Section 179D Tax Deduction Claimed in Final Year – Houston Tax Attorneys

Architects and engineers who design energy-efficient government buildings can qualify for a Section 179D tax deduction. Technically, it is the building owner who qualifies, but since the government is the owner of the building and does not pay tax, our tax law allows the allocation of the deduction to the designer. This allocation provides an incentive for designers to take on government building projects.

This allocation raises some interesting questions, such as what year the allocated deduction is available. Designers often work on multiple buildings for the same client or project, and the work typically spans several years. So can the designer simply claim the tax deduction on their current year return–perhaps in the year that the final building for the project is completed? The court in Cannon Corp. v. Commissioner, No. 23-XXX (2d Cir. Feb. 18, 2025), recently answered this question.

Facts & Procedural History

The taxpayer in this case designed energy-efficient buildings for government clients between 2006 and 2011. As the designer, was allocated the Section 179D tax deductions that would normally go to the government building owners. After successfully claiming these deductions on an amended return for 2006, the taxpayer failed to claim approximately $3.9 million in Section 179D deductions for buildings placed in service from 2007 through 2010 on its originally-filed income tax returns.

Instead of filing separate amended tax returns for each year, the taxpayer reported all of the deductions at once on its 2011 tax return. It did this by reporting the deduction as an accounting method change on a Form 3115. The IRS audited the tax return and issued a notice of deficiency denying the Section 179D deductions. The taxpayer challenged this determination in tax court, but the court granted summary judgment for the IRS. This appeal was from the tax court case.

About the Section 179D Deduction

Section 179D allows owners of commercial buildings to deduct the cost of energy efficient commercial building property. This is for property placed in service during the tax year. The amount of the tax deduction is calculated based on a formula that considers the building’s square footage and energy cost reductions.

Specifically, the deduction amount starts at $0.50 per square foot and can increase up to $1.00 per square foot based on the building’s energy efficiency. The rate increases by $0.02 for each percentage point by which the building’s total annual energy and power costs are certified to be reduced by more than 25 percent. For certain qualifying properties, these base amounts can be increased to $2.50 per square foot (up to $5.00 per square foot) if prevailing wage and apprenticeship requirements are met.

The energy efficient improvements must be to one or more of three specific building systems:

Interior lighting systems
Heating, cooling, ventilation, and hot water systems
Building envelope

These improvements must be certified as part of a plan designed to reduce the building’s total annual energy and power costs by 25% or more compared to a reference building that meets minimum efficiency standards. The certification must be performed by qualified individuals using approved software.

As noted above, there is an allocation rule that can apply to government-owned buildings. Since government entities cannot use tax deductions, they can allocate the deduction to the person primarily responsible for designing the property. This allocation makes the designer “the taxpayer” for purposes of claiming the Section 179D deduction. Eligible government entities include federal, state, and local governments, their agencies and instrumentalities, Indian tribal governments, and other tax-exempt organizations.

One challenge presented by this Section 179D allocation is determining who qualifies as the “designer” of the energy-efficient commercial building property. Only the designer is eligible to claim the deduction when the property is owned by a government entity. The courts addressed this in United States v. Oehler, 9 F.3d 1538 (2d Cir. 1993), for a designer who installed and identified additional fixtures for replacement, but did not create the technical specifications for the lighting systems. The architects and engineers retained provided the designs, and the taxpayer’s role was limited to implementation. Because the taxpayer merely installed the systems rather than designing them, the court held that it was not entitled to the deduction as they were not the designer for purposes of this tax deduction.

When to Report Section 179D Deductions?

Another aspect of this allocation that is challenging is that the designers do not control when the property is placed in service–the government entity does. While designers may complete their work well before the building systems are operational, IRS Notice 2008-40 states that designers may only claim the deduction in the tax year that the government places the property in service.

This timing rule creates practical challenges. Designers may not know exactly when the government places the property in service. Even when they do know the placed-in-service date, they might not learn about their ability to claim the Section 179D deduction until after they have filed their tax return for that year. This raises the question of how to claim the deduction for prior tax years.

One approach taxpayers have tried is to treat missed Section 179D deductions as an accounting method change. A change in accounting method typically involves changing when an item of income or deduction is reported – essentially shifting the timing between tax years. Under Section 481 of the tax code and its regulations, a material item qualifies for accounting method change treatment only if it involves the proper time for including an item in income or claiming a deduction.

Section 179D Deduction for a Prior Year a Method Change?

One might think that taking a Section 179D deduction for a prior year is an accounting method change. An accounting method change typically involves changing when an item of income or deduction is reported–essentially shifting the timing between tax years. Under Section 481 of the tax code and its regulations, a material item qualifies for accounting method change treatment only if it involves the proper time for including an item in income or claiming a deduction.

However, the regulations clarify that an accounting method change cannot permanently alter a taxpayer’s lifetime income. Instead, it must merely affect the timing of when income or deductions are reported. For example, changing from the cash to accrual method shifts when income and expenses are recognized but does not permanently change the total amount reported over time.

This brings us to the court case. The Second Circuit agreed with the tax court that Section 179D deductions do not qualify as an accounting method change. The court noted that these deductions permanently reduced the taxpayer’s taxable income rather than merely shifting the timing of deductions between years. This is due to the Section 179D deduction. Unlike building owners who might accelerate depreciation deductions, designers receive a one-time allocated deduction that permanently reduces their tax liability.

The Second Circuit also found that Revenue Procedure 2011-14, which the taxpayer cited, did not authorize designers to use the accounting method change procedures. While this guidance included some filing instructions for designers, it never explicitly permitted them to report prior year Section 179D deductions as accounting method changes.

The Role of Amended Returns and Statutes of Limitations

The designers do have a few ways to deal with this situation. As noted in this case, the proper procedure for claiming missed Section 179D deductions is to file amended returns for the specific tax years when the buildings were placed in service. The time for filing an amended return is limited by the general three-year statute of limitations for filing amended returns under Section 6511.

It was this timing limitation that prevented the taxpayer in this case from filing an amended return for 2007. The statute of limitations had expired. However, the taxpayer did file “protective” amended returns for the 2008-2010 tax years that were filed within the limitations period. While the court did not directly address these amended returns, they likely preserved the taxpayer’s ability to claim deductions for these years. This is the way that designers can proactively report these deductions when they are not certain as to whether they will be allocated the tax deductions and in what year the property will be placed in service.

The Takeaway

This case shows that Section 179D tax deductions allocated to designers must be claimed in the tax year when the energy-efficient property is placed in service. These deductions cannot be claimed in later years through accounting method changes because they permanently affect taxable income rather than merely shifting the timing of deductions between years. Designers who may qualify for this deduction should consider filing protective claims with the IRS in the years that the properties could have been placed in service. This can help preserve the deductions if the property is placed in service in one year, but the allocation is not made until a later year.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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IRS Cannot Assess Foreign Information Return Penalties – Houston Tax Attorneys

Many businesses today have some international transactions. Many U.S. businesses even have operations in foreign countries–which may include ownership of entities, operations, or just sales.

Our tax laws include several provisions that require U.S. taxpayers to report most of these foreign business interests and activities. These filings are mostly made by filing various information returns.

Failing to file these information returns can result in significant penalties. The U.S. Tax Court had concluded that the IRS does not have the authority to assess these penalties. An appeals court did not agree. The issue came back before the U.S. Tax Court in Mukhi v. Commissioner, 4329-22L (Nov. 18, 2024), which again asks whether the IRS can assess these penalties or must pursue them through district court litigation.

Facts & Procedural History

The taxpayer in this case created three foreign entities in 2001 through 2005. This included a foreign corporation.

From 2002 through 2013, the taxpayer failed to file Forms 5471 to report his ownership interest in the foreign corporation. After the taxpayer pleaded guilty to criminal tax violations, the IRS assessed $120,000 in penalties under Section 6038(b)(1). That’s a $10,000 penalty for each year the taxpayer failed to file the returns.

The IRS then attempted to collect the penalties. It issued a notice of intent to levy and filed a federal tax lien. The taxpayer challenged these actions in the U.S. Tax Court, arguing that the IRS lacked authority to assess these penalties in the first place. As we’ll get into below, while the U.S. Tax Court initially ruled for the taxpayer based on its Farhy v. Commissioner, 160 T.C. 399, 403-13 (2023), decision, the D.C. Circuit reversed Farhy. See Farhy v. Commissioner, 100 F.4th 223 (D.C. Cir. 2024). The IRS filed a motion to reconsider based on the appeals court’s Farhy decision. That led to the current opinion reconsidering whether the IRS has assessment authority for these penalties.

To understand the significance of this case, it’s helpful to first understand the Form 5471 reporting requirements.

About the Form 5471 Information Return

Section 6038 requires U.S. persons to file information returns to report their ownership or control over certain foreign corporations. This is done by filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.

Form 5471 requires detailed information about the foreign corporation, including its ownership structure, financial statements, and various transactions with related parties. The form must be filed with the taxpayer’s annual tax return.

Different filing requirements apply based on the category of filer:

Category 1: U.S. shareholders of specified foreign corporations
Category 2: Officers and directors of foreign corporations with U.S. owners
Category 3: U.S. persons who acquire or dispose of significant ownership
Category 4: U.S. persons who control a foreign corporation
Category 5: U.S. shareholders of controlled foreign corporations

Those who trigger these provisions have to pay attention to these requirements. The penalties for non-compliance can be substantial. This is particularly true given how many different categories of persons must file the form.

The Section 6038 Penalties

The IRS has a number of tools at its disposal to “encourage” taxpayers to voluntarily comply with filing requirements. Civil tax penalties are one such tool.

Congress has created a number of different penalties related to foreign transaction reporting. The FBAR reporting requirements for foreign bank accounts are probably the most notorious as they are often extremely large.

For the Form 5471, there are two distinct penalties for failing to file. First, Section 6038(b)(1) imposes a $10,000 penalty for each annual accounting period. This penalty can be increased by $10,000 per month (up to $50,000) if the failure continues after IRS notification. Second, Section 6038(c) reduces the taxpayer’s foreign tax credits by 10%. This reduction increases quarterly if the failure continues, potentially eliminating all foreign tax credits for the unreported corporation.

Both penalties can be avoided if the taxpayer shows reasonable cause for the failure to file. The standard reasonable cause defenses apply. We have covered many of them on this site before, such as reliance on a tax advisor, honest mistake, etc.

The IRS Assessment Authority Question

With these penalties in mind, we can now turn to the key issue in Mukhi: whether the IRS can assess these penalties directly or must pursue them through court action.

The term “assessment” refers to the recording of a tax balance on the IRS’s books. It is what creates a balance due by a taxpayer that the IRS can collect.

The IRS’s authority to assess penalties is found in Section 6201(a). This provision allows the IRS to assess “all taxes (including interest, additional amounts, additions to the tax, and assessable penalties).” The question in this court case is whether Section 6038(b)(1) penalties fall within this authority.

The U.S. Tax Court analyzed this issue by comparing Section 6038(b)(1) to other penalty provisions that explicitly state they are assessable. The Court found that unlike those other provisions, Section 6038(b)(1) contains no language suggesting Congress intended these penalties to be assessable. Without explicit authority, the U.S. Tax Court held the IRS must pursue these penalties through district court litigation.

But What About Farhy?

The U.S. Tax Court’s analysis, however, isn’t the end of the story. The previous D.C. Circuit decision in Farhy reached the opposite conclusion.

The appeals court in Farhy held that the IRS could assess these penalties. That appeals court focused on Congressional intent and administrative efficiency, reasoning that requiring district court litigation would make the penalties “largely ornamental.”

However, under the Golsen rule, the U.S. Tax Court follows the precedent of the circuit court where appeal would lie. Since Mukhi would appeal to the Eighth Circuit (not the D.C. Circuit), and the Eighth Circuit hasn’t addressed this issue, the U.S. Tax Court was free to follow its own analysis rather than Farhy.

This creates different results depending on where taxpayers reside. Those in D.C. Circuit states face immediate IRS assessment, while those in other circuits may get the procedural protections of district court litigation.

For taxpayers facing these penalties, the IRS can no longer simply assess and begin collection actions in most circuits. Instead, the Department of Justice must file suit in district court. This gives taxpayers additional procedural protections and opportunities to raise defenses before paying.

The Takeaway

For the time being, the U.S. Tax Court’s decision creates different procedures depending on where taxpayers reside. Outside the D.C. Circuit, the IRS must pursue these penalties through district court litigation rather than immediate assessment and collection. This gives taxpayers additional procedural protections and opportunities to raise defenses. However, the penalties themselves remain substantial – only the collection process has changed. Taxpayers should continue to prioritize compliance with foreign information reporting requirements to avoid these penalties entirely.