Small Business Taxes & Management

Special Report

Overdoing Depreciation Deductions


Small Business Taxes & ManagementTM--Copyright 2021, A/N Group, Inc.




There are a number of ways to deduct the cost of equipment. Generally, you can't expense the cost of a new truck, machine tool, etc. in the year purchased. You've got to depreciate the item over a number of years. But there are several special rules (usually to encourage capital investment and equipment spending) that allow a much quicker writeoff, often in the year of purchase. In addition you can expense assets with a life of one year or less.

Writing off the full purchase price in the year of acquisition means you save tax dollars for that year and boost your cash flow. That's a big advantage. For example, assume your S corporation purchases a truck for $50,000. (Remember profits and losses of S corporations, partnerships, LLCs, are passed through to the owners and taxed on their personal return.) If you pay cash you're out $50,000. If you write off the total cost in the same year, and you're in the 30 percent bracket (federal and state), you'll save $15,000 in taxes in the year of purchase. (More if you're in a higher bracket; less in a lower.) Of course you've traded that immediate saving for deductions in subsequent years, so over the life of the truck your tax savings from depreciation even out.

Things would be simple and we could end the discussion here if it were not for the fact that few business owners, are in the same bracket every year. That creates some tax planning opportunities and some pitfalls.


Basic Depreciation Rules

We'll review the depreciation rules briefly here. We're only reviewing the points needed for this discussion.

Simple Expensing You just bought a new printer for the office for $1,750. Do you have to depreciate it? If the invoice amount is $2,500 or less you can simply deduct the full amount in the year of purchase. You need a written policy of expensing small items and you have to use the same method for non-tax purposes. For example, financial statements you show suppliers, partners, a bank, etc. If you qualify, this is the cleanest approach. You avoid many of the issues discussed below. As a result, unless there's a compelling reason not to, you should adopt this method for small items.

Section 179 Expense Option More rules, but bigger writeoffs. Under this rule you can elect to expense up to $1,050,000 (2021; indexed for inflation; SUV limitation $26,200). For example, you purchase a backhoe for $65,000. If you so elect, you can expense the entire amount in the year of purchase. There's a net income limitation, but if you exceed it the amount can be carried forward to subsequent years. Check the rules for your state. Some have retained the old maximum expense amount of $25,000 or some other limitation. This option requires making an election on Form 4562 (depreciation) but is only slightly more complicated than simple expensing.

Bonus Depreciation Normally assets are depreciated over a number of years. For example, five years for computers, seven for office equipment, many assets are classified by industry. For example, assets used in agriculture (machinery and equipment used in the production of crops, etc.) get a seven year life. Assets used in businesses that provide personal or professional services have a five-year life. While a taxpayer can elect to use slower depreciation, the usual approach is an accelerated system where more depreciation is taken in the first few years.

From time-to-time Congress has provided for special "bonus depreciation". Generally it's been 50-percent and 100-percent bonus on qualifying property. In the 2017 tax act, provision was made for the 100-percent rate to decline over time. It's currently 100 percent but will drop to 80 percent for property placed in service in 2022, than to 60 percent for property placed in service in 2024. There are two more drops, to 40 and 20 percent and then to 0. With 100 percent bonus depreciation you can deduct as depreciation the full amount of the cost in the year the asset is placed in service. With 80 percent you can only deduct 80 percent up front; the remaining 20 percent is depreciated over the life of the asset. You can opt out of bonus depreciation, but you must do it by class of property. Not every state follows the federal rules on bonus depreciation.


Making the Most of the Depreciation Rules

Cash Flow Benefits Most articles in magazines and newspapers advise taking as much depreciation as possible upfront such as taking the 100-percent bonus depreciation or Sec. 179 option. That's because you'll get a big tax deduction up front and the tax savings will improve short-term cash flow. There's no question that's true but that's not the end of the story. There are other factors that you've got to take into account.

We're assuming that your business is operating as a sole proprietorship, S corporation, partnership etc. Most small businesses use this approach. Income and losses from these entities are passed through to the shareholders/partners/owners and added to their personal returns. Regular (C) corporations pay tax on their own and it's now at a flat rate.

Tax Rates and AGI Dependent Benefits You'd like to get the most use out of any deduction and the higher your tax bracket, the more tax savings. Ideally you'd like to take the depreciation when you're in the highest brackets. That could mean spreading the depreciation deduction into later years. You've got to have some idea of what your income will be in the future. If you anticipate it to be much higher, spreading the deduction makes sense. If the current year is unusually good, take the deduction this year.

There are ways to create the best results. You can immediately write off a portion of the purchase using Sec. 179 and elect to use slower depreciation on the rest of the asset.

Your adjusted gross income (AGI) should be taken into account. For example, the interest deduction on student loans, the lifetime learning credit, the child and dependent care credit, and the American Opportunity Tax Credit (for college tuition) are phased out as your AGI increases. There are others. The benefits vary. Trying to stay below the phaseout limits might result in important tax savings. That's particularly true for the American Opportunity Tax Credit if you have more than one child in college.


Potential Traps

Depreciation Recapture What the tax man giveth, the tax man can taketh away. When you sell or trade in that truck, machine tool, etc. you might have to recapture some or all of the depreciation you took. For example, you purchased a truck for $60,000 and fully depreciated it. You now sell it for $28,000. The entire $28,000 is ordinary income. Now assume you took only $20,000 in depreciation by the time of sale and sold the truck for $28,000. Your basis in the truck would be $40,000 ($60,000 less $20,000) and you would have an ordinary loss on the sale of $12,000 ($40,000 less $28,000).

The problem here is that the depreciation recapture can occur at the wrong time. One taxpayer bought two trucks for $75,000 each and took the Sec. 179 expense option. The $150,000 deduction brought his income down to near zero for that year. But in the following year he sold one of his retail locations and the trucks were included in the sale. The sale of the operations alone put him in the 35 percent bracket and the $150,000 in Sec. 179 expense had to be taken into income at the higher rate. He saved taxes at a lower rate and paid them back at a higher one. The direct opposite of good tax planning.

In the past you might be able to postpone recapture by trading in the truck, tractor, etc. for a new one or related equipment. It's technically a like-kind exchange. By doing multiple tradeins, you could defer the recapture years down the road, possibly to a time when you'd be in a lower bracket. The 2017 tax law change now allows like-kind exchanges only on real property. That might not be so bad if you buy new equipment and write off the cost in the same year the old equipment is sold. You can still avoid the problem if you purchase property at least equal to the gain on the property sold and use Sec. 179 or bonus depreciation in the same year. For example, you sell a backhoe with a $40,000 gain on December 1, 2021. As long as you purchase property for at least $40,000 you can expense or take bonus depreciation on by December 31, 2021 you'll have an offsetting expense. If the property isn't purchased until the following year, you'll pay tax on the gain in 2021 and get a deduction in 2022. (Technically, the property has to be "placed in service" by December 31. That means available for use in the intended service. Ask your tax adviser for details.)

Net Operating Losses and Startups In some situations, where your income is already low, taking a large writeoff for equipment purchases can create a net operating loss (NOL). In prior years you could carry back the loss for two years, offsetting income in those years. That's generally no longer the case. (There are exceptions for farming losses.) Net operating losses can be carried forward indefinitely. A similar situation can occur in startup companies. These situations demand more careful tax planning. To minimize taxes you've got to have a clear idea of your taxable income going forward. In most situations that's difficult to do. In some cases it may be better to spread the depreciation deduction over a longer period of time, in some cases take it all at once and use the NOL to spread the loss forward. Talk to your tax advisor.

No Longer Business Use If the asset is no longer used in the business, you might have to recapture some depreciation. While this is a topic for an article in itself, there are some traps to watch out for and discuss with your tax advisor. For example, Madison Inc. purchased a truck for $50,000 in 2021. You wrote off the entire truck that year. In 2025 you convert the truck to personal use. That tax consequences are similar to a sale. In the case of a car (or other listed property) if the business use drops to 50 percent or below, it will trigger depreciation recapture. The recapture is the difference between the depreciation (or Section 179 expense) taken and slower ADS depreciation.

Basis Problems and Owner Differences Many small businesses organized as S corporations, LLCs or partnerships pay out much if not all of their income in salaries and distributions to owners. In addition, the original capital contributions may be small. The purchase of a significant amount or even a single large piece of equipment can trigger problems.

For example, Madison Inc. buys a piece of construction equipment for $250,000. Madison only puts up $30,000, financing the rest of the purchase with a $220,000 loan. Madison can write off the entire $250,000 in the year of purchase using bonus depreciation. But Fred only put up $10,000 when he started the company and earnings in the past have all been distributed to him. Normally Madison has $100,000 of cash flow that's paid out to Fred. In the year of purchase the company has the cash (the equipment was largely debt financed) and makes the usual $100,000 distribution. But the company reports a loss for tax purposes of $150,000 because of the equipment writeoff.

Two things have happened. First, Fred can't take the whole loss created by the equipment purchase because he doesn't have enough basis in Madison. That unused loss can be carried forward and used in subsequent years. Second, the distribution is in excess of Fred's basis by $100,000. It's as if Fred sold his stock and has a $100,000 gain and will have to pay tax on it. The example here has been grossly simplified. But the traps are real. You may be able to easily avoid them, but you'll have to talk to your tax advisor before the end of the year.

A similar situation can occur with a partnership, but the tax consequences are even more complex.

Owner differences are another consideration. If you have two or more owners in a S corporation, partnership, etc., they may have very different tax situations. For example Sue and Fred (both single) are both civil engineers and own a construction company. Sue is independently wealthy and doesn't really work for the company. Since she doesn't materially participate in the business, the losses don't reduce her taxable income. They can be carried forward and used to offset income in future years. Fred gets a small salary because they're trying to build the business. He may not be able to utilize the losses because of his low income.

Assume the facts are the same but Sue is active in the business. She can reap the benefit of the losses while they won't save Fred much at all. There are often ways to equalize these situations, but you've got to do some tax planning.

Leasing Leasing, rather than buying is one way to avoid some of the pitfalls. It must be a true lease, not one where you get to purchase the equipment at the end of, say 5 years, for a nominal amount. Leasing vehicles makes sense, particularly if you normally replace the equipment at the end of a couple of years. Equipment leases can also be attractive, but the imputed interest costs can be high.


Bottom Line

Small equipment purchases, particularly those you turn over regularly, most likely won't require careful scrutiny, at least from a tax standpoint. However, if the equipment purchases during the year are significant relative to your pretax income, it would make sense to pass it by your tax advisor. You don't want to end up in a situation you'll long regret for a hour or two consulting fee.


Copyright 2021 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 10/25/21