IRS Code 291: Corporate Preference Item Rules

Internal Revenue Code Section 291 establishes special rules that reduce certain tax benefits for corporations. These provisions are designed to ensure that corporations with significant tax preference items still pay a minimum amount of tax. The rule targets specific deductions and the tax treatment of certain income, effectively decreasing the value of these tax advantages for a specific class of taxpayer.

The function of this section is to limit the ability of corporations to substantially lower their tax liability through congressionally provided incentives. By designating certain deductions as “preference items,” the code requires a mandatory adjustment, which either reduces a deduction or recharacterizes a portion of a capital gain as ordinary income. The adjustments are not optional and apply automatically when a corporation engages in transactions involving these preference items.

Entities Subject to the Rule

The regulations under this section of the tax code apply exclusively to C corporations. C corporations are treated as separate taxable entities from their owners, filing their own income tax returns and paying taxes at the corporate level. This separate legal and tax status is the primary reason they are the focus of this rule.

In contrast, pass-through entities are not directly impacted. This group includes S corporations, partnerships, and LLCs that elect to be taxed as partnerships. For these entities, income and deductions are not taxed at the business level but are instead “passed through” to the owners’ individual tax returns, making the corporate-level adjustments inapplicable.

An important exception exists for S corporations that were previously C corporations. If an S corporation was a C corporation within the three immediately preceding tax years, it may be subject to these rules. This provision prevents a C corporation from avoiding the preference item adjustments by simply changing its tax status shortly before a transaction that would trigger the rule.

Corporate Tax Preferences Affected

A primary target is the gain realized from the sale of depreciable real property, known as Section 1250 property. This category includes buildings and their structural components, such as apartment buildings and office buildings. When a C corporation sells this type of property for a gain, the rule recharacterizes a portion of that gain into ordinary income, which is taxed at higher rates than capital gains.

Another preference item involves percentage depletion for certain minerals. Corporations in the business of extracting iron ore or coal are permitted to claim a deduction for depletion, which represents the exhaustion of the mineral reserves. This rule reduces the allowable percentage depletion deduction for these specific minerals, targeting the amount of the deduction that exceeds the adjusted basis of the property.

Intangible drilling costs (IDCs) are also subject to these corporate preference rules. IDCs are expenditures made by an oil or gas operator for wages, fuel, repairs, and supplies necessary for drilling wells. For integrated oil companies, the rule mandates that 30% of these otherwise deductible IDCs must be capitalized and amortized over a 60-month period rather than being fully expensed.

Mineral exploration and development costs face similar adjustments. These are costs incurred to ascertain the existence, location, or quality of any deposit of ore or other mineral. Like IDCs, the rule requires that 30% of these costs be capitalized and amortized over a specific period, reducing the immediate tax benefit. Financial institutions are also impacted through a reduction in the deduction for interest expenses related to carrying certain tax-exempt securities.

Computation of the Required Adjustments

When a C corporation sells depreciable real property at a gain, the adjustment recharacterizes a portion of that gain as ordinary income. The amount is calculated as 20% of the excess of what would have been ordinary income if the property were Section 1245 property over the amount treated as ordinary income under standard recapture rules. This effectively treats 20% of the straight-line depreciation claimed as ordinary income upon sale.

To illustrate, consider a C corporation that sells a commercial building for $1,000,000. The corporation’s original cost for the building was $800,000, and it has claimed $300,000 in straight-line depreciation. The adjusted basis is therefore $500,000, and the total gain is $500,000. The corporation must calculate 20% of the depreciation claimed, which is $60,000. This $60,000 of the gain is treated as ordinary income, with the remaining $440,000 treated as a Section 1231 gain.

For percentage depletion related to iron ore and coal, the adjustment is a direct reduction of the deduction. The excess of the percentage depletion deduction over the property’s adjusted basis at the end of the year is calculated. This excess amount must be reduced by 20%, which means the corporation loses a portion of the tax benefit.

The computation for intangible drilling costs and mineral exploration costs is a percentage reduction of the amount that can be immediately expensed. For integrated oil companies, 30% of the IDCs that the company elected to expense must instead be capitalized. This capitalized amount is then deducted ratably over a 60-month period, beginning in the month the costs were paid or incurred. The same 30% capitalization rule applies to mineral exploration and development costs.

For financial institutions, the adjustment targets the interest expense deduction related to holding certain tax-exempt bonds. The amount of interest expense that is allocable to the debt used to purchase or carry these obligations is determined. The rule then mandates a 20% reduction in the amount of this otherwise allowable interest expense deduction.

Reporting Adjustments on Tax Forms

The required adjustments are integrated into the standard forms used for corporate tax returns. The recharacterized gain from the sale of depreciable real property is reported on Form 4797, Sales of Business Property. A corporation must calculate the ordinary income portion of the gain and report this amount in Part III of the form, with the remaining portion of the gain reported in Part I.

When a corporation must reduce its deductions for mineral depletion or amortize costs, these adjustments are reflected on the main corporate income tax return, Form 1120. For example, the reduced percentage depletion deduction would be entered on the line for depletion. The unallowable portion of the deduction is simply not claimed.

For intangible drilling costs and mineral exploration costs, the 70% of costs that are still eligible for immediate expensing are deducted in the current year. The remaining 30% that must be capitalized is not deducted immediately. Instead, the amortization deduction for the first year of the 60-month period is calculated and included on the appropriate line for amortization, requiring the corporation to track the schedule over five years.

Financial institutions report their reduced interest expense deduction directly on their tax returns. The total interest expense is calculated, the portion allocable to carrying the specified tax-exempt obligations is identified, and that allocable amount is reduced by 20%. The final, reduced interest expense deduction is what is entered on the return, which directly increases the corporation’s taxable income.