The current depreciation system used for all assets placed in service after 1986 is Modified Accelerated Cost Recovery System (MACRS), which divides asset working lives into periods of 3, 5, 7, 10, 15, and 20 years. Assets, which are required to be depreciated, are those items that are expected to last more than a year.
For the businessperson, depreciation has two sides: a positive side and a negative one. The positive side is that necessary equipment (and buildings and other assets) is considered a tax write-off, reported on IRS Form 4562. The negative side is that the Internal Revenue Service dictates that asset purchases can’t be totally written off at once (with some subtle exceptions, which will be discussed shortly).
“Basically, depreciation deals with items that the IRS considers a capitalized asset,” says Gary Capata, CPA, of Capata & Company in Laguna Nigel, California. “Whereas with things like supplies, rent or legal fees you’d get a full deduction, things like equipment you have to allocate over its projected life. If it costs under $250, the IRS usually doesn’t care about depreciating it.”
Depending on a company’s financial situation, a large investment can hurt in up-front expense, and prolonging the write-off is like sprinkling salt on a wound. Capata recalls the straits some of his clients have passed through because of this tax code.
“Where it hurts a lot of my clients is when they’re paying out so much cash, but can’t recoup the cost for years,” says Capata. “They shell out $40,000 for equipment; now they have a $40,000 asset, but they only get to write off $8,000 that year. They’re paying tax on that other $32,000.”
There is relief found within the code, however. In an effort to stimulate the economy by encouraging the purchase of more fixed assets, Congress enacted Section 179. This proviso allows businesses to take a maximum dollar amount the same year in which assets were purchased, known as “expensing.”
According to Russell Tollefson, a CPA in Redding, California, the maximum amount allowed under Section 179 has gone from $18,500 in 1998, to $19,000 last year, and will eventually reach $20,000.
“That’s the key choice,” says Tollefson, “whether you want to expense it in the first year, or choose to depreciate it over the next five, seven, or ten years. What normally happens in 90-plus percent of the time, the choice is to take the expense deduction.”
No wonder, as with any tax-paying company, shifting tax benefits to earlier years sounds like a winner. But, as with any tax code, there is a proviso within the proviso. Businesses that purchase more than $200,000 worth of assets may see their limits slashed to zero. With any company involved with heavy machinery and complex operations, such as the irrigation industry, this amount is often easily surpassed before the third quarter.
In the case of assets exceeding a maximum depreciation write-off of $19,000, it makes sense to take the full depreciation deduction instead of expensing. For example, a contractor who purchases equipment totaling $100,000 with an expected life of five years can take a deduction of $20,000. Also, expensing under Section 179 guidelines means taxes are reduced for the current reporting year, but what of future years? In maximizing the expense deduction for asset purchases, the option of deducting depreciable amounts in future years doesn’t exist. With this in mind, it’s easy to see the advantages of depreciating equipment over expensing it.
Less obvious benefits for taking full depreciation on equipment are seen in financial reports. Without taking full depreciation on equipment, management is unable to accurately make well-informed purchasing and operational decisions. Accumulated depreciation affects the balance sheet, income statement (profit and loss), break-even analysis, and other critical reports.
Consider the piece of equipment that originally cost $40,000 when you purchased it two years ago. Its working life is five years, meaning that, using a straight-line depreciating method, it depreciates $8,000 a year. On the books for that item, accumulated depreciation should be $16,000 after two years. If only partial depreciation is taken, or even completely overlooked (yes, this happens!), profit figures are inflated. Depending on what reports are being analyzed, inflated profit can seriously curtail good business decisions.
Reports with insufficient depreciation amounts also lead to insurance problems. Equipment, which is overvalued due to under-reported accumulated depreciation, is likely carrying too much insurance. This equates to paying too much in insurance premiums, not unlike paying Porsche-priced full coverage premiums on a Ford Escort’s liability.
Another issue to keep in mind is the lazy accounting practice of forgetting to take equipment off the books after its working life has ended. Because of an inadequate asset management system, that item continues to be insured, even though it holds no book value!
One question many business owners have is which accounting method to use with their depreciation schedules. The straight-line method is the most popular schedule used, where the rate of depreciation is constant for the entire working life of the asset. This allows for the same amount of depreciation to be expensed each year, and makes for easier financial calculations.
Another widely used method is accelerated depreciation, in which larger deductions for depreciation are seen in the early years of an asset’s life. The accelerated cost recovery system (A.C.R.S.) is an accelerated depreciation schedule allowed for tax purposes. Capata sees the logic in using both methods, dependent upon a company’s financial situation.
“Choosing how to depreciate equipment depends on how profitable a business is, and how long they’ve been around,” says Capata. “If a business is just starting out they’ll want to take it over a long life. Or if it’s established, they’ll want to take it as soon as possible and take it up front.”
The reason for the young company to evenly spread depreciation over its working life is to reduce expenses (remember that depreciation is considered an expense on the books). Lower expenses means more profit. Although higher profits mean higher taxes, being able to accurately project future success with constant depreciation amounts and steady taxes is crucial for the business in its infancy.
Established companies, on the other hand, benefit from accelerated depreciation, where expenses are high in the asset’s early years, creating lower profits which means less for the tax man. This strategy coincides with accounting’s purpose to legally tilt a company’s financial well being in its direction, not the government’s. With more capital and on-hand cash, the established company can afford to do this.
Both methods take full depreciation, and strengthen any company’s financial foothold. But perhaps the best method of getting the most of equipment depreciation isn’t found in any accounting textbook — it’s preventative maintenance.
Regular maintenance on equipment will drastically reduce the likelihood of breakdown and the subsequent unexpected expense, not only of repair but of downtime. In addition, the useful life given to any piece of equipment, whether it’s three years or 25, can be greatly prolonged. The equipment that outlives the allotted life span ceases to be an expense, giving its owner free use of its services. Of course, obsolescence is the exception to this scenario.
When talking about equipment and depreciation, a common misconception is that renting or leasing will avoid the sticky tax code and even save money. In those general terms, that’s not necessarily so, according to Tollefson.
“If you rent the equipment, it’s a current deduction,” says Tollefson, who suggests that may be the way to go if an 18- to 36-month project is pending, such as a golf course, but not for a long-term acquisition. “A lease, though, can be capitalized and then becomes an asset. Based on the specific lease, the equipment is subject to the same terms as something purchased outright. If it’s a closed-end lease, it’s the same as a purchase agreement.”
Tollefson advises to read any lease or even rental agreement carefully. Leasing can be a way of reducing costs if the time period you need the equipment for is less than a normal ownership period. The disadvantage, however, is that leasing equipment without a purchase agreement doesn’t allow for net worth to build over time. Leasing is also usually more expensive than an equal period of ownership.
If considering renting or leasing to bypass the red tape of keeping depreciation schedules and dealing with the IRS, and the equipment will be used on future projects, consider the long-term benefit of owning the equipment.
In a nutshell, Capata suggests: “If you’re going to keep the equipment, you should buy.”
Maintaining an asset management system to ensure full depreciation is being realized can be a messy, time-consuming task. Fortunately, there is an abundant supply of easy-to-use software to meet this burgeoning need. Many systems on the market classify asset type, location, general ledger account number and person property type.
Other important items to look for in these systems are: depreciation summaries, federal tax Form 4562 report, annual purchase and disposal activity, book values, personal property tax reports, and lifetime projection report. With a quality system, a business owner is able to see from standard calculated and formatted reports the value based on depreciation of all his equipment.
Putting equipment depreciation on the top of the accounting priority list will ease other burdens associated with running your business; and the benefits that come from it (increased profitability and better control over assets) is payment for your attention.