IRS May Lengthen Depreciation Schedule for Ethanol Plants—But Relief is Possible

The Internal Revenue Service may rule that taxpayers lengthen the term of depreciation on first-and second-generation ethanol plants, and understanding the proposal will be key for the industry.
By Adam Thimmesch and Lisa Pugh | November 11, 2009
The Internal Revenue Service issued a proposed revenue ruling earlier this year under which taxpayers will be required to depreciate ethanol plant property over seven years, rather than five. This change will have a negative financial impact on ethanol producers that do not place their plants in service prior to the effective date of the final revenue ruling—which, as of today, is unknown.

Producers who build cellulosic biomass ethanol plants however, maybe able to take advantage of a federal bonus depreciation allowance that would mitigate the financial impact of the IRS' proposal.
The financial impact of this bonus depreciation allowance is materially greater than the impact of the lengthened depreciation schedule. Producers eligible for the bonus-depreciation allowance should continue to focus on ensuring that they qualify for that benefit.

Requirements
On Aug. 24, the IRS issued Notice 2009-64, which provides a proposed revenue ruling regarding the depreciation of ethanol plants. Under this proposed ruling, the IRS would require taxpayers to depreciate tangible property used in converting corn to fuel grade ethanol over seven years.

The IRS has indicated this ruling will be prospective only—and will apply only to ethanol plants placed in service after the final revenue ruling is published. Comments on the proposed ruling were accepted by the IRS until Nov. 23. The date of the final revenue ruling is unknown.

Depreciable Life of Ethanol Plants Extended
Historically, producers have depreciated ethanol plant assets over five years. This ruling would thus extend the life of those assets and generally reduce yearly deductions granted to taxpayers. This could have a significant financial impact on producers whose ethanol plants are not placed in service prior to the effective date of the final revenue ruling. (Under terms of the proposed revenue ruling, producers currently depreciating ethanol plant property over five years will not be affected.)

This lengthened depreciation schedule will have a very real impact on producers that place ethanol plants in service after the proposed revenue ruling is finalized. For a $75 million facility, this would cost a producer over $1 million in present dollars (assuming a 5 percent discount rate and a 40 percent tax rate). See Table 1, (all illustrations assume double-declining balance and mid-year conventions). This loss represents a 3.7 percent reduction in the tax benefits realized from the depreciation deductions. (At a 3 percent discount rate, producers would see a 2.3 percent reduction in tax benefits. At a 7 percent discount rate, this reduction would climb to 4.97 percent.)

Producers should be aware of this potential negative financial impact and adjust their construction timelines or financial projections accordingly.

Special Considerations for Cellulosic Ethanol Producers
The IRS' proposed revenue ruling is specifically directed toward "the depreciation of tangible assets that are used in converting corn to fuel grade ethanol." It is thus not technically directed at ethanol plants that use cellulosic biomass materials rather than corn. It appears reasonable to assume, however, that the IRS will apply this ruling equally to those plants as well. The proposed ruling is based on the IRS' classification of the ethanol plant property as property "used in the conversion of refuse or other solid waste or biomass to heat or to a solid, liquid, or gaseous fuel." This classification appears to encompass ethanol produced from cellulosic biomass to the same extent that it encompasses ethanol produced from corn. Cellulosic biomass plants, however, may not face the full brunt of this change due to federal bonus depreciation that may be available for those plants.

The potential negative financial impact of the proposed ruling may be mitigated for cellulosic biomass ethanol plants placed in service prior to Jan. 1, 2013. In 2006, Congress adopted a bonus-depreciation provision under which producers who place such plants in service prior to Jan. 1, 2013, may be allowed to depreciate the plant 50 percent in the first year if the property was acquired by purchase after Dec. 20, 2006, (and no written binding contract for the acquisition of that property was in effect on or before that date). This bonus depreciation is granted in addition to the normal depreciation allowed in the first year.

This bonus-depreciation provision significantly frontloads the depreciation allowances and thus mitigates the effect of depreciating the remainder of the plant over the new, extended period. The effect is to reduce the cost of moving from the five-year depreciation schedule to the seven-year depreciation schedule by 50 percent. (Because 50 percent of the cost is depreciation in the first year, the time-value effect of the elongated depreciation schedule is reduced by half.) The net loss on the hypothetical $75 million facility is thus reduced to $509,549. Table 2 illustrates this effect.

Producers who have already factored the bonus-depreciation allowance into financial projections for a project will take no small comfort in the allowance's mitigating effect on the cost of the extended depreciation schedule. As Table 2 shows, the proposed revenue ruling still imposes a 1.77 percent loss of the anticipated tax benefits from the depreciation deductions. Even at a 3 percent discount rate (rather than the 5 percent rate used above), the extended depreciation schedule will cause a 1.13 percent loss of tax benefits—or $329,344 on a $75 million facility.

The cost of losing bonus depreciation outweighs the cost of an extended depreciation schedule.

Unfortunately, the mitigating effect of the bonus-depreciation provision is temporary. The current provision applies only to facilities placed in service prior to Jan. 1, 2013. After that date, producers would be required to use the seven-year depreciation schedule without the offsetting effect of the bonus depreciation (unless, of course, Congress extends the bonus-depreciation provision or implements a new program with similar results).

Given the great benefit of the bonus-depreciation allowance, it should not be surprising that the costs to a producer of failing to qualifying for that benefit outweigh the costs of the proposed revenue ruling. As Table 3 shows, the cost of losing the bonus-depreciation allowance on a $75 million facility would be more than $1.7 million, which is more than three times the $509,549 cost (shown in Table 2,) of moving to the seven-year depreciation schedule from the five-year schedule and is more than 6 percent of the tax benefit that would have been realized if the facility had qualified for the bonus depreciation (again, assuming a 5 percent discount rate). Under the five-year depreciation schedule, the cost to a producer of failing to qualify for the bonus depreciation would have been "only" 4.3 percent. The proposed revenue ruling thus increases the cost of failing to qualify for the bonus depreciation by roughly 40 percent (from 4.3 percent to 6 percent). On a $75 million facility, this represents a loss of more than $500,000.

What Can Producers Do?
Producers who are currently constructing, or considering constructing, an ethanol plant will be affected by the IRS's proposed revenue ruling.

To mitigate or control the costs of this proposed ruling, producers should consider adding or modifying timing incentives to their construction contracts to ensure facilities are placed in service prior to the relevant dates (either before the effective date of the final ruling, if possible, or before the bonus depreciation allowance expires, if applicable). The increased cost of failure to meet these dates may warrant adjustment of any incentive already offered.

Producers should also focus on the availability of the bonus-depreciation allowance and consider lobbying—or joining industry groups that to lobby—Congress to extend or expand this provision. EP

Lisa Pugh is a partner with international law firm Faegre & Benson LLP as a member of its tax practice. Reach her at LPugh@faegre.com.

Adam Thimmesch is an associate with international law firm Faegre & Benson LLP as a member of its tax practice. Reach him at AThimmesch@faegre.com.