IRS Grants Extension for Tax-Exempt Controlled Entity Election Due to Administrative Oversight

IRS Grants Relief for Missed Election to Avoid Tax-Exempt Entity Status

The IRS granted a taxpayer’s request for an extension to make a late § 168(h)(6)(F)(ii) election, allowing the taxpayer to avoid tax-exempt entity status for depreciation purposes. Section 168(h)(6)(F)(ii) permits a lessee to elect out of the "tax-exempt entity leasing" rules if the property is not predominantly used by tax-exempt entities, thereby preserving MACRS depreciation deductions instead of being forced into the Alternative Depreciation System (ADS). The relief was granted under §§ 301.9100-1 and 301.9100-3, which provide extensions for regulatory elections when reasonable cause exists. This non-precedential private letter ruling (PLR-115239-25) highlights the IRS’s willingness to correct administrative oversights in election filings.

The Taxpayer’s Mistake: A Costly Oversight in Election Documentation

The taxpayer, a C corporation organized under State Z law and wholly owned by Parent, operates in industry X. Parent’s partners include more than 50 percent tax-exempt entities under § 168(h)(2), making the taxpayer a tax-exempt controlled entity under § 168(h)(6)(F)(iii)(I). To preserve MACRS depreciation deductions instead of being forced into the Alternative Depreciation System (ADS), the taxpayer intended to elect out of tax-exempt entity status under § 168(h)(6)(F)(ii).

Parent’s subscription documents and Advisor’s engagement materials reflected this intended election, and the taxpayer provided Advisor with Forms 4562, Schedules K-1, and K-3 from its subsidiary partnerships to support depreciation claims. However, due to an administrative oversight, the taxpayer failed to include the required § 168(h)(6)(F)(ii) election statement in its Form 1120. Neither the taxpayer nor Advisor realized the omission during filing. The error was discovered only later, when confirming tax filings for Parent’s partners.

Why the Election Matters: Depreciation Deductions at Stake

The stakes of the § 168(h)(6)(F)(ii) election hinge on a fundamental choice between two depreciation regimes. Without the election, the default treatment under § 168(h)(6)(F)(i) classifies a tax-exempt controlled entity as a tax-exempt entity for depreciation purposes. This triggers the alternative depreciation system (ADS) under § 168(g), which mandates longer recovery periods and straight-line depreciation—effectively slowing deductions and reducing tax benefits.

ADS applies to tax-exempt use property, a category that includes property leased to or used by tax-exempt entities. Under ADS, nonresidential real property depreciates over 40 years instead of 39, residential rental property over 40 years instead of 27.5, and qualified improvement property over 20 years instead of 15. The system also bars bonus depreciation under § 168(k), a significant drawback in the current tax environment where accelerated deductions are highly valuable.

The general depreciation system (GDS) under § 168(a), by contrast, offers faster deductions through shorter recovery periods and accelerated methods like declining balance depreciation. For example, GDS allows 39-year depreciation for nonresidential real property using straight-line, but with the option of bonus depreciation in eligible years. The § 168(h)(6)(F)(ii) election enables a tax-exempt controlled entity to sidestep the ADS trap and claim deductions under GDS, preserving cash flow and reducing tax liabilities. The election is irrevocable once made and binds all tax-exempt entities holding an interest in the entity.

IRS’s Rationale: Reasonable Reliance and No Government Prejudice

The IRS granted the taxpayer’s request for relief under § 301.9100-3(a), which permits extensions for regulatory elections when the taxpayer demonstrates reasonable and good faith actions and no prejudice to the Government. The taxpayer argued it had acted reasonably by relying on professional advice and exercising diligence in attempting to correct the error. The IRS concluded these requirements were satisfied based on the taxpayer’s prompt discovery of the oversight and the documentation reflecting its intent to make the election.

The IRS emphasized that the taxpayer’s reliance on its advisor constituted reasonable and good faith conduct under § 301.9100-3(a), as the error stemmed from professional guidance rather than negligence. Additionally, the IRS found no prejudice to its interests, as the late election would not impair its ability to assess or collect any tax owed. The subscription documents submitted with the request further supported the taxpayer’s claim of intent to make the election, reinforcing the IRS’s decision to grant the 60-day extension.

Implications for Taxpayers: Avoiding Costly Election Errors

The IRS’s decision in this PLR underscores the critical importance of explicitly including election statements in tax returns to avoid unintended tax consequences. For taxpayers with tax-exempt partners, failing to make the § 168(h)(6)(F)(ii) election—permitting a lessee to opt out of "tax-exempt entity leasing" rules under § 168(h)—can force the use of the Alternative Depreciation System (ADS). ADS, governed by § 168(g), mandates longer recovery periods and bars bonus depreciation, significantly reducing near-term tax benefits. The election must be made on the original return for the taxable year the property is placed in service, and late filings are not eligible for automatic relief under § 301.9100-1.

However, taxpayers who miss the deadline may still seek discretionary relief under § 301.9100-3, which allows the IRS to grant a 60-day extension if the error stems from reasonable reliance on professional advice and causes no prejudice to the government’s ability to assess or collect tax. The IRS’s willingness to grant such relief in this case signals flexibility for taxpayers who can demonstrate good faith and lack of negligence. Still, PLRs are non-precedential, meaning they offer no binding authority for other taxpayers—each case is evaluated on its own facts.

To mitigate risks, taxpayers should document their intent to make elections in subscription agreements or governing documents and verify that return preparers include the election statement. For partnerships or LLCs with tax-exempt members, confirming ownership percentages is essential to determine whether the entity qualifies as a "tax-exempt controlled entity" under § 168(h)(6)(F)(iii)(I). Best practices include maintaining contemporaneous records of property usage to support "predominant use" determinations and consulting tax advisors before structuring long-term leases with tax-exempt entities. As the IRS continues to show leniency for reasonable oversights, proactive compliance remains the most reliable safeguard against costly errors.