Given Congress’ recently updated rules on the first-year bonus depreciation of equipment, it’s important for businesses, especially leasing and other equipment-heavy companies, to be planning for next year.
And the year after next.
And the year after that.
In a nutshell, Congress late last year passed a package of tax extensions. One of the most important was the extension, toward an ultimate phase-out, of bonus depreciation over the next three years. The change, included in the Protecting Americans from Tax Hikes (PATH) Act of 2015, makes it crucial for businesses to plan their asset acquisitions, and related depreciation deductions, carefully in the next three years.
Businesses that don’t plan wisely for the phase-out of this deduction could be setting themselves up for unexpected tax liabilities as the benefit expires.
Under PATH, bonus depreciation was extended through 2019. Businesses were allowed to deduct 50% of their equipment cost up front in 2015, 2016, and 2017. The deduction will then drop to 40% in 2018 and 30% in 2019.
After that? It’s gone — unless, of course, Congress approves another extension. We all know how predictable Congress is these days; companies that benefit from the deduction should stay abreast of this evolving issue.
It’s prudent for any equipment-heavy business is to be planning for the deduction’s eventual demise. That much is fairly obvious.
Less so is that the lower depreciation on current-year acquisitions will be coupled with a lower current depreciation deduction on assets for which bonus depreciation was taken in prior years, as their depreciable basis has been lowered by the bonus already taken.
This double hit will, for many companies, result in larger-than-anticipated tax liabilities. If not properly planned for, these additional liabilities could be damaging — potentially even fatal — to businesses without adequate cash reserves.
Bonus depreciation has been around since 2001, although it was left expired for three years starting in 2005, and has ranged from 30% to 100% over the years.
How will the gradual elimination of bonus depreciation impact your business? Here are the questions CFOs should be asking in order to prepare for this new reality:
What will this mean for taxable income? It depends on your specific business and how you have been treating equipment depreciation for tax purposes. Resource-heavy businesses such as equipment leasing, manufacturing, construction, and trucking companies will likely see more of an impact than white-collar firms. That’s because they have more physical equipment on their books and bonus depreciation has likely brought more significant tax savings for them.
You need to know just how much the current bonus depreciation structure has been impacting your taxable income in recent years in order to fully understand what the phase-out will mean for you.
What constitutes a qualified asset? For property placed in service before this year, qualified assets included items such as certain types of computer software, water utility property, and some leasehold-improvement property, as well as new tangible property with a recovery period of 20 years or less. That means office furniture, on-site equipment, and other physical assets. Only new equipment qualifies for the bonus depreciation deduction.
What is qualified improvement property? Starting this year, qualified improvement property — including improvements that are made to building interiors, for example — can also be taken into account for bonus depreciation, regardless whether it is leased. It includes any improvements made to the interior of a nonresidential building, if the user puts the improvement into service after the owner puts the building into service. Exclusions include internal framework, enlargements, elevators, and escalators.
Are there any alternatives to bonus depreciation? It’s time to talk about Section 179 of the tax code.
While the current bonus depreciation structure allows for an immediate 50% deduction on new equipment, the Section 179 election is an alternative that allows companies to deduct up to 100% of their overall asset purchases in the year of acquisition, but with some significant limits.
This deduction, available for both new and used equipment, can be applied on an asset-by-asset basis, rather than making the election for everything in an asset classification (as bonus depreciation rules require), as long as the business stays below some set purchase limits.
Section 179 might be used when a company purchases used equipment, since used equipment doesn’t qualify for bonus depreciation. It might also be more desirable for a business that has $2 million or less in total fixed asset purchases for a year: the business will be able to regulate how much of the allowable $500,000 under Section 179 it wants to utilize, thereby allowing it to control both its depreciation deduction and its taxable income.
For example, let’s say a company has $1 million in fixed asset purchases for the year; that all asset purchases qualify as five-year equipment for depreciation purposes and all are new assets; and that the company is showing $750,000 of taxable income prior to any depreciation being taken on the new asset purchases. In this scenario, the company has several options:
- Elect not to use bonus depreciation, take $200,000 of accelerated depreciation on its $1 million of qualified five-year asset purchases, and show $550,000 of taxable income.
- Elect to use bonus depreciation, which would result in $500,000 of bonus plus $100,000 of regular depreciation, for a total of $600,000 depreciation and taxable income of $150,000.
- Elect to use $500,000 of the Section 179 deduction and then apply bonus to the remaining $500,000 of asset basis, resulting in $250,000 of bonus depreciation and an additional $50,000 of accelerated depreciation on the remaining $250,000 of asset basis. This would result in a total depreciation deduction of $800,000 and a net tax loss of $50,000.
- Elect to use less than $500,000 of the Section 179 deduction (companies can choose any amount up to $500,000 to use), thereby managing taxable income.
How Can You Prepare for This Change? If your company has utilized bonus depreciation extensively in prior years, we recommend projecting out the next several tax years to see how the phase-out will affect your taxable income — based on projected income and anticipated asset addition/replacement needs — so that you can manage cash flow accordingly.
Additionally, you should project your depreciation deduction and taxable income under various acquisition scenarios to determine the best acquisition schedule to maximize asset usage and business and cash flow needs. While it might be desirable to accelerate an asset purchase on a short-term basis, it isn’t necessarily prudent to accelerate for multiple years; the acquisitions need to make good business sense.
Companies that prepare financials on a GAAP basis may be recording deferred tax liabilities on their financial statements. The deferred tax provision provides a total deferred tax effect, which would be a good indication of the future liability related to the difference between book and tax income, but in would not provide this information on an annual basis.
Putting together a multi-year projection allows companies to schedule asset purchases, see what effect the change in bonus will have on different asset acquisition timeframes, and project cash needs to cover income tax liabilities.
It all depends on the needs of your business and the structure of your accounting. The options are not one-size-fits-all.
Nancy A. Geary is a shareholder at the public accounting firm ECS Financial Services in Northbrook, Ill.