Preface: Control your expenses better than your competition. This is where you can always find the competitive advantage. -Sam Walton
Spending on Equipment and Saving on Taxes
Credit: Jacob M. Dietz, CPA
Do you like to save on taxes? Most taxpayers do. Do you enjoy having the right equipment for the job? In some cases, taxpayers get the double blessing of purchasing the right equipment to run their business and sending in less taxes to the government. Although “depreciation” might sound like a boring word, the tax savings are not boring. Working hard with the right equipment does not have to be boring either.
Business taxpayers depreciate, or expense, fixed assets on their tax return. Certain things that businesses buy, such as expensive equipment, buildings, and so on, cannot simply be written off as an ordinary expense. Instead, it must be capitalized as an asset, and then expensed as depreciation. This depreciation is normally over a period of years. In some cases, the IRS allows the business to deduct it all in one year using bonus depreciation or section 179 expense.
Normally a business has a depreciation schedule that lists their fixed assets, when they bought it, what it cost, how much is being depreciated this year, and so on. Often the tax preparer maintains this schedule.
The complexity of depreciation could put some to sleep and irritate others. This article will not dive into all the details but cover certain areas of depreciation. For further information, or for help falling asleep, consider reading all 112 pages of IRS Publication 946 “How to Depreciate Property.”
In Service
Taxpayers should place property in service before depreciating it. IRS Publication 946 explains that it is in service “when it is ready and available for a specific use.” The “Farmer’s Tax Guide”, which is Publication 225, gives the example of a planter purchased in December. Since the planter was “ready and available” depreciation starts in December even though it is not planting season and the planter will not be used until spring.
The “Farmer’s Tax Guide” goes on to explain that if the planter was not assembled when it arrived, and the farmer does not assemble it until the next year, then depreciates starts in the year it is assembled. If you are still awake after reading IRS Publication 946, consider reading the 94 pages of the “Farmer’s Tax Guide” to help with insomnia.
Determining which year to start depreciation can sometimes be difficult. Another problem that can arise is a taxpayer might order a piece of equipment in one year, but it does not arrive until a future year is already well underway. In that situation, the equipment most likely is not ready and available for service in the year ordered. If you are counting on the depreciation from a large purchase to reduce your taxes, considering confirming with your accountant before the year is over to see if your equipment will qualify. If you are a taxpayer in Pennsylvania, and your equipment is sailing across the Atlantic from Europe on December 31st, then it probably is not ready and available for service. If your business is either fishing or recovery of sunken treasure, however, the answer may be different.
Getting in a Pattern
If your business operates multiple pieces of equipment that periodically wear out, you may want to consider a purchasing pattern. For example, suppose your business operates 5 forklifts. You expect them to last about 5 years. One option would be to buy 5 new forklifts every five years. That could put a strain on the finances in that 5th year. It could also give you a large depreciation deduction in that year.
Alternatively, you may want to develop a pattern of replacing a forklift about once a year. That would spread out the cash needs. It would potentially allow you to optimize the depreciation deduction each year. If you happened to have a bad year, you could consider delaying, if possible, the purchase until the next year when the tax deduction might be more helpful, and when you might have more income. On the other hand, if you were having an exceptionally good year, you might choose to accelerate your pattern and buy 2 forklifts in the same year.
Bonus Depreciation and 179 Expense
Although depreciation can take years, and in some cases decades, for the taxpayer to expense their costs, the tax code provides some taxpayer-friendly ways to accelerate the deduction. One is section 179 expense. Another is bonus depreciation. I will not go into all the complexities and details and differences of these two options, but I will say they can be very beneficial for a taxpayer looking for a quick tax deduction. Not all purchases qualify, however. If you are hoping to take bonus depreciation or to expense under section 179, you may want to talk with your accountant before the year ends and confirm if your property qualifies.
Election to Capitalize Repair and Maintenance Costs
The IRS provides an option to capitalize repair and maintenance costs. If a taxpayer elects to do so, they may capitalize and depreciate repairs and maintenance instead of expensing them as a repairs and maintenance. Why would a taxpayer make such an election? There could be multiple reasons. One reason would be to increase their income for that year and reduce it in future years with depreciation expense when the expense would be more helpful.
For example, suppose a business had a rough year and income is down. The business expects profits will pick up in the future. The business owner may see limited benefits of getting his income too low this year, but the owner might benefit more from the deduction in a future year. This election allows the owner to do that. If in the future the taxpayer is in a higher tax bracket, then each dollar of deduction might save more in taxes in the future.
De Minimis Safe Harbor Election
Have you ever studied a depreciation schedule? If so, perhaps your eyes glazed over. Now, imagine if that depreciation schedule were twice as long. That could be a challenge to track.
Fortunately, the IRS has a de minimis rule for amounts too trivial to worry about. Taxpayers can elect on their tax return to deduct certain amounts without capitalizing and depreciating them. The amounts that are considered de minimis can vary. $2,500 is a common threshold used.
How does that work? Suppose a business taxpayer buys a generator for $2,000 that will last for 5 years. Under the general rules of depreciation, that generator should be capitalized and depreciated. If the taxpayer is using the $2,500 de minimis safe harbor, however, then the taxpayer deducts that generator without ever putting it on the fixed asset schedule. Over a period of years, this threshold can keep a lot of de minimis tools from cluttering the depreciation schedule.
Tax Planning
Depreciation can play a significant role in tax planning. If a taxpayer had a good year, then the tax bill might be enough to cause a significant dip in the checking account. Placing equipment in service by the end of the year can significantly decrease taxes if section 179 or bonus depreciation is taken.
Caution should be exercised, however, before simply buying equipment to save on taxes.
First, will the purchase qualify for bonus depreciation or section 179 in the year you wish it would qualify? Sometimes an asset will not qualify for reasons such as what type of asset it is, or when it was placed in service, or from whom it was purchased. For example, the code prohibits taking section 179 expense on purchases from certain related parties.
Secondly, you will spend more money on equipment than you save in taxes. The exact percentage you pay in taxes will vary depending on multiple factors, including your level of income and the state in which you reside.
Let’s suppose someone is in a 30% tax bracket for federal, state, and local income tax combined. Suppose their accountant estimates their taxes for them in December, and the projected tax causes concern. What can be done? The business taxpayer could rush out and buy equipment costing $10,000. In that case, they just saved $3,000 (30% of $10,000) and they spent $10,000. The net result is decreased cash of $7,000. If the taxpayer doesn’t have a use for that equipment, then that could be a waste of $7,000. On the other hand, if the taxpayer had a good use for that equipment, then they essentially received $10,000 worth of equipment for an effective price of $7,000.
If you run a business that purchases significant amounts of equipment, then you are probably already aware of the benefits of both having the right equipment and depreciation. Buy wisely and depreciate wisely. Enjoy working hard with your new equipment and enjoy the tax savings from depreciation.
Proverbs 21:5 “The thoughts of the diligent tend only to plenteousness; but of every one that is hasty only to want.”
This article is general in nature, and it does not contain legal advice. Contact your advisors to discuss your specific situation.
