Dave McCarron’s Appreciation for Depreciation: How Will Changes to Depreciation in the Tax Cuts and Jobs Act Affect Your Business?
Dave McCarron is the founder and president of McCarron Accounting and Consulting CPAs in Winter Park, Florida. He has been serving the Florida community since 1990.
Dave and I recently discussed a very “hot” topic: depreciation. He makes clear that the radical changes to depreciation in the new tax law will have equally radical effects on your business.
Ed: We’re going to talk today about how the Tax Cuts and Jobs Act changed Section 179 deductions and depreciation more generally. But before we jump in too deep, let’s start with the basics. So, Dave, what is a Section 179 deduction?
Dave: Well, Section 179 is a section in the Internal Revenue Code that allows a business to directly expense (that is, deduct) qualified equipment and business purchases to reduce their taxable income.
Ed: So, if my business buys a piece of equipment for $100,000, I can expense that against the gross income of the business for the year that I bought it?
Dave: Correct. Without Section 179, the equipment purchase would be depreciated over a period of time, ranging from, typically, 5 to 15 years. So, in this example, your company would get a tax deduction for that equipment purchase spread out over the next 5 to 15 years, depending on what type of equipment the purchase was.
But Section 179 allows the equipment purchase to be immediately expensed, as long as it fits the definition of “qualified equipment purchase” and the company has enough income for the Section 179 expense to reduce. Unfortunately, Section 179 cannot create a loss. It can reduce taxable income, but if it reduces the taxable income below zero, the excess costs are carried forward to the next year.
And the great thing is that it doesn’t matter if you pay for that equipment in the year of purchase. You could finance 100% of the equipment, have no out-of-pocket costs in the year of purchase, yet depreciate the full equipment purchase price through Section 179.
Changes to Section 179
Ed: That’s a powerful tax benefit! But we’ve been talking about what the law used to be, so I don’t want to get my hopes up too high just yet. How did the new tax law change Section 179?
Dave: Ed, the new tax law made dramatic changes to depreciation in general. But, don’t worry, in my opinion, it’s one of the top tax incentives of the new tax code. Section 179 deductions have been expanded from a $500,000 maximum annual cap to a $1 million annual cap. Additionally, if your company purchases equipment in excess of $1 million, that Section 179 deduction only begins to phase out if your total equipment purchases exceed $2.5 million. That’s only half of the good news.
If you are in a business that purchases more than $2.5 million in equipment, you might be thinking, “I’m not going to get a great deduction. This is no big incentive for me to purchase equipment and expand my business.” But the fact is very contrary to that. If you exceed the equipment purchases that would eliminate your Section 179 deduction, there’s still a 100% bonus depreciation under Section 168(k)!
Ed: Since you brought it up, let’s just talk a little bit about accelerated depreciation versus bonus depreciation. What’s the difference between those?
Dave: Accelerated depreciation is a method to calculate the depreciation expense on equipment purchases that incentivizes the buyer to have a bigger tax deduction in the first few years of life of the equipment. The idea being that you’re going to get the most use out of that equipment, it’s going to be most beneficial to your business, in the first few years. Then after that, you’re not going to be as profitable from that equipment purchase, so the depreciation tails off in later years.
It essentially front loads the deduction through a method called “double declining balance.” You get double the depreciation in the first couple of years and then a lesser amount in the following years. This is different than a Section 179 deduction, which creates an immediate deduction in the year of purchase.
Ed: So, what is bonus depreciation?
Dave: Bonus depreciation is set out in Section 168(k) and deals with equipment purchases in excess of the Section 179 expense cap.
Bonus depreciation is, I think, probably the most radical change to the tax law. In the past, it was limited to 50% of the cost of new equipment purchases that qualified for the bonus depreciation. But with this new tax law, bonus depreciation is available for 100% of the costs of the equipment, and the equipment can even be used. It no longer is required to be a new equipment purchase. The criteria for bonus depreciation are that you cannot have owned the equipment in the past, it has to be “new to you,” and you can’t purchase the equipment from a related party.
The equipment that qualifies for the bonus depreciation has also been expanded. Now you can depreciate the improvements to leasehold property, as long as the leased property qualifies, and there is a very simple criterion for that: The lease premises have to have been used in the past by somebody. It doesn’t have to have been used long, but it can’t be a new building that you’re improving. Any interior improvement to a building that is not a structural improvement and not an expansion of the building will qualify for immediate depreciation under the bonus depreciation in Section 168(k). That’s a radical change from what we’ve had in the past.
If you think about it, there’s really unlimited depreciation available for new equipment purchases. That’s really a radical change from what we’ve seen in the past.
Ed: You said a few minutes ago that Section 179 deductions couldn’t create a loss. Can bonus depreciation create a loss?
Dave: Bonus depreciation can create a loss!
Again, I don’t know if you want to go this deep, but with the new tax code, there’s a pass-through deduction that is limited to your taxable income. If you have $100,000 taxable income and then you buy a piece of equipment for $100,000, bringing your taxable income down to zero, it may or may not be the best thing to do. If you have zero taxable income, you may have lost the ability to reduce your taxable income by a 20% deduction under the new tax code.
Ed: You’re referring to the Qualified Business Income Deduction, correct?
Dave: Yes, the Qualified Business Income Deduction, which is also known as the “pass-through deduction.” You have to take a lot of extra planning now to consider the effects of that equipment purchase on the current year’s taxable income and tax deductions, as well as on future years’ taxable income and tax deductions.
Ed: If I buy $100,000 of equipment, and I am able to take a $50,000 Qualified Business Income deduction, can I elect to have a $50,000
Section 179 deduction for that equipment and then take the other $50,000 in some form of depreciation?
Dave: Absolutely. You can make the election to take Section 179 deduction or to take bonus depreciation, or to take normal accelerated depreciation, or even sometimes it’s more beneficial to take a straight-line depreciation and to not use the accelerated depreciation methods.
Ed: It seems like this new structure will definitely require careful planning ahead of time.
So, for small- and medium-sized businesses, which do you think is more important, Section 179 or Bonus depreciation?
Dave: For small businesses that are going to be purchasing under $1 million of equipment or leasehold improvements per year, Section 179 is going to be adequate as a tool to reduce your taxable income. If your company is purchasing over $2.5 million, the additional bonus depreciation is going to give it an unlimited ability to write off equipment purchases directly from taxable income.
Effects on Mergers and Acquisitions
Ed: Let’s switch gears a little bit. Let’s say someone is thinking of buying a business. If you buy a business that has a significant amount of equipment and hard assets versus soft assets like goodwill, would Section 179 or bonus depreciation allow you to write off a substantial portion of the purchase price in year one so that even though that the business made money, you would have a very low tax bill in that year?
Dave: Yes, purchasing a business that has a substantial amount of equipment can make a deal work or not work, because depending on how the purchase price is allocated between goodwill, non-compete agreements, customer lists, or hard assets—equipment, buildings, or other tangible equipment—that asset purchase allocation is going to determine what the buyer can immediately depreciate and how much he can reduce his taxable income in the year of purchase.
Again, the buyer doesn’t have to pay for the full purchase of the business in the first year, but he would be eligible for the deduction. You have to really consider, “How are we going to allocate that purchase price,” and “When are we going to negotiate that with the seller.”
Ed: I see. So, it’s critical more than ever to establish the allocation of the purchase price at or before the closing. It seems to me, to some extent, a zero-sum game for the seller, meaning that the seller wants to recognize as much as possible as goodwill, but the buyer wants as much as possible allocated to tangible assets and as little as possible to goodwill, right?
Dave: That’s exactly right. Generally, what’s good for the buyer is bad for the seller, because if the seller has a high value attached to the equipment, they’re going to have a higher tax bracket, because they’re going to pay what’s called ordinary income tax rates on their depreciation recapture. Generally, the seller is motivated to inflate the goodwill and reduce the value attached to the tangible property. The buyer is incented for just the opposite.
Now you know that there are exciting changes in the new tax code that can truly benefit your business. But you also realize that it is vital that you carefully weigh these complex tax considerations beforehand. By seeking out advice from professionals, you will ensure that you take full advantage of these tax benefits.
Make sure to stay tuned to our future newsletters for more information and updates on how your business may be affected by the new tax laws.
We would love to speak with you more about your business needs and learn how we here at Alexander Abramson can help you grow and manage your business.
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