpayer filed its federal income tax return on Date1, in connection with a partner’s State income tax return.

Firm was also not aware that Taxpayer’s claiming the additional first year depreciation deduction on its federal income tax return for the Taxable Year would result in unfavorable State tax implications that impacted one or more partners of Taxpayer. As a result, Firm did not advise Taxpayer to make the election not to deduct the additional first year depreciation for the classes of property placed in service during the Taxable Year.[2]

The taxpayer submitted a request to the IRS, seeking the following ruling to be granted.

Accordingly, Taxpayer requests an extension of time pursuant to §§301.9100-1 and 301.9100-3 of the Procedure and Administration Regulations to make the election under §168(k)(7) not to deduct the additional first year depreciation deduction for all classes of property that are qualified property under §168(k) and placed in service by Taxpayer during the Taxable Year.[3]

The Law Governing Electing to Not Claim Bonus Depreciation

The private letter ruling commences by providing an overview of the relevant provisions within the Internal Revenue Code that govern bonus depreciation and the election to forgo deducting such depreciation.

Sections 168(k)(1) and (6) allow, in the taxable year that qualified property is placed in service, a 100-percent additional first year depreciation deduction for qualified property acquired by the taxpayer after September 27, 2017, and placed in service by the taxpayer after September 27, 2017, and before January 1, 2023 (or before January 1, 2024 for qualified property described in §168(k)(2)(B) or (C)).

Section 168(k)(7) provides that a taxpayer may make an election not to deduct the additional first year depreciation for any class of property that is qualified property placed in service during the taxable year (the §168(k)(7) election).[4]

The ruling next delves into a discussion of the Treasury regulations pertaining to the election to waive the claim of bonus depreciation under IRC §168(k).

Section 1.168(k)-2(f)(1)(i) provides that the §168(k)(7) election applies to all qualified property that is in the same class of property and placed in service in the same taxable year. Section 1.168(k)-2(f)(1)(ii) defines “class of property” for purposes of the §168(k)(7) election as meaning each class of property described in §1.168(k)-2(f)(1)(ii)(A)-(G).

Section 1.168(k)-2(f)(1)(iii)(A) provides that the §168(k)(7) election not to deduct additional first year depreciation must be made by the due date (including extensions) of the Federal tax return for the taxable year in which the property is placed in service by the taxpayer.

Section 1.168(k)-2(f)(1)(iii)(B) provides that the §168(k)(7) election not to deduct additional first year depreciation must be made in the manner prescribed on Form 4562, “Depreciation and Amortization,” and its instructions. The instructions to Form 4562 for the Taxable Year provide that the election not to deduct the additional first year depreciation is made by attaching a statement to the taxpayer’s timely filed tax return indicating that the taxpayer is electing not to deduct the additional first year depreciation and the class of property for which the taxpayer is making the election.[5]

It is worth noting that the deadline for making the election is determined by Treasury regulations rather than the statute. Although the IRS maintains the position that it cannot waive election due dates prescribed by the statute, it does offer an alternative for cases where the deadline is established in regulations issued by the Treasury Department. In such instances, the IRS has provided an option for taxpayers to request consideration of a late election. The ruling describes this specific option, which the taxpayer intends to pursue to their advantage.

Under §301.9100-1, the Commissioner has discretion to grant a reasonable extension of time under the rules set forth in §§301.9100-2 and 301.9100-3 to make a regulatory election.

Sections 301.9100-1 through 301.9100-3 provide the standards the Commissioner will use to determine whether to grant an extension of time to make an election. Section 301.9100-2 provides automatic extensions of time for making certain elections. Section 301.9100-3 provides extensions of time for making elections that do not meet the requirements of §301.9100-2.

Section 301.9100-3(a) provides that requests for relief under §301.9100-3 will be granted when the taxpayer provides evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and that granting relief will not prejudice the interests of the Government.[6]

Although this option necessitates submitting a formal private letter ruling request and paying the relevant user fee, it provides an avenue to rectify the issues stemming from the adviser’s lack of awareness regarding the state tax consequences resulting from the failure to make the aforementioned election. Consequently, the taxpayer proceeded to file the formal request that ultimately resulted in the issuance of this private letter ruling.

The IRS Decision

The IRS decided to grant the taxpayer’s request in this case, stating:

Based solely on the facts and representations submitted, we conclude that the requirements of §§301.9100-1 and 301.9100-3 have been satisfied. Accordingly, Taxpayer is granted an extension of 60 calendar days from the date of this letter ruling to make the election not to deduct the additional first year depreciation under §168(k) for all classes of qualified property placed in service by Taxpayer during the Taxable Year.[7]

The ruling provides instructions to the taxpayer regarding the actions they must undertake within the given 60-day timeframe to effectively utilize the granted permission to make the late election.:

This election must be made by Taxpayer filing an amended Form 1065 for the Taxable Year, with a statement indicating that Taxpayer is electing not to deduct the additional first year depreciation for all classes of qualified property placed in service by Taxpayer during the Taxable Year.[8]

As previously discussed, it is important to acknowledge that this option is not without costs. In numerous situations, the expenses associated with obtaining a favorable ruling may exceed the tax cost of accepting the consequences resulting from the failure to make the election. Additionally, it is imperative to emphasize that making the change without obtaining a private letter ruling is prohibited by law. However, when the ramifications are substantial, pursuing the letter ruling becomes a viable course of action.

This case serves as an important reminder that when an adviser is engaged for tax matters concerning a partnership, it is crucial for the adviser to recognize that the ultimate tax implications will materialize at the individual partner return level, which may not involve the adviser in any capacity. Furthermore, as evident in this case, these partners may reside in states with income tax provisions that could significantly influence decisions such as electing or not electing certain options on the partnership return.

Advisers should carefully consider the possibility of state or other individual partner-level impacts resulting from available elections. It is advisable to inform partnership management that they may want to consider reaching out to individual partners and consulting their respective tax advisers to assess any potential impacts on their tax situations arising from such elections. Subsequently, partnership management would need to determine how to strike a balance between the interests of the various partners when making these decisions.

[1] PLR 202323001, June 9, 2023, https://www.irs.gov/pub/irs-wd/202323001.pdf (retrieved June 9, 2023)

[2] PLR 202323001, June 9, 2023

[3] PLR 202323001, June 9, 2023

[4] PLR 202323001, June 9, 2023

[5] PLR 202323001, June 9, 2023

[6] PLR 202323001, June 9, 2023

[7] PLR 202323001, June 9, 2023

[8] PLR 202323001, June 9, 2023