What a difference a year makes

This time last year the political rhetoric and conversation around coffee was about the expiration of the Bush “tax cuts.” Most provisions lowering federal income taxes after President Bush had taken office had expired as of Dec. 31, 2011 and the pressure was on to extend the tax breaks retroactively.

Congress, at the last minute, passed the American Tax Relief Act of 2012 and President Obama signed it into law on Jan. 2, 2013. This year Obamacare and health insurance exchanges rule the conversation and headlines.

The American Tax Relief Act did permanently extend certain provisions such as keeping lower tax brackets (although somewhat modified) and taxing qualified dividends at capital gains rates. But many of the provisions were only extended until the end of 2013.

The Joint Committee of Taxation  published a report, List of Expiring Federal Tax Provisions 2013-2023, that lists 55 provisions in the Internal Revenue Code that expire on Dec. 31, 2013.

Personally I’m not concerned that the American Somoa economic development credit is expiring. And until I had read this report, I had never heard about the “temporary increase in limit on cover over of rum excise tax revenues to Puerto Rico and the Virgin Islands.” I don’t even understand the description. But the one provision expiring that many business owners will miss is the generous $500,000 limit for expensing “tangible property or computer software … which is section 1245 property … which is acquired by purchase for use in the active conduct of a trade or business,” or as referred to by us common folk, machinery, equipment, cars and trucks, and certain qualified real property. This provision is widely referred to as the Section 179 deduction.

Another provision businesses will miss after December 31, 2013 is bonus depreciation.  Bonus depreciation is a provision allowing businesses to deduct 50% of the cost of new depreciable equipment in the year equipment was placed into service.

Let’s review the basics.

For 2013, a business that acquires additional new or used equipment or off the shelf computer software where the aggregate cost is less than $2 million can elect to expense $500,000 of this cost in 2013. The expense is limited to the business’s taxable income, but any of the deduction not used can be carried forward to future years and reduce taxable income in those years.

In contrast, beginning in 2014 the section 179 election to expense assets still exists, but the limits are significantly lower. In 2014 a business that acquires new or used equipment with an aggregate cost of $200,000 or less can elect to expense up to $25,000. Notice that off the shelf computer software is no longer included as qualified property.

First year bonus deprecation allows 50% of the cost of original use, or new, qualified property to be deducted in its first year. Let me emphasize that bonus depreciation is for new equipment only. Qualified property for bonus depreciation is property with a recovery period of 20 years of less, computer software, water utility property, or qualified leasehold improvements. (To see a more specific list of property that qualifies, see IRS Publication 946, How to Depreciate Property, Appendix B). In 2014, bonus depreciation will ceases to exist.

If you not familiar with the concept of depreciation, it is basically an accounting convention allocating the cost of an asset over several years. The logic is that if you buy an asset that will last more than one year, then the cost should not be recognized in only one year. The cost should be capitalized then depreciated over the asset’s useful life. Depreciation amounts can be different on your financial books versus you tax return. The Internal Revenue Code requires the cost of an asset to be spread over a number of years they prescribe, as opposed to the asset’s useful life.

To illustrate why businesses like expensing their equipment in the year purchased under section 179, let’s assume a business bought $500,000 of equipment and elected to expense it in the first year it was placed in service. Then we will compare it to a scenario where the same equipment was depreciated rather than expensed.

In the illustration below, we will assume the IRS prescribes the equipment in our illustration to have a depreciable life of 7 years. And yes, my math is correct. It takes 8 years to recover the cost of a 7 year asset using the IRS’s formula. The formula assumes you bought the asset in the middle of the year.

The illustration compares an election under section 179 to expense equipment costing $500,000 with the alternative of depreciating the same equipment with a 7 year life.  The assumed tax bracket is 35%.

The difference in federal income tax in the year of purchase between electing Section 179 and expensing the assets as compared to depreciating the assets over the 8 year period prescribed by the “normal” MACRS tax depreciation is $149,992. That tax savings goes a long way in providing cash to pay for the equipment.  With the death of the $500,000 section 179 limit and the upfront cash generated through tax savings, many businesses will incur additional borrowing costs when buying equipment. If you had to borrow the upfront amount of lost tax savings, in our illustration 149,992, paid this amount back to the creditor with your future tax savings from normal depreciation, assuming an interest rate of 6%, the additional cash outflow paid for interest expense over this period would be somewhere in the neighborhood of $27,000.

The bottom line is this. If you have consistently benefited from electing section 179 to expense your business assets, you are fixing to take a significant hit to your cash flow through higher income taxes. The lack of bonus depreciation works the same way, the difference just isn’t as dramatic.

If it makes sense for your business to purchase additional equipment soon and accelerating the purchase is an option, you better make your decision quickly. You only have a month to get the equipment purchased, delivered, and placed in service.

Get ready. Set. Go!