Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 79-20

1979-1 C.B. 137

Section 312

IRS Headnote

Earnings and profits; corporate member of partnership; excess accelerated depreciation. The computation of the earnings and profits of each corporate member of a partnership is subject to the adjustments under section 312(k) of the Code, and each corporate member is required to restore to its share of partnership earnings the excess of accelerated depreciation over straight line depreciation.

Full Text

Rev. Rul. 79-20

ISSUE

In computing earnings and profits is a corporate member of a partnership required to increase its share of partnership earnings by excluding the excess of accelerated depreciation over straight line depreciation, in accordance with section 312(k) of the Internal Revenue Code of 1954?

FACTS

On January 15, 1977, two unrelated corporations, each separately engaged in a manufacturing business, entered into an agreement. The corporations agreed to construct and become equal owners of a factory to produce and sell a product. The factory commenced operation in June 1977 and under the agreement each corporation shares equally in the capital, operating costs and profits of the business. The foregoing business arrangement is a partnership for federal income tax purposes.

The partnership taxable income for 1977, computed using an accelerated method of depreciation, was 1,000x dollars. The partnership taxable income for 1977, if computed using the straight line method of depreciation would have been 1,400x dollars. Each corporation's distributive share of partnership taxable income was 500x dollars. Each corporation's distributive share of partnership taxable income would have been 700x dollars, if computed using the straight line method of depreciation.

LAW AND ANALYSIS

Section 312(k) of the Code provides that for purposes of computing the earnings and profits of a corporation the allowance for depreciation shall be deemed to be the amount that would be allowable for such year, if the straight line method had been used.

Section 312(k) of the Code (originally section 312(m)) was enacted by section 442 of the Tax Reform Act of 1969, 1969-3 C.B. 10, 92. (Section 1901(b)(32)(B)(i) of the Tax Reform Act of 1976, 1976-3 (Vol. 1) C.B. 1, 276, redesignated former section 312(m) of the Code as 312(k), effective for taxable years beginning after December 31, 1976.) Congress, in considering the Tax Reform Act of 1969, reconsidered the tax treatment generally accorded accelerated depreciation allowed to corporations under the Code. Prior to the enactment of section 312(k), a corporation's earnings and profits were generally computed by reference to the method of depreciation used in computing the corporation's taxable income. Consequently, corporate earnings were reduced dollar-for-dollar by the amount of depreciation deducted by the corporation on its return, whether by the straight line method or if an accelerated method was elected, by that method. Since sections 301(c)(1) and 316(a) of the Code define a dividend as a distribution of property by a corporation to its shareholders out of either current or accumulated earnings and profits, a distribution in excess of such earnings of the corporation is a so-called "tax-free" or "return-of-capital" dividend under section 301(c)(2). The availability of accelerated depreciation deductions to reduce earnings available for distribution to shareholders was found by Congress to be directly related to the increasing "phenomenon" of tax-free dividends in several industries. Congress felt these tax-free distributions "constitute an improper tax benefit to shareholders which is generally unrelated to the purposes for which accelerated depreciation deductions are made available to corporations." H.R. Rep. No. 91-413, 1969-3 C.B. 200, 284. The Congressional solution to the problem, section 312(k), was drafted to provide that only straight line depreciation, or its substantial equivalent, will be permitted in the computation of corporate earnings and profits.

There is no evidence in the legislative history of section 312(k) of the Code that Congress intended to curb the tax-free dividend abuse only as it applies to accelerated depreciation taken on property owned directly by a corporation. Rather, the adjustment required by section 312(k) is intended to apply in any case in which accelerated depreciation is a factor in the determination of a corporation's earnings and profits.

The situation sought to be corrected by section 312(k) of the Code is presented by the instant situation. The amount of the excess of accelerated over straight line depreciation has the effect of understating total earnings available for distribution to shareholders. This is exactly the situation to which Congress intended that section 312(k) apply.

HOLDING

Accordingly, the computation of the earnings and profits of each corporate partner is subject to the adjustments under section 312(k) of the Code and each corporate partner in computing its earnings and profits for 1977 is required to take into account its share of partnership earnings by excluding the excess of accelerated depreciation over straight line depreciation. Thus, for the earnings and profits computation of each corporate partner, its share of partnership earnings should be 700x dollars.