Tax Savvy for Small Businesses:

Writing Off Business Assets

“Of all debts, men are least willing to pay the taxes.”

—Ralph Waldo Emerson

As a business person, one of the few joys of spending money on a new computer, photocopier or even that great rosewood desk you have been coveting is knowing that the government is paying part of the expense—maybe as much as 50%. Just how much tax benefit you get from buying equipment depends on your business’s earnings and your tax bracket; the more you make, the more your business purchases will be subsidized by Uncle Sam.

You can’t deduct costs for equipment, buildings or other “fixed assets” as ordinary business expenses. Instead, you must “capitalize” these costs. (IRC § 263.) With one important exception, this means you must spread these expenditures by taking tax deductions (in tax lingo, “depreciate”) over a number of years. Put another way, you recover your costs for these assets as tax benefits in future years. (IRC §§ 167 and 168.) Just how many future years depends upon which category of the tax code the particular asset falls into—it may be as few as three or as many as 39 years.

Important exception to the rule that capital expenditures must be depreciated or recovered over a number of years. Section 179 of the tax code lets you write off or deposit, immediately, up to $24,000 of most capital expenditures (2002).

This chapter explains how to use both IRC § 179 and regular tax code depreciation rules to benefit your small business.

Writing Off Business Assets in a Nutshell

1. The tax code divides expenditures for business into “current expenses” and “capital items,” and treats each type differently.

2. Capital expenditures for business assets must be deducted over a number of years under regular tax code depreciation rules.

3. A special tax code provision, IRC § 179, allows most business owners to tax-deduct up to $24,000 or more of capital expenditures as if they were current expenses.

4. Typically, assets are tax-deducted using one of two methods, called “accelerated” and “straight-line” depreciation. No matter which method is used, the entire cost of the asset may be written off over a number of years.

5. There are several ways to tax-deduct the business-use portion of an automobile.

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A. Some Expenditures Must Be Capitalized

The most fundamental rule of deducting business expenditures is that they must first be divided up into two categories, called “current expenses” and “capitalized” costs.

Generally, costs of things used up within a year are current expenses. These include ordinary operating costs of a business such as rent, equipment repair, telephone and utility bills for the current year. Garden-variety supplies, such as stationery and postage stamps, are also considered expenses even though they may be around from one year to the next. All items that fall into the current expense category can be fully deducted in the tax year they are purchased.

Capitalized costs, on the other hand, are usually for things the tax code says have a useful life of more than one year—equipment, vehicles and buildings are the most common examples. A capital cost may be either to acquire an asset, or to improve one so as to substantially prolong its life or adapt it to a different use.

No matter the size and scale of the business, all capital items come under the heading of “business assets.” And while almost all provide tax write-offs for a business owner, not all capital expenditures are treated equally by the tax code.

Business Assets That Must Be Capitalized

Buildings

Cellular phones and beepers*

Computer components and software*

Copyrights and patents

Equipment*

Improvements to business property

Inventory

Office furnishings and decorations*

Small tools and equipment*

Vehicles

Window coverings*

(See IRC § 263 and Reg. 1.263 for details about items that must be capitalized.)

[*May be subject to immediate deduction under IRC § 179 at your option.]

1. Types of Property

Almost any kind of property, such as a building or a car, can qualify for a tax write-off if it is used in a business.

The tax code categorizes assets as “tangible” or “intangible,” and “real” or “personal.” These distinctions are important because they dictate how you must calculate and deduct asset costs and how fast you can take the tax deductions.

Tangible items of property are things that can be touched—for example, warehouses, machines, desks, trucks, vans and tools. The vast majority of property owned by a small business is tangible. Intangible property refers to things like trademarks, franchise rights or business goodwill.

Long ago the English legal system, which we adopted, divided the world of property into two broad kinds: real and personal property. Real property is land and anything permanently attached to it, termed “improvements,” such as fences, parking lots, buildings and even trees. Everything else in the universe is called personal property, such as furniture, equipment, cars and paper clips.

These two divisions are deeply imbedded in all our laws, including our tax law. In general, the tax code dictates much longer periods to write off real property than personal property. This makes sense. Real property improvements—structures—wear out more slowly than personal property, such as cars. Land itself is considered to never wear out, and so logically it should be nondeductible, and it is.

2. Inventories

Businesses selling goods (rather than services) usually maintain stock, called “inventory.” Money spent for goods to sell is not a current business expense. Instead, inventory is considered a business asset and its cost is expensed as it is sold—or discarded.

You must value your “cost of goods sold” using an IRS-approved inventory accounting method. In effect, what you spend for inventory is deducted, as it is sold, from the revenue it generates, to come up with your gross profit. From this figure, your general business expenses are deducted to determine your net profit. It is the net profit that is taxed.

Tax rule. Inventory generally must be listed at the lower of cost or market value.

Example: At the end of its first year of operation, Rick’s Music Store has an inventory of compact discs that cost him $50,000, and vinyl LP records that cost $30,000. Using the “cost method,” Rick has an ending inventory worth $80,000. Here is Rick’s cost of goods sold deduction:

$0 beginning inventory

+ $300,000 purchases

- $80,000 ending inventory at cost

= $220,000 cost of goods sold

You may reduce (“write-down”) the value of any inventory that has become unsalable. For tax purposes, this needs to be documented. For instance, if you write-down and destroy dead stock, keep evidence of the destruction—photos, videos, receipts or the statement of a reputable third party who can certify the goods were destroyed.

Example: At inventory time, Rick knows his inventory of CDs have held their value, but his LP records hardly sell any more. Rick asks a prominent music distributor to appraise the LP inventory and gets a written statement saying the market value is only $8,000. Accordingly, Rick reduces their retail prices and lowers the inventory on his books by $22,000. Now Rick’s cost of goods sold deduction for tax reporting looks like this:

$0 beginning inventory

+ $300,000 purchases

- $58,000 ending inventory

= $242,000 cost of goods sold

The difference between the two examples is the method of valuing the inventory. Using fair market value instead of cost reduces Rick’s income for tax purposes by $22,000. It is improper to reduce the book value of the inventory without some evidence of the loss in value and without reducing the retail price of the goods. With the taxes saved from the inventory write-down, Rick can build up his CD inventory or do anything he wants to with the extra money in his pocket.

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B. Expensing Business Assets: IRC Section 179

Small business owners don’t need to learn the Internal Revenue Code by section number, but it pays to remember at least one: IRC § 179, perhaps the best small business tax break of all. IRC § 179 allows—but doesn’t require—a business owner or C corporation to deduct up to $24,000 (in 2002) of asset purchases each year as current expenses. This produces an immediate write-off of capital assets.

Using § 179 is referred to as “expensing an asset,” as opposed to capitalizing it under normal tax code rules. Within the $24,000 limit, a business may buy assets at any time during the year and deduct the costs in full—as long as they are “placed in service” in that same year. I once bought, set up and started using a new computer on December 31 for $3,000, and wrote it off completely that year.

Example: Hal, a self-employed consultant, buys a computer for $5,000 in early 2001. Hal plans on using IRC § 179 to write off the computer. Hal’s business is very profitable and later in the year, while estimating how much he is going to owe in taxes for 2001, Hal finds he will owe $4,000 more than the estimated quarterly tax payments he has made. Hal was planning to buy a $12,000 color printer in 2002. If, instead of waiting, Hal purchases and starts using the printer before December 31, 2001, he qualifies under § 179 to write off a total of $17,000 in 2001 and wipe out most or all of his 2001 tax balance.

It works out like this: Hal is in approximately a 30% combined federal and state income tax bracket and pays self-employment taxes of 15.3%. This means that for Hal’s tax bracket every business deduction dollar saves him roughly 45¢ in taxes. So the total tax savings resulting from the $12,000 printer purchase in 2001 wipes out Hal’s projected $4,000 tax balance. Of course, Hal had to spend $12,000 to get the tax savings. But Hal would still get the deduction even if he purchased the machine on credit and paid in later years. As long as he needs the printer, this is still the next best thing to a free lunch.

Think twice about taking a 179 deduction. When would you not want the fast deduction of IRC § 179? Answer: When you don’t get much, if any immediate tax benefit from it. For instance, say your business is new and you don’t have enough business income to offset the Section 179 deduction, but you expect big things in a year or two. In that case, choosing regular depreciation and spreading the deduction over future years makes more tax sense.

Example: Hal’s advertising agency loses money in 2001 when a major account doesn’t pay him and then declares bankruptcy after Hal buys a $5,000 computer. The tax code prescribes a five-year depreciation period for computers. Hal doesn’t have any outside income, so spreading the deduction over five years makes more sense than writing off the whole cost under IRC § 179 in 2001.

A few other tax code sections let you choose whether to expense all assets similar to IRC § 179 or capitalize certain assets. These special provisions don’t affect small businesses except for research (IRC § 174), agriculture (IRC §§ 175, 180 and 193), publishing (IRC § 173) or mining (IRC §§ 615 and 616). (See IRC § 263 and Reg. 1.263 or a tax pro for details.)

Increasing § 179 Deductions

The annual limit on expensing of business assets under IRC § 179 is scheduled to increase as follows:

2001 and 2002: $24,000

2003 and thereafter: $25,000

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C. Depreciating Business Assets

Because of its obvious advantages, most successful small business owners look first to IRC § 179 to write off asset purchases. But you must go with regular depreciation methods instead of IRC § 179 if:

• you don’t have other earned income to offset the IRC § 179 deduction, or

• the asset doesn’t meet IRC § 179 qualifications, or

• you’ve already used up your IRC § 179 dollar limit that year.

1. What Is Depreciation?

The tax code recognizes that almost everything wears out over time. So property used in a trade or business or held for the production of income is entitled to a tax deduction called “depreciation.” A depreciation deduction is commonly called a “write-off”; the formal term favored by the tax code is “cost recovery.” In a few special cases, this deduction is called “amortization” or “depletion.”

A tax deduction for depreciation works something like this. You buy and use a copy machine in your business. Under the tax code a copy machine is assigned a (rather arbitrary) five-year life expectancy. (IRC § 168, Reg. 1.168.) This means you can write off part of the cost of the copier in the year you bought it and in each of the following five years, by taking annual deductions. (Yes, I know this is a total of six years, not five, as the tax code seems to indicate.) Eventually, the whole cost of the copier has been deducted from your business income if you stick around that long. Just how much you can take each year, and how to claim the deduction, are explained next.

An important exception to the normal depreciation rule: land costs can never be deducted. Special rules also apply to deducting business inventories and natural resources.

Keeping Up With Changing Depreciation Rules

Congress changes the depreciation rules frequently —six times in the last two decades. The good news is that if the rules change after you acquire something, the old rules still apply. The bad news is that you will have to learn and use the new rules for any new property. So, you may end up tracking depreciation of different business assets—computers, buildings or whatever—under several sets of rules. A tax pro can keep the process straight and even compare different methods available to see which one produces the best results for you. Software (such as Turbotax for Business) also can track depreciation under multiple schedules.

2. Depreciation Categories

The tax code establishes depreciation categories for all assets. Each category is assigned an arbitrary “useful life,” which is the minimum time period over which the cost of an asset can be deducted—for example, five years for a computer. In tax lingo, this is called the “recovery period.” IRS Publication 534 lists the categories and the depreciation periods for different assets.

Most small business assets fit into one of four classes. Here is a summary of the rules, which are quite technical:

• 3-Year Property: Manufacturing equipment (plastics, metal fabrication, glass).

• 5-Year Property: Cars, trucks, small airplanes, trailers, computers and peripherals, copiers, typewriters, calculators, manufacturing equipment (apparel), assets used in construction activity and equipment used in research and experimentation.

• 7-Year Property: Office furniture, manufacturing equipment (except types included in
3- and 5-year categories above), fixtures, oil, gas and mining assets, agricultural structures and personal property that doesn’t fit into any other specific category.

• Real Estate (varying periods): Business-use real estate is depreciated over 39 years using the straight-line method only (discussed below) if placed in service after May 31, 1993. Residential rental real estate is allowed a
27.5-year recovery period. Some types of land improvement costs (sidewalks, roads, drainage facilities, fences and landscaping) are depreciable over 20 years.

There are also classes of 10, 15 and 20 years, which might apply if your business is agricultural or unusual, like breeding horses or operating tug boats. See IRC § 168 and IRS Publication 534 for more information on all asset classes.

3. Methods of Depreciation

Once you find the correct tax category for an asset, you must determine the most advantageous depreciation method to use. You may or may not have a choice, depending on the type of asset.

Depreciation methods fall into two general types, which accountants call:

• straight-line depreciation, and

• accelerated depreciation.

The tax code makes it a little more complicated by offering four principal methods of depreciating most business assets—one straight-line and three accelerated—all of which result in the same total amount of deductions in the end. An additional method, for farm equipment only, isn’t covered here. (See IRS Publication 946.)

a. Straight-Line: The Slowest and Simplest Tax Depreciation Method

The straight-line method allows the cost of an asset to be deducted as a depreciation expense in equal amounts every year, except for the first and last years. In those two bookend years, you get only half of a year’s tax deduction.

For instance, with a $10,000 business machine, straight-line tax code depreciation allows these deductions:

Year 1 $1,000 (one half year)

Years 2, 3, 4 & 5 2,000 each year

Year 6 1,000 (one half year)

Total deductions $10,000

Assuming you own and use the machine for six years, you can deduct 100% of its cost.

b. MACRS: The Fastest Accelerated Tax Depreciation Method

The present tax code accelerated depreciation system is known by the acronym MACRS (pronounced “makers” by tax folks). This stands for “modified accelerated cost recovery system.”

Technically, MACRS covers all of the accelerated depreciation methods, but also is a shorthand reference to just the most widely chosen accelerated method: MACRS 200% Declining Balance. This is the very fastest—that is, most “accelerated”—way to write off assets (except for IRC § 179, described above). It allows greater deductions in early years of ownership of an asset than in later ones. For instance, using this method to depreciate a $10,000 business machine produces $7,120 in depreciation deductions in the first three years, versus $5,000 with the straight-line method.

To find the yearly deduction amounts, refer to the IRS tables that show the deduction as a percentage of the cost for each year of ownership. MACRS tables are found in your annual Form 1040 instruction booklet, IRS Publication 946 and annual tax preparation guides. Tax software such as Turbotax for Business will automatically compute these amounts, too.

c. Special Depreciation Rules for Motor Vehicles

Special tax code depreciation rules and limits apply to motor vehicles used in business. The technical name for these rules is “alternative ACRS depreciation.” These rules favor trucks over passenger cars, and will be different if the vehicle is partly used for pleasure and partly for business, which is often the case with small time operators.

As long as your business vehicle use is more than 50%, then accelerated depreciation deductions are allowed. However, there are caps (annual dollar limits) on motor vehicle deductions, as shown in the table below. The total depreciation for the first three years is $11,110 if the car is 100% used for business. Note that the annual depreciation deduction after the third year of ownership drops to only $1,775 per year. The net effect is to extend the period for deducting the cost of most vehicles to five years or more.

Should business use be 50% or less, slower straight line depreciation rules apply. The annual cap is the same, no matter whether the accelerated or straight-line depreciation method is used. Don’t forget that the percentage of personal use reduces the amount of depreciation deduction each year. This can get a little tricky. IRS tables guide you through the process, but better is tax software like Turbotax for Business.

The fastest depreciation method may not be the best. Don’t automatically conclude that the quicker you can take a deduction, the better. If your business has been around a while and is quite profitable, you are probably right. But most start-up businesses are not money-makers, so they don’t benefit by using accelerated depreciation. For them, the straight-line method, with smaller deductions in their formative years, gives the best long-term tax benefit.

Depreciation Limits for Vehicles

The tax code imposes absolute dollar maximums on depreciation deductions for each year that you own a passenger car used for business—no matter how much it costs; but see the exception for heavy vehicles in Section B2 above. For 2001, you are limited to depreciation deductions of:

1st year $3,060

2nd year $5,000

3rd year $2,950

4th and subsequent years $1,775

These amounts are adjusted annually for cost of living changes. (IRC § 280F.) New electrically powered vehicles enjoy significantly higher limits, though!

Excerpted from “Tax Savvy for Small Business”, by Frederick W. Daily