This is one installment in our series of articles for business owners. To access the other articles in the series, please click on the following links:
Tax Issues for Business Owners – Travel and Transportation
Tax Issues for Business Owners – Depreciation of Fixed Assets
In this article we will discuss the depreciation of fixed assets, which applies to all business entities.
In 2016, Scott and Jeff created a corporation and began operations for ABC Food Truck Co, Inc., which we will refer to as “ABC Company”. One of the first and largest expenses of the company when starting operations was the purchase of property and equipment (or fixed assets). The owners rented a small office space and needed to purchase furniture for the office. Computers were also needed for both of the owners and any additional employees. In addition, a truck and cooking equipment were also purchased for the business.
When a company buys an asset that will probably last for more than one year, the cost of that asset cannot always be counted as an immediate expense. Rather, the cost is usually spread out over several years in a process known as depreciation. There are different methods of depreciation such as straight-line, where the cost of the asset is deducted evenly over a period of time, or accelerated depreciation, where more of the cost is deducted in the early years of the asset’s life. However, before one decides which method of depreciation they intend to use, there are many other considerations that should be addressed first.
In recent years, the IRS issued the Tangible Property Regulations, which had a drastic impact on fixed assets and depreciation. One of the most significant provisions for small businesses was the De Minimis Safe Harbor (DMSH) election. The regulations essentially created a threshold under which a fixed asset that was purchased could be deducted entirely in the year purchased, as opposed to being capitalized and depreciated over multiple years. The safe harbor amount for companies without audited financial statements or statements submitted to a government entity began at $500, and was subsequently raised to $2,500 effective with tax years beginning on or after January 1, 2016. So, if the de minimis election is made, when ABC Company purchases a computer for $2,000 in 2016, the entire cost of the computer can be expensed in 2016, which results in tax savings in the current year. If ABC Company purchases a desk for $3,000 in the same year, that item would be above the threshold set by regulations and therefore would not qualify for the safe harbor. Also of note is that the $2,500 threshold is on a per item basis. This means that if ABC Company buys two computers for $2,000, and pays the total invoice for $4,000, the company would be allowed to deduct the entire amount in the current year because each item on an individual basis is below the threshold. Because deducting an entire purchase in the current year is most advantageous to the taxpayer, determining if a purchase would fall under this election would typically be our first step in evaluating the tax ramifications of a purchase.
For assets that we have determined do not fall under the De Minimis Safe Harbor rules, one detail that must be determined is the depreciable life of the asset. The IRS has published comprehensive guidance as to the depreciable life of major asset classes, some of which are as follows:
Asset Class | Depreciable Life
Furniture, fixtures, and equipment | 7 years
Computers | 5 years
Automobiles | 5 years
Residential rental property | 27.5 years
Non-residential real property | 39 years
Different methods of depreciation, such as straight-line or accelerated mentioned before, will be applied to these lives and an annual depreciation amount will be allowed as a deduction each year. Your accountant will help you in making this decision.
Another important topic to discuss is the Section 179 deduction. This is a very taxpayer-friendly provision which can allow for a depreciation deduction equal to the entire cost of the fixed asset in the year it was purchased and placed in service. The deduction is limited to $500,000 per year and begins to phase-out when total purchases exceed $2,000,000, and is completely eliminated above $2,500,000. However these limits do not impact the majority of small businesses in most industries. If you have determined that the DMSH election amount does not apply to a purchase, you may still be able to deduct the full cost of the asset in the year purchased. For example, the $3,000 desk purchased by ABC Company would likely qualify for the Section 179 deduction, which is advantageous for the company as it reduces their taxable income in the current year. One important note to remember regarding the Section 179 deduction is that it can only be made to offset taxable income; therefore if the company is in a loss position before the Section 179 expense, then no deduction can be taken. Other complexities may also be involved, including the possibility of carrying over unused Section 179 deductions and what types of specific property qualify for the deduction, but those details are beyond the scope of this article. Please feel free to email us any questions you may have regarding the Section 179 deduction or other items discussed in the article.
Let’s now assume that the company bought a server for $5,000, and that it is not eligible for the De Minimis Safe Harbor election and also is not eligible for Section 179 expense because the company does not have taxable income. Based on the regulations, the asset is to be depreciated over a life of five years. It is important to note for income tax planning purposes that the deduction is not going to be an even $1,000 for each of the next five years. There will often be partial depreciation in the first and last year based on when in the year the item was purchased. But more importantly, there will often be accelerated depreciation (meaning higher deductions in earlier years) and the asset may be eligible for bonus depreciation. In general, if an asset meets certain criteria to be eligible for bonus depreciation, you may deduct 50% of the cost of the asset in the year it was purchased and placed in service.
As a small business owner, reducing taxable income and improving cash flow are important planning strategies, especially in the early years of a business. It is important to analyze the different provisions discussed above to determine how significant asset purchases will be treated for income tax purposes. Due to many taxpayer-friendly regulations, it might be advantageous to plan asset purchases before the end of 2016. This article provides an overview of some of the concepts and regulations related to fixed assets and depreciation to help make this determination. However, many of the items discussed above can become more complicated depending on the purchases being made and the operations of a business. In addition, the above regulations are federal regulations, and the rules and deductions for states can differ. If planning any large purchases, please contact us to help determine which regulations would apply and the resulting impact on taxable income.
