Understanding the New   Depreciation Deductions

By Jim Gante, CPA
Small Business Manager

The Economic Stimulus Act of 2008 includes two valuable changes that allow much faster depreciation deductions for business assets, including most software.

In the current slowing economy, businesses may be reluctant to invest in new equipment and vehicles. But the new tax breaks, along with current low interest rates, provide a golden opportunity for financially healthy manufacturers to add or replace business assets. If your company is paying high federal income taxes, these deductions might result in Uncle Sam helping to foot the bill.

However, there are some important considerations to take into account so your company can make informed decisions about the best time to buy equipment, software, vehicles and other assets.

The Expanded Section 179 Deduction

Thanks to the Economic Stimulus Act, larger Section 179 depreciation deductions are allowed for qualifying new or used assets placed in service in tax years beginning in 2008.

Specifically, the new law almost doubled the maximum Section 179 deduction to $250,000 (up from $128,000). For 2009 to 2010, however, the maximum deduction will revert back to $125,000 (plus inflation adjustments) unless Congress takes further action.

Under Section 179, many small and medium-sized businesses can write off most or all of the cost of qualifying assets in the year they are placed in service -- rather than writing them off over several years under the regular depreciation rules. Most depreciable business assets (other than real estate) qualify for the Section 179 deduction. It can also be used for large SUVs, with a gross vehicle weight rating of more than 6,000 pounds, but the maximum Section 179 amount that can be claimed for these vehicles is $25,000.

First-Year Bonus Depreciation

You may remember 50 percent first-year bonus depreciation from a few years ago. Under the Economic Stimulus Act, it's back -- but only for new qualifying assets that are acquired and placed in service during calendar year 2008 (the placed-in-service deadline is extended through the end of 2009 for certain long-lived assets). Used assets do not qualify.

Under first-year bonus depreciation, your business can immediately deduct half of the cost of a qualifying new asset if it's purchased and placed in service before the deadline.

Qualifying assets include most types of tangible personal property used by your company, as well as new cars and light trucks that are used more than 50 percent for business. Some leasehold improvement costs also qualify.

As you can see, the new law has created a tax-saving opportunity for businesses that are able to take advantage of both the Section 179 deduction and 50 percent first-year bonus depreciation. These two breaks can be combined to offset a big chunk, or maybe all, of a company's taxable income for the year.

Example: Your calendar-year corporation adds $800,000 of new equipment and software that qualifies for both the Section 179 deduction and 50 percent first-year bonus depreciation. Assuming there's no problem with the Section 179 income limitation, the corporation can first claim a $250,000 Section 179 deduction. Next, it can claim a 50 percent first-year bonus depreciation deduction of $275,000 ($800,000 minus $250,000 equals $550,000 times .50 equals $275,000). Finally, the corporation can write off the remaining $275,000 of depreciable cost ($800,000 minus $250,000 minus $275,000 equals $275,000) over several years under the regular depreciation rules

That's the good news. But you should understand the potential consequences to make the best decisions. Here are five considerations that may come into play with the depreciation deductions:

1.

 The Impact of Lower Write-offs in Future Years. Let's say your business adds equipment and software now in order to claim bigger first-year depreciation write-offs. One side effect of this strategy is that your business must forego claiming depreciation deductions in future years. That's fine if you believe your business will not face significantly higher tax rates in future years. In that case, taking advantage of the deductions now makes sense from an anticipated-tax perspective and from a time-value-of-money standpoint.

On the other hand, if you expect significantly higher tax rates in future years, you may be better off waiting until later to add equipment and software. The resulting depreciation write-offs could save your business more than they would now.

2.

 Cash Flow Implications. Your business will obviously have to spend or borrow to take advantage of the larger Section 179 deduction and 50 percent bonus depreciation. While bigger tax write-offs are beneficial, it's inadvisable to take unnecessary financial risks to get them. Instead, consider all cash flow and financial implications. It's also possible that future tax depreciation write-offs might turn out to be worth more than those claimed this year.

3.

 The Section 179 Phase-Out Rule for Larger Businesses. A business that buys a great deal of assets that would otherwise qualify for Section 179 deductions can lose part or all of the deduction under an unfavorable phase-out rule. Specifically, the maximum Section 179 deduction is reduced dollar for dollar by the amount of qualifying assets in excess of a phase-out threshold for the year. For tax years beginning in 2008, the new law generally increased the phase-out threshold to $800,000 (from $510,000). For 2009 to 2010, however, the phase-out threshold will revert back to $500,000 (plus inflation adjustments) unless Congress takes further action.

If your business might be affected by the phase-out rule, take this factor into account before acquiring extra equipment or software. Otherwise, your deduction might be smaller than expected.

Example: Your corporation adds $940,000 of new and used equipment during 2008. Due to the phase-out rule, your Section 179 deduction is reduced to only $110,000 ($250,000 maximum Section 179 deduction reduced by the $140,000 excess over the $800,000 phase-out threshold). If you were expecting the full $250,000 write-off, you will be disappointed.

4.

 The Section 179 Income Limit and the Impact of Pass-Through Entities. Annual Section 179 deductions are limited to the amount of taxable income that is derived from the taxpayer's active conduct of business activities (calculated before Section 179 write-offs). In other words, your

Is your company paying expensive insurance premiums to carry equipment that has no value or serves no purpose? Consider: Suspending insurance on idle or seasonal equipment. Auditing your insurance policy for non-existent equipment. Evaluating equipment values. What is the cost of replacement versus the cost to insure the property? Caution: Before dropping insurance, make sure the equipment is not being used as collateral for a loan. Lenders generally require coverage on items used as collateral.

business cannot use Section 179 deductions to generate an overall taxable loss for the year. Deductions that are disallowed under this rule are carried forward to future years. Helpfully, individual taxpayers are allowed to count wage and salary income as active business income for purposes of the taxable income limitation.

If you own an interest in a pass-through entity (a partnership, multi-member LLC, or S corporation), you need to know that the Section 179 deduction dollar limit ($250,000 for tax years beginning in 2008), the phase-out threshold ($800,000 for tax years beginning in 2008), and the taxable income limitation all apply at both the entity level and again at the individual owner level. Therefore, what happens in a pass-through entity can affect the amount of Section 179 deductions that you can write off on your return. For this reason, advance planning may be required to take full advantage of Section 179.

5.

 State Rules. Not all states allow the larger Section 179 deduction and 50 percent bonus depreciation. So your business might be able to claim a big deduction for federal tax purposes, but the amount allowed for state income tax purposes may be lower.

Conclusion: There's no doubt that the new tax breaks provide a golden opportunity for financially healthy businesses that are paying high current income taxes. However, each business is unique and it is important to examine all the tax angles.

(For more information about the depreciation write-offs, click click here to read our previous article, "Combine Deductions for a Real Tax-Saving Windfall.")

If you have questions about this topic, please contact Small Business Manager Jim Gante, CPA at 717-757-6999 or 800-745-8233, or send Jim an email by using the form below.

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