10 N Martingale Rd. Suite 400 60173
Schaumburg, IL
60173 USA

Make Sense For A Change

How to effectively reduce your business taxes

Remember when…Alice fell down the rabbit hole and found that nothing really made sense? Is that how you felt when the only suggestion offered by your accountant to reduce taxes was to buy more equipment? Did you feel like you were spending the proverbial dollar to save a quarter?

For many small business owners, this is the only advice they receive and, sadly, too many choose to follow their accountant’s advice and purchase equipment that is simply not needed in an effort to claim the available “depreciation” deductions. When this advice is followed, you truly are spending a dollar to save a quarter (or less). Similar to Alice’s adventures in Wonderland, this recommendation does not make much sense.

What is depreciation?

While the Internal Revenue Code allows a business to deduct the costs of purchasing an asset, a business is generally not allowed to deduct the full purchase price in the year the asset was acquired. Instead, the deductions are spread over the useful life of the asset. This concept of depreciation is rooted in the accounting principal of matching, which requires that expenses be matched to revenue. In other words, because a piece of equipment will create an income stream for the business, the acquisition costs must be deducted—or depreciated—over the periods in which the equipment generates revenue.

For example, if a manufacturer purchases a machine for $100,000, which will operate for five years, offsetting the company’s revenue by $100,000 in year one would not accurately reflect the current company earnings. Similarly, profit levels in years two through five would not accurately reflect income. Therefore, the concept of depreciation would spread the $100,000 expense across the expected five years of the machine. Under the straight-line method of depreciation, $20,000 of the machine’s cost would be expensed each year.

What is Section 179?

To encourage businesses to acquire capital assets, the government created Section 179. Section 179 allows a taxpayer meeting certain criteria to potentially deduct the entire expenditure in the first year, regardless of its useful life. In 2007, the amount a business can deduct within a single year is $125,000. The amount has increased to 250,000 for 2008, although it will be reduced to 125,000 plus inflation adjustments for 2009 and subsequent years. Although certain limitations apply, a business can deduct the expenditure of the equipment even if the purchase was financed, meaning the company used cash for the purchase.

One pill lowers your taxes

If acquisitions are properly planned, claiming available depreciation and Section 179 can provide a tremendous benefit by lowering taxable income. The resulting tax savings will assist a business in replenishing its cash flow within a year of a large capital expenditure. The amount of the tax benefit will vary and will depend upon the marginal tax rate and the cost of the asset.

For example, let us pretend the amount of the equipment purchased by Alice was $125,000. We will further assume that Alice owns 100 percent of the company, that she does not own any other corporations and that all other limitations and conditions of Section 179 have been met. The tax deduction benefit she receives from her $125,000 expenditure is $125,000 multiplied by her marginal tax rate. If Alice is in the highest tax bracket (35 percent), her tax savings will be $43,750.

This calculation holds true for any tax bracket, and many small and medium-size, closely held business owners may not be near the 35 percent tax bracket, causing their savings to be substantially less. For example, a taxpayer in the 15 percent bracket would save $18,750. The argument does become somewhat circular, as the deduction itself can lower a taxpayer’s marginal bracket.

One pill increases your taxes

In many cases, when you decide to purchase new equipment, it may be to replace outdated equipment. This old equipment is often sold. Unfortunately, though your accountant has recommended that you purchase equipment and deduct the depreciation and Section 179 expense, he or she often fails to tell you about “depreciation recapture.” Depreciation recapture is a provision under the Internal Revenue Code that is triggered when a business asset is sold and depreciation and Section 179 deductions were previously claimed. Essentially, it requires that the difference between the sales price and the asset’s “basis,” or the original cost of the asset less all previously claimed depreciation and Section 179 deductions, to be reported as income.

This comes as a nasty surprise to most business owners since they often assume that because the asset is sold for far less than the original purchase price, no tax will be due. Further, because depreciation offsets ordinary income, the depreciation recapture must be put into ordinary income. Basically, this means the depreciation recapture income will vary depending on the client’s marginal tax rate. Unfortunately, there is not a beneficial rate, such as a long-term capital gain rate of 15 percent, the taxpayer may use.

Again, let us utilize Alice as an example. Her accountant suggests she purchase a new piece of Caterpillar equipment for $125,000. She decides two of her lifts are outdated, as she purchased the equipment years ago for $170,000, though they both have book values of $0. Therefore, she sells them for $60,000. She is pleased because she financed the new piece of equipment thereby reducing her tax liability by $43,750, providing her with an additional $60,000 from the sale.

However, when it comes time for her to file, she discovers that she must recapture the depreciation on this equipment. She must recapture a portion of the depreciation she claimed on the equipment, which adds $60,000 to her income. This amount multiplied by her tax bracket is a significant portion of what Alice saved from her deduction on the purchase. Like the Cheshire Cat, a large portion of Alice’s alleged savings from the equipment purchase has simply vanished.

When you should avoid using Section 179

As previously discussed, aside from the need for the equipment, the recommendation of depreciation deductions and Section 179 to reduce taxes is simply a “Cheshire tax strategy” as the savings may vanish quickly. This is not to say that depreciation deductions and Section 179 deductions should not be properly claimed, but merely to indicate that the associated tax savings should not be the driving force behind an equipment purchase. Instead, business factors such as the additional revenue that may be generated by the equipment, the maintenance costs of current equipment and the current and projected cash flows, for example, should be carefully considered before an asset is acquired.

In our first example, Alice purchased a new excavator for $125,000, which provided tax savings of $43,750 once the Section 179 deduction was claimed. However, unless the business can either generate sufficient additional revenue with the equipment or reduce existing expenses, the business will suffer a net loss. In the worst case scenario, the business owner made a poor decision and purchased unnecessary equipment. This causes the equipment to generate no revenue, and forces the business to receive a net loss of $81,250 ($125,000 in acquisition costs less $43,750 in tax savings).

Even worse, if Alice financed her purchase, she is facing payment periods, including interest, that will interrupt cash flow. So, although she received a current deduction and a potential increase in cash flow due to her decreased tax burden, eventually cash may be tight due to principle and interest payments on this equipment, even though the interest is tax deductible. Additionally, since the business did not need this equipment, it may sit idle, and be more likely to fall into disrepair, requiring more maintenance.

Proper tax planning

Clearly, depreciation and Section 179 deductions are not long-term tax planning strategies. Even in the best of circumstances, attempting to utilize these deductions as tax planning tools may lead to little or no tax savings, or horrific losses in the worst of circumstances. Instead, the available depreciation and Section 179 deductions are merely small aspects that should be considered in conjunction with the business needs when contemplating any equipment purchase.

Perhaps the true misconception with Section 179 is that a single action can provide a magic fix to a taxpayer’s situation. However, proper tax planning involves a careful analysis of the business, the business’ owners, the current and projected cash needs and the implementation of specific long- term strategies designed to reduce federal and state income taxes, payroll taxes, sales taxes, estate taxes and gift taxes. Proper tax planning may focus on implementing available fringe benefit plans, wages versus dividends, accounting methods, tax credits, business restructuring and many other details. Simply put, Section 179 and depreciation deductions do not replace the need for proactive tax planning throughout the year. Planning to reduce taxes through an equipment purchase at the end of the year is similar to drinking tea with the Hatter, the March Hare and the Dormouse.