Tax Tuesday
Depreciation is a Key Source of Small Business Planning
Small businesses are allowed a wealth of depreciation options. The best option may not be what you think.
Since I just finished teaching a class about it, depreciation is on my mind. So let me share a few thoughts about this often oversimplified feature in the US tax code. It’s not the sexiest of topics, but it’s one that most small businesses — even freelancers and self-employed — will have to deal with on an almost annual basis.
The Depreciation Debate
If you buy something and use it over multiple years, accounting logic says that you should take the expense of that item over multiple years.
Thus enters depreciation, an accounting feature designed to do just that.
Sure, you might have spent $8,000 on that fancy desk this year, but you’ll be using it for a while. So obviously that $8,000 should be spread over multiple years, right?
Well, sure. For accounting purposes. But we’re talking tax, which also includes the government’s experiments to try to boost the economy. One popular way to do this is to come up with various ways to make more of that depreciation taken in Year 1, encouraging more businesses to buy more crap and get the benefit now.
Especially small businesses. Politicians love to emphasize their commitment to those, whether they have an D or an R beside their names.
So a small business has 3 different ways to take the expense now on most non-real estate items in their business (big exception: cars).
Let’s talk about how you can do it. Then let’s talk about why you might not want to take any of them.
De Minimis Exception
First and foremost we have the De Minimis Exception. This is a concept that has grown out of the fact that most people aren’t going to bother tracking $15 staplers over multiple years, even though they will most likely last forever.
So, the IRS just said, “Screw it, if the item is under a certain amount, you can just expense it.”
Best of all, that “screw it” amount is $2,500. For a huge business, $2,500 is nothing. For the small business, though, that $2,500 is probably going to end up covering the vast majority of your assets.
So expense now, deduction now, lower taxes now.
Best of all, no additional tracking.
Section 179
If you have an asset over that de minimis amount, small businesses still can deduct the full thing now for most of the stuff they buy.
This can be done through the cleverly titled “Section 179 Election,” so-called because…well, it’s the election allowed by Section 179 of the Internal Revenue Code. Apparently Congress was out of catchy acronyms that year.
This election will allow you to currently expense most items, with three big limitations:
- You can’t use it to expense more than $1,050,000 (in 2021 — indexed for inflation)
- You reduce that $1,050,000 amount when you put more than $2,620,000 of assets in service that year (reduced dollar for dollar, also 2021 amounts and indexed for inflation
- The 179 deduction can’t create a loss.
For those first two points, those that are limited are definitely on the high end of a small business. The last item can be huge, though.
Section 179 can only make your business income zero. But if you were allowed a loss, you could potentially offset your other, personal income.
Example: Your business has $100,000 in net income before factoring your Sec 179 deduction. You bought $200,000 of assets this year. You can only deduct $100,000 of that through Sec 179, and the rest would be carried forward for future years.
Bonus Depreciation
The last and most powerful deduction is Bonus Depreciation, which currently (at least through 2022) allows you to deduct 100% of the price for most non-real estate assets in the year of purchase.
Unlike the Section 179 expense, there are no income or asset limitations. And unlike the 179 expense, this CAN create a loss, which you can use to offset other sources of income.
So potentially a negative business income tax rate. Great, right?
Where the Planning Begins
Us CPAs like to brag about how important we are, but the truth is that for a lot of individuals, TurboTax can get you the answer (though with a bit more effort on your part).
With depreciation, though, a good CPA can really add value.
Most people really like to take deductions now. They want the lowest tax now, the biggest refund, etc.
The fact of it is that deduction now might not be the best.
Would you rather have a deduction while you’re in the 10% tax bracket or the 21% tax bracket? Definitely the latter. If you do everything you can to have the lowest taxes now, it might mean higher taxes later.
Interweaving that between the three potential ways noted above to accelerate your depreciation can cause all kinds of complexities. It’s the kind of situation where you’ll want to consider the future to determine when to best take the deduction.
Are your tax rates likely to go down (either due to Congress changing the laws or lower income in the future)? Then, by all means, deduct everything now.
Are your tax rates going up? Then spread that deduction out by accelerating as little as possible.
It’s not brain surgery, but if you don’t consider it now, you’ll be paying more taxes down the road.
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