Tax Court Rejects Modification of Sec. 179 Election

In Patton, 116 TC No. 17 (2001), the Tax Court ruled that the Service did not abuse its discretion in refusing to allow a taxpayer to modify a Sec. 179 election to expense additional assets. Because the maximum amount that qualifies for expensing under Sec. 179 is now $24,000, the ruling is an important issue for many businesses.

Sec. 179 allows a taxpayer to expense, in the year placed in service, a limited amount of depreciable personal property used in a trade or business. All entities except estates, trusts and certain noncorporate lessors are eligible. Congress increased the maximum deduction from $5,000 in 1982 to $25,000 in 2003. Dollar for dollar, a taxpayer must reduce the maximum deduction by the amount of Sec. 179 property placed in service during the year in excess of $200,000. While the deduction cannot exceed the taxpayer's taxable income from the trade or business, there is a carryover allowance. Sec. 179(c)(1) requires the taxpayer to specify the items of Sec. 179 property and the portion of the cost of each item to be expensed. Sec. 179(c)(2) states that the taxpayer cannot revoke the election (and any specification contained therein) without IRS consent. "Revoke" includes any modification of the election.

Regs. Sec. 1.179-5(a) requires a taxpayer to make the election on the first return to which it applies, whether or not the taxpayer files the return timely. The taxpayer can also make the election on a timely filed amended return (including extensions). The election is binding for property elected for the election year and all subsequent tax years. Once made, the election is revocable only with the Service's consent. Regs. Sec. 1.179-5(b) indicates that the IRS will consent to a taxpayer's request to revoke the election, including any specification contained in the election, only in "extraordinary circumstances."

Sam Patton, a self-employed welder, reported a Schedule C loss of $36,271 on his 1995 return. On the return, he elected to expense, under Sec. 179, a $4,100 torch. He was unable to deduct this amount in 1995 due to his Schedule C loss. On audit, the IRS determined that he failed to report $135,638 in gross receipts from his welding business. Also, Patton had deducted as "materials and supplies" three items the Service determined were depreciable assets. These items had a combined cost of $13,400. As a result of these determinations, Patton's welding business correctly showed a profit in excess of $17,500.

Patton unsuccessfully requested IRS consent to expense the three items under Sec. 179, arguing that he was not aware that these items qualified under Sec. 179 until the Service reclassified them. As a result, his 1995 deficiency was $26,526, plus a Sec. 6662(a) accuracy-related penalty of $5,305.

The Tax Court reviewed the Service's action under the "abuse of discretion" standard. Under this standard, courts can overturn the IRS only if the action proved "unreasonable, arbitrary or capricious." Under the abuse-of-discretion standard, the burden of proof is greater than under the typical "more likely than not" standard. The court ruled that the Service did not abuse its discretion in denying Patton's request. It found that Patton misclassified depreciable assets as deductible materials or supplies because, in 1995, he could not expense them under Sec. 179, as he reported a loss in that year. Finally, the Tax Court ruled that the IRS's classification of the three items as depreciable assets was correct.

Patton points out the difficulty in challenging the Service's denial of a taxpayer request to revoke or modify a Sec. 179 election. The facts in Patton made it especially difficult, because his return contained errors related to his request to modify the Sec. 179 election. However, it is difficult for a taxpayer to prevail under the abuse-of-discretion standard even without these contributing factors. The taxpayer either will have to rely on the IRS to exercise discretion in his favor or to make a correct Sec. 179 election in the first place. Of course, the latter approach is preferable, even if it requires making the election on an amended return.

From Peter C. Barton, MBA, J.D., CPA, and Roy C. Weatherwax, Ph.D., CPA, University of Wisconsin– Whitewater, Whitewater, WI (neither affiliated with Summit International Associates, Inc.)