Every business has to make certain purchases in order to continue providing the products or services around which it is built. Some of those purchases come with an added bonus: a valuable tax deduction that is often overlooked. The concept is known as depreciation, and you can claim it on many different kinds of equipment, vehicles, real estate, and other business property.
“Depreciation is legislated, and therefore legal, tax avoidance,” explains Eric Chen, associate professor of business administration at the University of Saint Joseph in West Hartford, Connecticut. The policy reasoning behind allowing a tax deduction for depreciation is to encourage businesses to invest in themselves, thus freeing up funds for hiring, purchasing more equipment, and expanding. “This is a public good. Jobs are created, and jobs mean taxes and productive workers who have money to spend. There’s economic value here,” he says.
Like any other business tax deduction, depreciation is governed by a set of rules; some are fairly straightforward, others more arcane, so it makes sense to work closely with your banker, accountant, and/or tax advisor when considering your options here. A simple rule of thumb is that if the asset will be consumed during the process of generating revenue, then it can be amortized against the sales it helps to generate, says Gene Osekowsky, coordinator at the Tennessee Small Business Development Center. “From a business point of view, depreciation is a non-cash expense transaction reducing the book value of the profit for tax purposes; it lowers your tax liability without using cash,” he explains.
|35% tax||-21||Pretax profit||40|
|Net income||$39||35% tax||-14|
|Actual take-home||$39||Net income||$25|
“If you focus on net income, it looks like a better scenario without depreciation—$39 versus $26. But the funny thing about depreciation is that you don’t pay it to anyone; that’s why it’s called a non-cash expense,” Chen explains. “When you add the $20 to the net income of $26 in the scenario with depreciation, your take-home is now $46, leaving you with an extra $7 you can use to support your business.”
Howard E. Hammer, a CPA with accounting and consulting firm Fiske & Company in Plantation, Florida, says it is important for business owners to be familiar with these depreciation basics:
- Depreciation begins when the asset is actually “placed in service,” not when it is purchased.
- It can be applied to tangible (assets with a physical form, such as equipment, buildings, inventory, etc.) and intangible (assets that are not physical in nature, such as patents, copyrights, business methodologies, etc.) property.
- Assets with a useful life of five years or more can be depreciated; shorter periods apply to certain assets.
- The Internal Revenue Code allows several different ways to calculate depreciation, subject to certain restrictions. Straight-line (divide the cost of the asset by its useful life in years and claim that amount each year) is the simplest and most common, but accelerated depreciation, which increases the deduction in the early years of an asset’s life, and bonus depreciation, an additional deduction that can only be taken in the first year of an asset’s life, are allowed for certain assets and leasehold improvements subject to dollar limitations.
- When a capital asset is sold at a gain, previous depreciation taken is recaptured at ordinary income tax rates before capital gains treatment kicks in.
“For a business that is cash-strapped, depreciation can go a long way towards providing a boost to much-needed working capital,” Chen says. “For owners seeking to sell their business in the short term, it can provide a way to take cash out without affecting the income statement.”
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified CPA, tax advisor, and/or other financial professional.
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