Why Depreciation No Longer Exists for Small Businesses

With Congress' passage of the Protecting Americans From Tax Hikes Act of 2015 (PATH), Congress did more than just protect Americans from tax hikes...they eliminated depreciation altogether for most small businesses.  

In PATH, Congress extended Section 179 depreciation permanently, which means that from 2015 until infinity, a business can expense 100% of the cost of most new or used assets in the year of purchase, as long as the cost doesn't exceed $500,000 or the total assets purchased don't exceed $2 million.  

This new law achieves what small business owners have been vying after for some time - that cash spent is directly related to a tax deduction.  

Couple this new law with the repair regs, which allow a small business to elect all expenses $2,500 or less are repairs and maintenance, and Congress has effectively eliminated the need for depreciation to extend over a number of years.  

Think about it: if a small business buys a new computer for $1,000, they can expense it.  If they buy a new x-ray machine for $25,000, they can expense it.  The only time a small business will get into a situation of having to depreciate an asset is if it does not qualify for Section 179 or it costs more than $500,000.  

This is a dream come true for small business owners that live by cash flow and want all of their purchases to translate into tax deductions.  

All I Want for Christmas is Another Bulldozer

Last year I wrote a post discussing the tax benefit of buying a piece of equipment by 12/31.  As I predicted, the depreciation rules were not extended at the end of 2013, and taxpayers marched into 2014 with no provision for bonus depreciation and only $25,000 of Section 179 available.  But, thanks to Congress' call to action with the Tax Extenders bill signed into law December 19th, these great depreciation provisions are back for 2014.  

Although it might not be too late to ring the register on a new capital acquisition for 2014 if you both need and have the funds to purchase equipment or other assets, the following information can help determine the impact bonus and Section 179 depreciation will have on your tax situation for 2014.  

50% Bonus Depreciation

Bonus depreciation permits a taxpayer to expense 50% of the cost of an asset in the first year, plus normal depreciation on the remaining 50%.  Bonus depreciation can only be taken on assets that are new or being used in a new way in the hands of the user.  Simply, a new computer is eligible for bonus, but a used delivery truck that is purchased to be used as a delivery truck is not eligible for bonus.  Bonus is "automatic", meaning that in order to not take bonus on new assets you must classify the asset as "used" or elect out of bonus, which must be done by class life.  Bonus cannot be limited either by income or other factors, and bonus can put the taxpayer into a loss.

Section 179

For 2014, taxpayers can elect to expense 100% of an asset in 2014 using Section 179.  Taxpayer's can elect up to $500,000 of Section 179, but this amount is limited by taxable income and also by the amount of purchases eligible for Section 179 made during the year.  The asset can be new or used.  Section 179 cannot be utilized if the taxpayer does not have a profit, and any elected 179 that is unused is carried forward to future periods.  Once a taxpayer has made $2 million worth of eligible purchases, the amount of 179 available is reduced.  Unlike bonus depreciation, Section 179 is an election the taxpayer must make.  

Special considerations

One of the methods above is not necessarily better than the other, because all taxpayers have different motives.  But there are a few things to consider when accelerating depreciation:

• Depreciation taken now cannot be taken later.  Taxpayers should consider their 2015 income and capital acquisition budget when determining how much accelerated depreciation to take in 2014.  
• Cars are special, especially luxury cars, SUV's or trucks.  The amounts of bonus and 179 in some cases are limited.  
• Cash flow planning is essential.  Utilize credit cards or short-term financing to purchase the asset before 12/31 and pay it off in January or in 2015.  
• Don't purchase new equipment simply to avoid taxes.  If you were planning to purchase the new equipment then do it before 12/31 to take advantage of the depreciation rules.  But remember some deductions do not create a dollar-for-dollar reduction in taxes.

Straight cash

Cash basis taxpayers can make decisions during these last few days of December to improve their tax situation.

Cash basis taxpayers report income and expenses in the year that they actually occurred.  This allows cash basis taxpayers to defer income or accelerate expenses as the situation requires.

Income

Income must be recognized by a cash basis taxpayer when it has been constructively received and is available to the taxpayer.  If a taxpayer receives a check in January for work performed in December, that income is taxable in the next year.  However, if a taxpayer receives a check in December for work performed in December but puts it in a drawer and doesn't deposit the check until January, this is still income to the taxpayer because it had been constructively received and was available in December.  With this being the case, tax basis taxpayers can manage their cash inflows at year-end by sending out bills later to defer collection to next year, or requiring customers to prepay if more cash/income is needed.

Expenses

Expenses can be recognized by a cash basis taxpayer in the year paid or charged.  Yes, you read that correctly, charged.  The IRS will allow charges on a credit card as cash basis expenditures, even if the bill is not paid until the next month.  This provides some wiggle room for businesses that have cash flow concerns at year-end, because they can use a credit card to make purchases instead of cash.

Cash basis taxpayers can also use the end of the year to stock up on capital assets, especially right now due to the expiring Section 179 and Bonus depreciation provisions.

A word of caution: just because an entity is a cash basis taxpayer does not mean that every cash expense is deductible.  All expenses must still be properly substantiated and properly deductible.

Cash basis taxpayers should also consider their business operations when making year-end decisions on spending.  Yes, buying $5,000 of office supplies on New Years Eve will reduce the tax burden on the entity, but will that cash outlay penalize the business operations in January?

All I want for Christmas is a new bulldozer

Beginning in 2010, businesses have been afforded beneficial tax breaks via fixed asset additions and depreciation. These breaks are primarily Bonus depreciation and Section 179 expensing. Absent further action by Congress, Bonus is scheduled to go away and the 179 limits will be greatly reduced after 2013. Taxpayers can make an election to expense 100% of the cost of a new asset in the year of purchase under code section 179 of the Internal Revenue Code.  This method, commonly known as "179", has both cost and income limits.  In 2013, taxpayers can expense up to $500,000 under Section 179.  If the taxpayer's acquisitions exceed $2 million, their allowable expense is reduced and the taxpayer's 179 deduction cannot exceed taxable income for the year.  However, in 2014 the allowable expense drops to $25,000, with an acquisition limitation of $200,000.

Similarly, in 2013 taxpayer's can expense expense 50% of an acquisition up front, and then take normal depreciation on the other 50% for the year.  For example, taking bonus on a $1,000 asset would result in a $500 expense up front, plus regular depreciation for the year on the remaining $500.  It does not matter if the asset is new or used, there are no income or acquisition limits, and bonus can still be taken even if the taxpayer has no taxable income or the depreciation causes the taxpayer to have a net operating loss.  But, in 2014, bonus depreciation will "retire".

Now that we've discussed the rules, take a look at this bad boy.

This is a fine bulldozer made by Caterpillar, one of the largest heavy machinery manufacturers in the world.  Let's say that a taxpayer is in the market for this bulldozer and finds one at their local heavy machinery dealer with a list price of $250,000 (not actual list price, hypothetical only).  We can now look at how making that purchase in December 2013 vs. January 2014 will affect the taxpayer's situation.

If the bulldozer is purchased in December 2013, the taxpayer can either expense 100% of the cost assuming they had < $2 million in total additions and taxable income of at least $250,000, or the taxpayer can expense $125,000 of the bulldozer under bonus depreciation regardless of their other acquisitions and taxable income.

If the bulldozer is purchased in January 2014, the taxpayer will not be permitted to expense any of the addition under 179 because their acquisitions will exceed the limit.  The taxpayer will not be able to take any bonus depreciation either.

In this case, assuming a 39% tax rate, delaying the purchase to 2014 will cost the taxpayer savings in tax dollars of $97,500 if 179 could be taken, or $48,750 if bonus could be taken.

Although it is likely that Congress might pass some kind of extension to these depreciation rules, at this time there is no indication that the rules will be changed.  Taxpayers that have been considering making fixed asset additions, from bulldozers to printers to office furniture, should take advantage of the tax benefits in 2013 while they last.

Bonus

One of the better moves made by Congress at the end of 2012 was to extend the 50% bonus depreciation allowance to 2013. This is a great resource for businesses, but is often confused with its less beneficial counterpart, the Section 179 depreciation allowance. Bonus depreciation allows a business to expense 50% of the original cost (depreciable basis) of a qualified asset in the year of acquisition. The taxpayer can then take normal depreciation on the remaining 50%, beginning in the first year. For example, if a business buys a $5,000 piece of equipment, they can expense $2,500 in the first year plus the normal depreciation on the remaining $2,500. This is why it's called "bonus" depreciation - because you get your normal depreciation, plus a "bonus" of 50%.

Bonus depreciation has benefits that make it more useful than Section 179 in some cases. There is no income limitation, which means a business is eligible to take advantage of bonus depreciation no matter their level of income (or even loss). As a matter of fact, bonus is considered to be automatic, and the taxpayer actually has to elect not to take it. Bonus is also elected by "class life" instead of by specific asset.

Bonus can be helpful because, unlike Section 179, it can be used to reduce taxable income below zero. Using bonus to create a loss can be an especially helpful planning tool for 2013. With the 50% special bonus depreciation allowance slated to go away in 2014, a taxpayer can take advantage of the special allowance in 2013 by making as many planned PP&E acquisitions as possible. By utilizing bonus depreciation, the taxpayer can push their company into a loss for 2013, and the net operating loss (NOL) can be carried forward to 2014 (and future years) and used to offset ordinary income.

In some cases, electing out of bonus is a better decision for a business. For businesses that do not turn over PPE very often and count on depreciation each year to keep their taxable income down, bonus might not be ideal. It will provide a 50% write-off in year one, but the depreciation expense in each subsequent year will be significantly lower. Also, some states (such as my state of Arkansas) do not conform to the same rules as the IRS, which can create a Federal to State difference in depreciation. Although this is not a reason in itself to elect out of bonus, it does require the taxpayer to keep a record of the Fed to State difference in future years.

Thanks to my colleague for suggesting this topic. Have something you want to hear about? Email me.