The Internal Revenue Service sets the depreciation allowance based on the Code as promulgated by Congress. The most commonly referenced section is 179. This is a form of accelerated depreciation allowing the small business owner the opportunity to take a large expense deduction and reduce their tax obligation immediately. The maximum allowed deduction is $500,000. To qualify for this deduction the property must pass three tests. First, the property must be tangible for the deduction. Secondly, the property must be for business use. Finally, the property has to be acquired by purchase. See Pub 946 – Chapter 2 http://www.irs.gov/publications/p946/ch02.html for further details. If the property passes all three tests then you may elect this type of deduction. However, there are several reasons you may elect to use another method of tax depreciation.
The first test of eligibility is relatively simple. The property must be tangible personal property. Examples include production equipment, tools, and storage equipment (not storage buildings). The following are examples provided by the IRS:
- Machinery and equipment.
- Property contained in or attached to a building (other than structural components), such as refrigerators, grocery store counters, office equipment, printing presses, testing equipment, and signs.
- Gasoline storage tanks and pumps at retail service stations.
- Livestock, including horses, cattle, hogs, sheep, goats, and mink and other fur bearing animals.
The IRS allows computer software that is off the shelf type software and not internally generated or custom made for your company to qualify. Real estate and structures attached and used for human habitat does not qualify for this deduction.
If the property is eligible then it must also be used in your business operation. If the item is used for personal purposes, it will not qualify. The most common questionable items are home computers, printers, and communication equipment. Of course, the most questioned item is a vehicle. In general, transportation equipment that can be used for personal purposes has a limit of no more than $11,260 for the 179 deduction. In respect to Sport Utility Vehicles, if the gross weight of the vehicle is more than 6,000 pounds and it is a four wheel drive; you may deduct up to $25,000 using Section 179.
The third requirement is complying with the purchase definition. Any inheritance or receiving the property as a gift does not pass the purchase test. Furthermore, to meet the purchase test, you must not purchase the item from a related member such as a parent or spouse.
Now there are stricter rules when it comes to listed property. Listed property is any tangible property that can also be used personally. Such items include computers, printers, automobiles weighing less than 6,000 pounds and cell phones, especially smart phones. Other examples include entertainment based equipment such as TV’s, music systems, and video equipment. The Internal Revenue Service scrutinizes these types of property by having the taxpayer record them in a special section of the depreciation report. In an audit, you will have to substantiate their use as business equipment. If an item seems marginal in nature to you, seek guidance from your CPA.
Remember, at the end of the day, your goal as a business entrepreneur is to pay the least amount of taxes over your lifetime. It isn’t always about this particular year. For a beginning business operation, your lower performing years for taxable income are generally early on. Therefore your tax rate is most likely in the lower rates such as 10 or 15%. You may elect to go with lower deductions and take advantage of the lower tax rates. Using depreciation deferral and utilizing this expense in the future when your tax rates are higher will save you money in overall taxation.
If you plan to sell the asset within a few years, it may not be a good idea to use accelerated depreciation due to the recapture rules. Those rules require you to recapture the excess depreciation you use now and pay ordinary income taxes on the financial amount. You may be in a better cash position now to pay that tax than in the future. Think your decision all the way through including other possibilities.
When using the 179 deduction consider the following aspects of the business decision to help you:
1) Match your cash out and financing of the asset to the depreciation amounts as close as possible.
2) Consider the utility of the asset and its life expectancy.
3) If the asset generates greater margins later in its utility because of the life cycle of the products you make, consider deferring the depreciation to later accounting cycles.
4) Calculate the total taxation of the income generated from the asset based on the expected income for each year at the expected tax rates. Use a spreadsheet to illustrate the possible different total taxation based on the different depreciation amounts.
Section 179 deduction brings the maximum benefit for the small business owner when used during maximum tax rate periods. By reviewing with your CPA the different expected dollar savings you can make the best decisions to benefit you in the long run. Act on Knowledge.