It is not easy to be a small business owner and be able to purchase equipment or assets every year or even every few years when it needs replacement. While there are not many avenues, which would lend to small business owners, they require some form of a tax cut or subsidy, which can help ease their financial constraints and help them to take their businesses forward.
The taxpayers who are involved in business or trade have many avenues of credits or tax deductions that are not available to individual taxpayers. Since the business taxpayers have to incur additional costs in order to run and operate a business, many of such expenses can be qualified for tax deductions so that the amount of total taxable income can be reduced.
One such benefit that can be availed by the business taxpayers is the accelerated depreciation. The tax code has provided MACRS depreciation from 1986, and it also has other provisions that allow further tax depreciation from the bonus one and the section 179 deduction.
What Is Depreciation?
Depreciation can be defined as the yearly allowance, which is given to the business for the wear and tear, exhaustion, and the obsolescence of its assets. The value of an asset has to be reduced by the allowed amount of depreciation in a given year, even if the taxpayer has not claimed the amount of depreciation for that year.
Most companies invest in assets, find their expected life, and then allocate a certain amount for depreciation as an expense, which is equivalent to the loss in the asset’s value over time. IRS has come up with an accelerated depreciation system under the tax code, which will induce the businesses to invest and to expand their business operations, creating economic growth.
Whether or not these claims are valid, that accelerated depreciation helps to induce demand, business expansion, and growth or investment in the long run. It has, however, encouraged companies to use the time value of money to their advantage. From a tax perspective, companies generally use bonus depreciation, MACRS depreciation, and Section 179 deductions. In doing this, it helps to lower the tax burden of the business today, when the dollar has more value.
What Is Section 179 Deduction?
This is a form of accelerated depreciation. In this form of depreciation method, the taxpayer depreciates the whole cost of the asset in the same year that it is purchased in (subject to certain limitations) rather than waiting for several years for deducting the expense from their taxable income.
It allows the taxpayers who are employed in business to deduct the expense from a particular property when it is placed in service during the year. Section 179 expense has a capping of $500,000, and it also has a phase-out limit of $2,000,000. These limits have, however, recently increased through tax reform to $1,000,000 and $2,500,000. These deductions are applicable for used or for new equipment purchases.
The following property is allowed for section 179 deductions:
- Computer software
- Tangible and personal property
- Qualified improvement property
- Some listed property
Limits Of Section 179 Deduction
There are certain limitations to how and when this form of depreciation can be used for an asset or a property. Mentioned below are specific points:
- The maximum amount, which can be deducted in a given year from the cost of an asset, can not exceed $1,000,000
- The maximum amount of equipment, which can be purchased, and to take the full amount of deduction can be for assets more than the value of $2,500,000
- The equipment has to be placed in use before 31st December 2019
Pros And Cons – Section 179 Deduction
The businesses, which are looking to take benefit from tax benefits and tax savings, find section 179 highly attractive due to its ability to lower the taxable income significantly.
- New Business Start-up Costs
There are several starts up costs involved when a business is just starting its operations. This includes the costs of purchasing computers, machinery, furniture, office equipment, and other long-term assets. If a company has a chance to deduce these expenses in the initial years of its purchase, it will be able to lower down its tax burdens swiftly.
- Makes bookkeeping simple
When a business has the ability to record their asset purchases as an expense in the first year, it reduces the need to capitalize on the asset and depreciate it over the coming years.
- Ideal for high tax brackets
For those businesses, which fall into the top tax bracket, section 179 deductions are a great way to reduce their taxable income. This can result in significant tax savings.
- Property over $2.5 million threshold
Section 179 deductions would end up reducing the total amount of this benefit if you have some property whose value exceeds $2.5 million and is placed in service.
- Partner deduction
Whether you are filling it jointly or separately, this agreement needs to be decided on how it is to be claimed by each spouse, or else it would be split evenly between both partners.
Section 168(K) Bonus Depreciation
Under this depreciation method, the taxpayers are allowed to put their assets into expense, which are brought between September 28, 2017, and 31st December 2022.
Under the Tax Cuts and Job Act, bonus depreciation is no longer 50%, but the entire 100% of the cost of purchases for a qualified property, which is made between the above-mentioned dates. There are, however, specific requirements for the property to be eligible, such as:
- The taxpayer or the previous owner of the property has not used the property at all, before being purchased by the business.
- The property has not been acquired from a related party.
- The taxpayer’s basis of the used asset is not figured in part or whole by reference to the adjusted basis of the property through the transferor or the seller.
- The basis of the used property by the taxpayer is not figured under the provision for deciding the basis of the property, which may be gotten from a decedent.
Is Bonus Depreciation The Same As Section 179?
Sometimes Section 179 and bonus depreciation can be confused with each other; this is because they both have similar purposes. One of the main differences between these two types of depreciation is that section 179, allows a business to expense the purchase cost of the asset immediately, while other forms of depreciation will enable a business to be able to recover the amount of depreciation over a period of time. This means, that section 179 deduction is used at first to reduce the cost of the asset as and when it is purchased, and then the method of bonus depreciation is used for decreasing the remaining amount of the asset over its useful life. Businesses, which go over their required spending, the limit for section 179, can also take advantage of this bonus depreciation method.
Difference Between Section 179 And Bonus Depreciation
As mentioned earlier, bonus deprecation is similar to section 179 as both allow a business to deduct the entire cost of the equipment in the current year in which it is being made of service. The main difference is, however, in the timings, deduction limits, and qualifying property.
Currently, this rule has no investment, no income, nor any limits for the deduction. For a vehicle, however, the limit is $18,000. There is no income limit, on the other hand, and it can be more than the business income, which can result in NOL or a net operating loss. This can be made use in order to reduce the taxable income in the future or can also be applied to the previous year’s taxable income amount. It can be used for the next twenty years and is then canceled after this cut off mark.
Bonus depreciation is used after section 170 has been applied and subtracted from the cost of the asset. This means if a business has bought an asset worth $1,100,000, it can use the section 179 for deducting the first million, and from there onwards, it can use bonus deprecation as 100% to deduct the remaining amount of the depreciation from the cost price. We have mentioned the same in the business scenario example we have mentioned.
- Qualified Property Types
It can be used for tangible property, which has a useful life of at least twenty years maximum. It can also be used for computer software, office equipment, fruit or nut-bearing plants, livestock, or for specific improvements to the inside of a commercial property or a non-commercial aircraft. The useful life refers to the amount of time the asset is expected to last and be used in the business before it becomes obsolete. This is referred to as the recovery period using the MACRS method, and the figure is used for calculating the straight-line depreciation method.
Section 179 Deductions
Currently, under this form of deprecation, the threshold for deduction is $1,000,000 for an investment of a maximum of $2,500,000, and it cannot exceed the business income. For vehicles, the limit is $10,000, and there is a higher limit for heavy vehicles such as SUVs, which is around $25,000. It cannot generate NOL, which can be done in bonus depreciation.
- Qualified Property Types
This can be applied to any kind of tangible property and does not take into account the useful life of the asset. It can also be used to computer software, just like bonus depreciation, and can also be applied to livestock and office equipment. It can also be applied to interior property improvement such as portable air conditioners, check out counters, and storage tanks.
Business Scenario – For Example
We have given below a model through which we can better explain how a business can benefit from using section 179 deductions along with bonus depreciation in order to avail tax savings and use depreciation methods to their advantage.
- Business purchases equipment worth $1,150,000.00 in 2019
- The tax bracket is 35%
First-Year Write Off
In the first year, the write off amount would be
$1,000,000.00 plus $150,0000 in order to completely write off the entire purchase price.
- Using section 179 deduction: The business will use section 179 deduction to write off the maximum amount of depreciation as an expense, which comes out to be $1,000,000.00.
- Using bonus depreciation: Even after writing off $1,000,000.00, there is still some amount left in the purchase price, which the business will write off using a bonus depreciation method, which comes around to $150,000.
This makes the total first-year depreciation amount that the business will write off as $1,000,000.00 + $150,000, which is equal to $1,150,000.00 that is the full purchase price in year one.
Note: Bonus depreciation is used after the section 179 deductions have been made. The maximum amount of section 179 deductions can be a million dollars, and from there onwards, the business can subtract the total 100% cost of the asset. Previously, a company could not do that and was only allowed to depreciate the remaining 50% of the asset cost as an expense. Things have changed, however, and now with the Trump administration, a business has the ability to depreciate the entire remaining cost by 100%.
Cash Savings In 2019
The total cash savings for a business using the above method of depreciation would be $402,500.00. This is when we assume the given tax rate for the year is 35%, as mentioned above. Since the business would subtract the total cost of equipment from their taxable income, it would allow them to have savings in cash by having to pay less tax.
The total amount of depreciation they will subtract from the taxable income is $1,150,000.00 (which is the purchase price of the equipment which is also what the business has completely written off as depreciation).
The tax amount applicable on this income as per 35% is equal to: $402,500.00 ($1,150,000.00 x 35%).
This means the business will reduce $402,500.00 from their taxable income and will thus be paying less amount in taxes.
Equipment Cost After Tax
When the business has decided to write off the entire cost of the equipment in the first year of purchase, they obviously have sufficient cash savings. This means that the total amount that it costed the business in terms of cost of the equipment is actually not the entire $1,150,000.00, but this amount minus the cash savings the business benefitted from, which is $402,500.00.
This means the total cost of the equipment to the business can now be considered as $747,500.00; this is after you have $1,150,000.00 minus $402,500.00.
How Depreciation Worked Before?
In the past, most businesses would buy equipment and other fixed assets for the company and typically writes it off over a period of years, little by little through the process of depreciation. There are different methods of depreciation that the business used, whichever suited them better.
Most of the businesses depreciate an asset over its life, using a straight-line method, which meant dividing the cost of the asset over its useful life, which comes to equal installments that the business would reduce from its initial purchase price over the years. For example, if a company bought machinery for $50,000, which was expected to last ten years, it would typically depreciate it with five equal installments over the five years of its useful life.
This means the business would be deducting $10,000 each year as depreciation for the next five years.
How Depreciation Works Now?
Now, most of the business owners have realized the importance of writing off the entire purchase price of their assets as depreciation in the year in which they purchase it. This is because they have understood the cost savings and the benefits they can gain in this method, plus easier and business-friendly ways and laws that have changed over the years to accommodate this. This is because section 179 deductions allow a business to write off the entire purchase price of your asset in the year you purchase it in the current tax year. This has made a significant impact on businesses and the economy in general.
How Section 179 Affects The Economy?
Thanks to this new and improved method of writing off depreciation for business assets, companies are now more eager to invest in new equipment and machinery, knowing they have tax savings through it.
A lot of businesses have used section 179 for buying equipment in the current year, rather than waiting for things to change. In fact, even the small business owners are also using this method of writing off the entire purchase price. This has given a boost to the overall economy as businesses are investing more in their resources.
Typical Section 179 Mistakes To Avoid
- Not Factoring
While depreciation is an excellent way of having tax savings, but one must also consider what will happen in case the asset is sold in a few years’ time? This is why a business should always factor in depreciation recapture, which is a way of the government of getting the money from the deductions made through depreciation. The recapture can only happen, however, if the proceeds from depreciation are higher than the cost of the asset and it is taxed at the ordinary income rates and not at lower capital gain rates. One of the ways you can avoid making this mistake is through the 1031 exchange. This is only applicable to real property, and it can occur when the proceeds from sales are reinvested into a similar asset. These proceeds can be the same as in 1031, but it also applies to life insurance contracts and annuities. Individuals, as well as businesses, can exchange life insurance contracts, annuities, life insurance for an annuity, but they cannot exchange annuity for life insurance.
- Increasing Income
Bonus depreciation and section 179 are excellent tools for savings on taxes in the current year when the asset is being used in the business. However, if the asset was being used previously for personal uses and has now been converted to business use, it will not be able to qualify.
Section 179 Deductions Or Bonus Depreciation?
At first glance, one would consider that section 179 would be a much more powerful tool for tax provisions as compared to bonus depreciation. While there are limitations to both and benefits to both, most companies have a lot to gain when they use a combination of both. As per the statistics, most of the corporate investment in the American forestry, agriculture, hunting, and fishing sector relies heavily on small businesses that can easily claim the tax benefit of section 179. In other industries, the corporate investment is not really influenced by this form of depreciation, as they are ineligible for section 179 corporations. This means this is an ideal form of depreciation method for small businesses, which are the backbone of an economy and can really help to increase demand, raise investment levels, and eventually, the levels of employment.
There are many forms of accelerated depreciation, which exists. All of these operated under the assumption that expensing the depreciation as quickly as possible would lead to more significant investment in the economy, more incentives, and growth in job opportunities. Section 179 deductions indeed allow the business to expense its assets on an immediate basis, which helps to lower down the after-tax costs of purchasing the asset. This provides them the advantage of a quicker turnaround for their funds and the chance to reinvest the money back in the business.
As mentioned above, section 179 can be a great impetus for growth in the economy since an economy relies heavily on small businesses, and small business owners generally do invest heavily in equipment and fixed assets. They also have limited access to funds, and cost savings in the form of section 179 can truly be a blessing for them. As the small business owners would be able to spend more on equipment, purchase the latest ones, replace their older ones with most recent models, they would be able to spend more money and thus create more jobs, more demand, and eventually, help the economy.