Provisions Affecting Businesses

Bonus Depreciation

The Act allows taxpayers to take a "bonus" depreciation deduction for certain qualified property if its original use commences with the taxpayer after September 10, 2001, and it is acquired by the taxpayer after September 10, 2001 and before September 11, 2004. The "bonus" deduction is equal to 30 percent of the basis of the qualified property. The remaining 70 percent of the basis of the qualified property will be depreciated under the usual rules for depreciating such property. For property for which the 30 percent bonus deduction is allowed, there is no depreciation adjustment required in computing alternative minimum tax (AMT) (i.e., the depreciation deduction, including the 30 percent bonus deduction, is the same for regular tax and for AMT).

Qualified property includes:

MACRS property with a recovery period of 20 years or less
Computer software (other than computer software that must be amortized under section 197)
Water utility property (as defined in section 168(e)(5))
Qualified leasehold improvement property

Qualified leasehold improvement property is defined as improvements that are made:

To an interior portion of a building that is nonresidential real property
Under or pursuant to a lease
By the lessee (or any sublessee) or the lessor of those premises
To premises that will be occupied exclusively by the lessee (or any sublessee) of those premises
Placed in service more than three years after the date the building was first placed in service

A commitment to enter into a lease will be treated as a lease for these purposes. Generally, leases between members of an affiliated group of corporations or between certain other parties that are under 80-percent common control will not be so treated.

Improvements do not qualify if they:

Enlarge the building
Are for elevators or escalators
Are to structural components benefiting a common area
Are to the internal structural framework of the building

Property is not eligible for the bonus deduction if the taxpayer is required to depreciate it using the straight-line method and the longer recovery periods of the Alternative Depreciation System (ADS). For example, property predominantly used outside the United States, certain property leased to a tax-exempt entity, or property with 50 percent or less business use is not eligible. Property remains eligible for the bonus deduction, however, if the taxpayer elects to use ADS.

Also, New York Liberty Zone leasehold improvement property does not qualify for bonus depreciation.

Example

Depreciation deductions that a taxpayer would take each tax year on an investment of $1,000 in qualified property, under current law and under the Act, for 5-year property and 7-year property, assuming a half-year convention applies, are as follows:

5-Year Property

Tax Year 1 2 3 4 5 6

Prior Law 200 320 192 115 115 58

The Act 440 224 134 81 81 40

7-Year Property

Tax Year 1 2 3 4 5 6 7 8

Prior Law 143 245 175 125 89 89 89 45

The Act 400 171 122 87 63 63 63 31

KPMG Observation

In Notices 2001-70¹ and 2001-74,² the IRS announced that it will allow taxpayers to elect to compute depreciation on property placed in service in a tax year whose third or fourth quarter includes September 11, 2001, without regard to the midquarter convention. The midquarter convention generally applies if more than 40 percent of the tangible personal property the taxpayer places in service for the tax year is placed in service in the last three months. If the midquarter convention applies, the taxpayer in most cases will be allowed less first-year depreciation than under the half-year convention. Taxpayers that make this election will use the half-year convention.

Special Rules

A special rule preserves the availability of the bonus deduction in sale and leaseback situations. Property originally placed in service after September 10, 2001, that is sold and leased back will be eligible for the bonus deduction.

Self-constructed qualified property may be eligible for the bonus deduction if the taxpayer begins its manufacture, construction, or production after September 10, 2001, and before September 11, 2004.

A taxpayer may elect not to take bonus depreciation on a class-by-class basis; for example, an "election out" may be made for all 5-year property, or all 7-year property, but not on a property-by-property basis.

Prior law limited the first-year depreciation deduction for certain "luxury" automobiles to $3,060 (in 2001 and 2002), and limited deductions in later years. The Act raises the first-year limitation by $4,600, to $7,660.

Effective Date

The bonus deduction will be allowed for property whose original use begins with the taxpayer after September 10, 2001, and acquired after September 10, 2001, but not if there was a written binding contract for the acquisition in effect before September 11, 2001. The bonus deduction generally will not be available for property acquired after September 10, 2004, unless there is a written binding contract in effect before September 11, 2001. The property must be placed in service by the taxpayer before January 1, 2005. A one-year extension of the placed-in-service date (to December 31, 2005) is provided for certain property (generally, self-constructed property) that has a recovery period of 10 years or longer or is tangible personal property used in the transportation business. However, only the portion of the property's basis attributable to manufacture, construction or production before September 11, 2004, will be eligible for the bonus depreciation.

Five-Year Carryback Of Net Operating Losses

The Act allows a taxpayer with a net operating loss (NOL) arising in a tax year ending in 2001 or 2002 to carry those losses back to be used as a deduction in the fifth preceding tax year, rather than in the second preceding tax year. For example, a calendar-year taxpayer would carry a loss incurred in 2001 back to 1996.

The five-year carryback also applies to "eligible losses" that are allowed a three-year carryback: certain casualty and theft losses of individuals and certain losses of a small business or a farmer in a Presidentially declared disaster area.

Losses eligible to be carried back five years under this rule remain eligible for a 20-year carryover if they cannot be used to offset income in the carryback years.

A taxpayer can elect to disregard the five-year carryback for any loss year in the period covered by this provision and, thus, to have losses for that year carried back under the usual two- or three-year carryback rule. The election must be made by the due date for filing the tax return for the loss year (including any extensions) and, once made, is irrevocable.

Taxpayers also will remain eligible, as under prior law, to elect to waive any carryback of net operating losses from a tax year, and only carry them forward.

The five-year carryback does not eliminate other special carryback rules. Thus, the five-year carryback does not apply to:

Net operating losses of REITs
Losses attributable to certain interest expense relating to a corporate equity reduction transaction
"Operations loss" carrybacks of life insurance companies (which are carried back three years and carried forward 15 years)

The Act does not eliminate the ability to carry back "specified liability losses" 10 years.

The five-year carryback applies for purposes of computing AMT, as well as regular tax, and an election not to use the five-year carryback would apply for both AMT and regular tax. Whether or not the five-year carryback applies, however, an AMT NOL deduction attributable to a net operating loss arising in 2001 or 2002, or carried forward from an earlier tax year into 2001 or 2002, may offset 100 percent of a taxpayer's alternative minimum taxable income for the year it is deducted (i.e., it will not be subject to the 90-percent limitation on the deductibility of AMT NOLs).

Suspension of Reduction of Deductions for Mutual Life Insurance Companies

Mutual life insurance companies are allowed to deduct certain amounts returned to policyholders in their status as customers, rather than as owners, of the company. The insurance company, however, is required to reduce the amount of its deduction for such policyholder dividends by the company's "differential earnings amount," which is a factor of a "differential earnings rate" based on industry experience.

The Act provides a zero percent differential earnings rate and recomputed differential earnings rate for mutual life insurance company tax years beginning in 2001, 2002, and 2003.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

¹ 2001-45 I.R.B. 437.

² 2001-49 I.R.B. 551.