Reporting business expenses and assets at tax time is never cut and dry. The federal government offers business owners options for reporting tax deductions that can save your business money. Are you taking advantage of them?
One overlooked tax deduction is depreciation. This relates to the decline in the value of your business property or assets. Small business owners often don’t realize this depreciation can help reduce the amount of taxes owed. Fully understanding how to use depreciation will help you make the smartest decisions for your business when tax time arrives.
Business Expenses vs. Business Assets
The first step is to understand the crucial difference between business expenses and business assets. They may seem the same at first but carry different meanings for tax purposes.
Business assets are defined as any big ticket item you purchase for your business that costs more than your capitalization policy. For most businesses, the value of this policy is typically $2,500. For the IRS, the value is $500, unless you make what’s called a De Minimis safe Harbor Election. This election allows you to raise the level from $500 to $2,500.
After the election, anything that costs less than $2,500 qualifies as a business expense. According to the IRS, deductible business expenses are “ordinary and necessary” costs to doing business, such as travel expenses, meals, and utilities. These are generally deducted the same tax year as the purchase.
Assets can be anything from a vehicle to a computer to office space. These items are generally financed over a longer period of time, meaning you have more time to pay them off and deduct the cost of that item from your business income. Depending on the item type, you may be able to deduct it all in the purchase year, or you may opt to deduct the cost over several years. Both of these methods are technically considered depreciation. Deducting all of the depreciation in the first year is classified as Section 179 or Bonus Depreciation.
You can finance an asset, make a few payments (or even none, if purchased in December), and then deduct the entire cost in the same tax year. That means you’ll be paid for an item in tax deductions before you finish paying it off. What could be better?
What is Depreciation?
Simply put, depreciation allows a business owner to take the value of an asset and deduct it from business income over time. Most businesses will follow a depreciation schedule that spans between 5 and 39 years. For example, if you were to purchase a $4,000 piece of office furniture, you would deduct about $800 from your taxes every year for five years.
It gets better. The Federal Government incentivizes the purchase of assets that contribute to domestic production. These incentives are classified as either Section 179 or Bonus Depreciation. They allow businesses to immediately deduct 100 percent of the purchase price for most assets during the first year of ownership. For small businesses, this is excellent news for increasing cash flow while deferring the asset’s cost over the loan term. If you choose to finance an asset, you’ll receive the depreciation benefit before you even pay for the asset.
Examples of some assets that qualify for bonus depreciation include land improvements, such as pavers for a driveway at your office or factory showroom, almost any type of machinery, and even that new Mercedes G-Wagon you have been drooling over. That’s right, SUVs qualify for bonus depreciation.
When Should I Utilize Section 179 or Bonus Depreciation?
The method of depreciation depends mainly on the business performance.
For example, if you purchased an item that was $5,000 in 2020, and your business made a profit of at least that, you may just choose to depreciate the entire asset in the same tax year. However, if you purchase an $80,000 truck in 2021, you may choose to depreciate a certain percentage year over year instead.
Before you commit to taking all of the expense in the year you purchase or depreciating the asset over its useful life, consider how much money your business made in the past year and how much growth you expect in the future. You should also consider current and future tax brackets, along with other variable concerns. How will the political winds affect the tax rates? Are tax rates increasing or decreasing anytime soon? How will your business be affected?
The key takeaway on depreciation is that you can only depreciate an asset once. Keep in mind that when it comes to resale or trading in property, you may have to recognize income on the sale or trade of the property. The type of income, capital gains or ordinary, depends on the type of asset and what type of depreciation has been taken. Once you depreciate the asset, there’s no taking it back. If you deduct it all at once, you will be unable to deduct payments on the property in future years.
Considerations for Personal Use
The final factor on depreciation involves the personal use of business assets. Have you ever heard the story of the IRS auditor who questions the business owner’s Cadillac? The Cadillac has a sign on the side advertising the business, is used daily to show clients houses for sale, and appropriately, had been included as a business asset and depreciated at its full value. The IRS auditor asks the business owner, “Do you ever drive the Cadillac to church?” He makes a valid point. What portion of your business asset should be classified as a non-deductible personal expense? It’s essential to consider these factors in the case of an audit. Better to be aggressive while limiting the risk of future taxes and penalties.
Your Experienced CPA Can Help You Decide
As we approach the end of 2021, there are several things to consider. Not only do you need to examine how you will make your tax deductions. You’ll need to judge when to make significant purchases as well. If you are going to buy a new vehicle, should you buy it in December or January? Would a new piece of machinery increase your production while also decreasing your tax bill?
It’s crucial to have an experienced CPA who will guide you to make the best decisions regarding your money and your business. That’s why Elevated CPA was founded, to help small business owners succeed. Schedule a 15-minute introductory call with us so we can get to know you better. When we’re on your team, you’re never in it alone.