President Obama signed the “Small Business Jobs Act of 2010” on September 27. I mentioned this previously in my October 9 blog post. One of the things this act does is to extend and increase the amount of equipment that you can write-off in the year of purchase, instead of depreciating it over several years. It is good for the economy and it is good for jobs to encourage these kinds of purchases. We can expect increases in equipment orders, which will help hiring. The businesses buying the equipment will also need to hire people to operate the equipment, or at least increase the hours of existing employees in many cases.
The question I would like to explore today is, once you decide buying new equipment makes economic sense for your business, are you better off taking the tax deduction in the current year or by claiming it as depreciation over several years. The quick answer is: It depends. Let’s look it further by considering a sample case.
Suppose a manufacturing company can get new orders if it buys a new $400,000 machine that is more effective at making custom designed metal parts. The factory wants to make the sale, so it offers low interest terms of 4% -- with 10% ($40,000) down and $4,920 monthly payments that pay off the machine over 7 years. Let’s suppose you know that worst case you could get enough orders to pay not only labor, materials, and other expenses but to have more than enough left over to make the monthly payments. But you don’t have enough for the down payment after you pay your taxes. This is the situation the tax law writers were hoping to help. You save enough in taxes by buying the machine that you can reduce your quarterly estimated tax payments and use that to have the down payment. Then you hire new workers and you pay more taxes on your higher income in the future. You, your workers, the government, and the economy all benefit.
The timing of when you claim the deduction for the machine can make a difference. Let’s look at a simplified example that illustrates the point:
Assume the business is organized as a pass-through entity (such as an LLC or an S corporation), so the business owner pays the taxes for the business as part of his or her personal tax return. Let’s suppose the owner is married filing a joint return and that the owner and spouse together have $200,000 in taxable income per year (but they live on $80,000 after paying taxes and setting aside money needed for working capital to keep the business operating). Lets also assume there are no changes in tax rates for the next 7 years (I know, a big assumption, but we’re trying to keep things simple here) and that there won’t be any long term difference in state taxes either way – so we’ll look at federal income taxes only.
One option is to claim the whole $400,000 in the year of purchase. We can’t use expensing rather than depreciation to create a tax loss, so we will take $200,000 in year 1 and the other $200,000 will carry forward to year 2, completely eliminating federal income tax in both years. In the following 6 years, the business owner will be in the 28% bracket on all taxable income above $137,300, and federal income tax will be $44,243 per year for a total of $265,458 for 8 years.
Another option is to claim standard (called MACRS in tax language) depreciation, which would provide a deduction of $57,160 in year 1, $97,960 in year 2, $69.960 in year 3, $49,960 in year 4, $35,720 each in years 5, 6, and 7, and $17,800 in year 8. These deductions add to the same $400,000, but over 8 years. Applying these deductions to $200,000 in taxable income each year results in federal income tax of $28,238 in year 1, $17,872 in year 2, $24,872 in year 3, $30,254 in year 4, $34,241 in years 5, 6, and 7, and $39.259 in year 8, for a total of $243,218 for 8 years.
The second option results in total federal income tax savings of $22,240 over an 8 year period. Your actual economic benefit would be different for several reasons. Depending on the interest rate you pay to borrow working capital, or the interest rate you receive on reserves you keep for working capital, there is a benefit to paying more tax later in order to pay nothing in the first two years.
There are also a number of variables in the tax law we ignored to keep this example simple that you would have to consider in your own situation. For example, at $200,000 of taxable income you would be subject to partial phase-out of your itemized deductions, if you have children you probably lost the child tax credit, if you have education expenses those were probably eliminated at your income level, etc. You would need to evaluate all of these for your own situation. There might be a benefit in taking more depreciation in one year and less in another to best deal with the timing of how these other tax law provisions interact with the depreciation deduction.
Chances are this exact set of facts don’t look anything like your own. You may be a contractor for whom one crew cab truck would better carry 4 workers and equipment to a job site, with less use of fuel, than multiple trucks would. You may be a service company with a network of computers that would work better if they were replaced. You might be a child care provider that could attract new children with new playground equipment.
Obviously, each situation is unique and individual. My point here is to simply illustrate that it is worth the effort to make the calculation several ways – the decisions you make, along with changes in the law, can make a big difference in the tax you pay over a period of years. And when you are doing the math, also remember there are a lot of moving parts in the tax laws. No matter how hard you try, you are likely to overlook something. Professional help can often save enough in taxes to pay for itself – several times over. We’d love to hear from you!
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I choose topics for my blog posts based on the questions I receive most frequently from you. I appreciate your input! Feel free to comment at http://www.dougbeecherstaxandmoneyblog.blogspot.com/
Important Note! The information in this article is intended to inform you of some of the financial opportunities provided in the tax laws or elsewhere. These laws are very complex and thus this article is not intended to give you specific advice for your personal situation. If you need such advice, please contact a qualified professional.
© 2010, Doug Beecher, MBA, CPA, all rights reserved. This article, either as a whole or in part, may not be reproduced or transmitted in any form without the prior written permission of the copyright holder. When such permission is granted, the user must state that the material was used by permission of the copyright holder.