When should a business opt out of federal bonus depreciation and why?

A business should consider opting out of federal bonus depreciation in several scenarios, depending on its specific tax situation, long-term planning goals, and the interaction of bonus depreciation with other tax provisions. The decision to elect out of bonus depreciation is irrevocable for each class of property placed in service during a taxable year, so careful analysis is required. Below are the primary circumstances and legal considerations for when and why a business might opt out:

1. Avoiding or Managing Net Operating Losses (NOLs) and Excess Business Losses

• Section 461(l) Limitation: The excess business loss limitation under IRC § 461(l) restricts the amount of business losses a noncorporate taxpayer can deduct in a year, with any excess carried forward as an NOL. If claiming bonus depreciation would create or increase an excess business loss that is subject to limitation, a taxpayer may prefer to opt out of bonus depreciation to avoid generating an NOL that is only partially deductible in future years (generally limited to 80% of taxable income).
• Planning Opportunity: By electing out of bonus depreciation for certain classes of property, a taxpayer can better control the amount of current-year deductions, potentially maximizing the use of losses in the current year and avoiding the less favorable NOL carryforward rules.

2. Maximizing the Use of Section 179 Expensing

• Section 179 vs. Bonus Depreciation: Section 179 expensing allows for immediate deduction of the cost of qualifying property, but is subject to annual dollar limits and a business income limitation (i.e., the deduction cannot exceed taxable business income). Bonus depreciation, in contrast, is not limited by income and applies to all eligible property in a class unless the taxpayer elects out.
• Strategic Use: Taxpayers may wish to use Section 179 expensing on longer-lived property (such as qualified improvement property, or QIP) to maximize current deductions up to the Section 179 limit, and then use bonus depreciation on shorter-lived property. To do this, a taxpayer may elect out of bonus depreciation for certain classes to preserve the ability to use Section 179 expensing most effectively.

3. Managing Taxable Income and Tax Bracket Planning

• Smoothing Deductions: If a business expects to be in a higher tax bracket in future years, it may prefer to defer depreciation deductions by opting out of bonus depreciation, thereby preserving larger deductions for years when they will offset income taxed at higher rates.
• Avoiding Waste of Deductions: Taking large bonus depreciation deductions in a low-income year may result in deductions that are less valuable than if they were taken in a future year with higher taxable income.

4. Impact on State Taxes

• State Decoupling: Many states do not conform to federal bonus depreciation rules. If a state does not allow bonus depreciation, but does allow Section 179 or regular MACRS depreciation, a taxpayer may opt out of bonus depreciation to simplify state tax compliance and avoid unfavorable state tax consequences.

5. Recapture and Asset Disposition Planning

• Recapture Rules: Both bonus depreciation and Section 179 expensing are subject to ordinary income recapture under IRC § 1245 upon the sale of the asset. However, the timing and amount of recapture may differ depending on the method used. Electing out of bonus depreciation may allow for more gradual recognition of income upon disposition, which can be beneficial in certain planning scenarios.

6. Controlled Groups and Lessors

• Controlled Groups: Section 179 limits are applied on a controlled group basis (using a 50% test for voting power and value), so practitioners may need to coordinate Section 179 and bonus depreciation elections across related entities to maximize overall tax savings.
• Lessors: Noncorporate lessors generally cannot use Section 179 expensing unless certain requirements are met, so bonus depreciation may be the only option. However, if those requirements are not met, and bonus depreciation would create an undesirable tax result, opting out may be appropriate.

7. Asset Class Considerations and Partial Elections

• Class-by-Class Election: The election out of bonus depreciation is made by class of property (e.g., 5-year, 7-year, 15-year property) for each taxable year. Taxpayers can elect out for one or more classes while still taking bonus depreciation for others, allowing for tailored planning.

8. Interaction with Other Tax Credits and Deductions

• Section 199A Deduction: Large bonus depreciation deductions may reduce qualified business income (QBI) for purposes of the Section 199A deduction, potentially reducing the benefit of the QBI deduction. Electing out of bonus depreciation may help preserve QBI and maximize the Section 199A deduction.

9. Other Strategic Considerations

• Anticipated Tax Law Changes: If a taxpayer anticipates higher tax rates in the future, deferring deductions by opting out of bonus depreciation may be advantageous.
• Transaction Planning: In anticipation of a sale or other transaction, a taxpayer may wish to manage the timing of depreciation deductions and recapture.

10. Legal Authority and Election Mechanics

• IRC § 168(k)(7): Allows a taxpayer to elect out of bonus depreciation for any class of property placed in service during the taxable year. The election is made by attaching a statement to the timely filed tax return (including extensions) for the year the property is placed in service. The election is irrevocable for that year and class of property.
• Regulations: Treas. Reg. § 1.168(k)-2(f)(1) provides further details on the election process and the definition of "class of property."

11. Summary Table of Key Considerations