Article: Plan Now to Beat the Depreciation Deadline

June 2008

Plan Now to Beat the Depreciation Deadline

The added deductions are significant, but in most cases businesses have until only December 31, 2008, to acquire qualifying assets

As Gerry Henderson discussed in the March issue of The Bottom Line (“Stimulus Act Benefits Individual and Business Taxpayers”), the Economic Stimulus Act of 2008 greatly improved first-year depreciation deductions – for one year only – to inspire businesses to accelerate their capital expenditures. The added deductions are significant, but the clock is ticking, and in most cases businesses have until only December 31, 2008, to acquire qualifying assets.

Increase in Section 179 Deduction. To recap, for tax years beginning in 2008, the first-year Section 179 deduction has been doubled to $250,000. The Section 179 deduction is generally labeled a “small business provision,” as it applies only to businesses whose current year asset additions are beneath a specific dollar threshold. But that threshold has also been expanded for tax years beginning in 2008. It now has a starting point of $800,000 of current asset additions (formerly about $500,000). Above that amount, the Section 179 deduction phases down dollar-for-dollar, so that a business is totally ineligible for any Section 179 above $1.05 million of asset purchases.

Caution: Fiscal year businesses have the enhanced Section 179 deduction available only for their tax year beginning in 2008 and ending in 2009 (see related article below).

50% Bonus Depreciation. The 50% bonus depreciation is also available as a first-year deduction, but in this case eligibility hinges on acquiring “original use” property during the 2008 calendar year. In terms of sequencing, any Section 179 deduction is claimed first, followed by the 50% bonus depreciation.

Example. During 2008, Smallco purchases $700,000 worth of new equipment. After claiming the maximum Section 179 deduction of $250,000, Smallco then claims 50% bonus depreciation of $225,000 (50% of the cost of $450,000). The remaining cost after the 50% bonus deduction is then recovered under the normal rules, such as five- or seven-year cost recovery, as the case may be. Assuming Smallco was in a five-year depreciable category with respect to its equipment, its total deductions in 2008 for depreciation from the $700,000 equipment purchase would be approximately $520,000 ($250,000 Section 179 deduction plus $225,000 50% bonus plus $45,000 of regular depreciation).

There are several qualification rules with respect to the 50% bonus that distinguish it from the Section 179 deduction, including these:

The bonus depreciation applies to new property only, not to used assets.
If a new asset is acquired by trade, both the “boot” – i.e., cash or other property used in an exchange to balance the values of property traded – and any remaining depreciable basis of the relinquished asset qualify for the 50% bonus (but it’s boot only for the Section 179 deduction).
A broader array of assets qualify for the 50% bonus. In general, all assets except buildings will satisfy the criteria, and even then leasehold improvements to an older structure can qualify for the 50% bonus.

Qualifying Property. Property that qualifies for the 50% bonus depreciation generally consists of the following:

depreciable property with a MACRS recovery period of 20 years or less (this includes most tangible personal property as well as farm buildings and land improvements);
qualified non-residential leasehold improvement property,¹ placed in service more than three years after the date the building was first placed in service;
depreciable computer software (other than software acquired as part of an overall business acquisition transaction and that is not readily available for purchase by the general public); and
water utility property.

Getting the Most from Both Tax Breaks. Under normal conditions, the Section 179 deduction should be used first to expense assets that are not eligible for bonus depreciation. That maximizes the amount of basis that can be written off under the super-fast Section 179 rules and the pretty- fast bonus depreciation rules. For example, you may be wise to use as much of the Section 179 allowance as possible for used equipment additions that are ineligible for bonus depreciation.

Next, the Section 179 deduction should be used to expense assets with longer recovery periods. Bonus depreciation deduction then can be claimed for the remaining basis (after subtracting the Sec. 179 deduction).

For guidance on how these depreciation incentives can fit your capital expenditure plans, contact your Schmidt Westergard tax professional.

¹Examples of leasehold improvements that do not qualify include expenditures to enlarge a building, elevators, structural components benefiting a common area, internal structural framework, and improvements made pursuant to leases between certain related parties.

Beware of the Fiscal Year Business Trap

As noted above, the Section 179 first-year depreciation deduction for small businesses has been increased to $250,000 for tax years beginning in 2008.

However, for partnerships and S corporations that operate on a non-calendar fiscal year, there is a trap in the way these rules were drafted by Congress. Because of the fiscal year status, such partnerships or S corporations would pass the Section 179 deduction into the business owner’s 2009 Form 1040. However, by 2009 the tax law reverts back to the regular Section 179 limit of $125,000 (probably $130,000 by 2009 with inflation indexing). Here’s an illustration of the flaw in the law:

Example: Lee is the 100% shareholder of an S corporation that has a November 30 fiscal year. For its tax year beginning December 1, 2008, and ending November 30, 2009, the corporation acquires a significant amount of equipment to take advantage of the new depreciation provisions. However, if a $250,000 Section 179 deduction is passed through to Lee’s 2009 Form 1040, he will be allowed to claim only the normal Section 179 amount (approximately $130,000) for 2009. The expanded $250,000 Section 179 limit could not be claimed in Lee’s 2009 Form 1040.

As a result, fiscal year partnerships or S corporations with a majority individual owner effectively do not have the benefits of the expanded $250,000 Section 179 deduction. This looks like a technical oversight in the drafting of the law, but because it affects only a small number of businesses Congress may not correct it.

Partnerships and S corporations that are affected by this timing issue need to recognize this limitation when budgeting their equipment additions under the one-year Economic Stimulus depreciation incentives.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.