Business Provisions of the American Taxpayer Relief Act

While a good majority of the tax changes in the 11th hour Fiscal Cliff bill (American Taxpayer Relief Act of 2012) concern individual taxes, there are a few changes for small business owners, which are mostly centered around the extension of and retroactive change to depreciation limits and rules.

Section 179 Depreciation Limit

In 2011, we had a $500k limit on the amount that could be taken as Section 179 depreciation expense (provided the business purchased less than $2 million in qualifying property in the year).  This limit was very generous and few small businesses had to worry about getting close to this limit.  However, in 2012 the limit was scheduled to be reduced to $139k (after inflation adjustments), and then even further reduction to $25k in 2013.  For small businesses that acquire a lot of equipment each year, such large limit reductions would have a big impact.

All of 2012, we were unsure if Congress would increase the Section 179 limit, and finally after the ball dropped in Times Square and many of us had resigned ourselves to the 139k limit, our bickering government representatives finally get it together and decided to make a retroactive change to the 2012 limit.  Now, it is as if the the treat of the $139k limit never existed, and we now have a $500k limit for 2012 and 2013.

Now, correct me if I am wrong, but I thought the purpose the Section 179 depreciation benefit was to encourage business owners to buy more business equipment and help spur economic growth?  How are we suppose buy equipment when our government does not decide on the depreciation limit until after the year is over?  I had several clients that typically buy more than $139k in equipment that were trying to make purchase decisions at year-end, and the delay caused by partisan politics in Washington on this limit was extremely frustrating.

Bonus Depreciation Kept Alive

Is bonus depreciation ever going to truly go away?  It seems it is always brought back by 11th hour legislation.  Unfortunately, this time around we only have 50% bonus depreciation that is extended through 2013.  While businesses with net taxable income will use Section 179 depreciation, bonus could be useful for those with losses.

In 2011, we were spoiled with 100% bonus depreciation, and we pretty much wrote off everything in the first year that qualified.  Now we are going to be a little more limited, but it is still a good benefit if you remember back to years before bonus was available.  At best, it provides a great first year deduction for those of you who purchased new vehicles weighing less than 6,000 GVW.  Even with 50% bonus depreciation, you are still going to get $11,160 in depreciation in the first year ($11,360 if a light van or truck) given that most new vehicles are well over $22,320 these days.  Remember, it has to be a brand new.  Certified new does not qualify.

Qualified Leasehold Improvement Retroactive Change

Even though this one will greatly benefit my calendar year filing businesses, it frustrates me to no end that Congress would make this change retroactive to 2012.  Not only did it make one paragraph from my book obsolete, but we are going to have to file several amendments for our fiscal year corporations that have already filed tax returns with qualified leasehold improvements put into use after 1/1/12.

To fully understand my frustration, you need the background history on this tax deduction:

  • In 2011 (and several years prior) you could depreciate qualifying leasehold improvements over 15 years and then use Section 179 or bonus depreciation on the improvements.
  • Before this rule, we had to depreciate them over 39 years, so this was a BIG benefit.
  • Due to the patchwork of tax code in the last few years, the special treatment expired as of 1/1/12, and qualified leasehold improvements could no longer be depreciated over 15 years.
  • Even worse, if you had any 179 carryover originating from qualified leasehold improvements at that point, you had to reclassify the amount (according to steps in Sec 179(f)(4)) and depreciate it under the 2012 rules over 39 years.  Reporting this adjustment was a bit complicated since the IRS did really anticipate the expiration of the tax rules, so not only was it a lost benefit, but it cost fiscal year small businesses more in tax prep fees.
  • Fortunately, there was some saving grace in that the qualifying improvements still qualified for bonus depreciation (since the availability of bonus treatment was not based on the 15 year life), so we were able to take 50% bonus depreciation, but the rest went over 39 years.

Now, fast forward a few months after these fiscal year returns have been filed to when we are all enjoying New Years and watching football (or soccer in my case).  Our government officials, in all their wisdom, decide to retroactively change the 2012 rules and make the 15 year special treatment available again.  In addition, they extend it to 2013 as well, so it is as if the rules we used during 2012 for fiscal year filers never existed.

Again, if you are a calender year filer and you made or are looking to make some leasehold improvements that qualify for the 15 year treatment, this is very welcome news.  However, if you are a fiscal year filing corporation, your CPA may need to file amendments for you once the tax preparation software companies update their software for all the Fiscal Cliff bill changes.

By the way, if you bought my book and would like more information on this change, please feel free to email me at pdxcpa@gmx.com.  Again, it only changes one paragraph in the Fixed Assets chapter, but I would be happy to provide additional details on this change for my readers.

Other Extenders

In addition to the depreciation changes and the retroactive change that has me all riled up (much like the Cascadian supporter groups are at Don Garber), there were also some minor extensions that will benefit a select group of small businesses.  The Research and Work Opportunity Tax Credits were both extended through 2013.  The enhanced charitable deduction for contributions of food inventory is also extend through 2013, as is the special treatment of qualified small business stock.

All in all, there was not much change for businesses; however, we will likely see more substantial changes later in the year.  You may say I am a dreamer, but I am thinking we may actually see some comprehensive tax reform this year.

To 179 or Not to 179

International CXT

For most business owners faced with questions on how to depreciate their fixed assets, usually the most common response is to expense as much as possible using Section 179 and then depreciate the remaining portion using MACRS.  This makes sense and usually saves considerable tax in the current year; however, you might want to put some more thought into that question the next time your CPA calls when working on your tax return as there are some additional considerations that you should be aware of:

1) Recapture

Like a ghost, recapture can come back and haunt you and the great deduction you took a few years may end up costing in the end with a higher tax rate on the gain from sale of the asset.  Capital gains rates are great right now (although that may be changing after the elections), but if you sell personal property that you took 179 depreciation on, you will end up with ordinary income rather than the capital gain you were hoping for.  The formulas are complex and it is something you would have to sit down with a CPA or accountant to discuss fully and apply it to your specific circumstances, but the bottom line is that you need to consider how long you will be holding a fixed asset when you are deciding on depreciation.  If you are planning on selling the asset after a few years, MACRS depreciation could be a better route to go in the long run.

2) The “Next Year”

Life is great in a tax year when you have a big 179 depreciation deduction, but what about the “next year”?  Lets say you had a good year and made a healthy net income, so in December you bought a ton of new equipment, or maybe a new commercial van that still qualifies for Sec 179 (maybe the above pictured truck over 14,000 GVW).  April comes and you get a big refund and your safe harbor estimated tax payments are nice and low – life is good.

You have another good year and get to December, but the problem is that you do not need much new equipment because of all you purchased last December and trading for a new vehicle using a 1031 exchange will have minimal impact.  Luckily, you realized the problem from reading my blog and called your CPA before year-end to get your 4th quarter estimated tax payments adjusted; however, this is not often the case.  For most, the “next year” can be painful – especially for those who file closer to October 15th.  Estimated tax payments are always based on 100% of the prior year tax liability less withholdings (110% if AGI is over $150k), and so if Sec 179 depreciation lowers you taxable income by $50k, you will be paying estimates based on that reduced amount.  Then the next year if business net income was the same but you only have $10k in Sec 179 deductions, your taxable income is going to be $40k higher – which can result in large amounts due with the return since your estimates were based on the reduced income from the prior year.   The next thing you know you are learning about installment agreements.  😦

3) Shareholder Basis Issues

If you are an S-Corp and you max out your 179 depreciation deduction ($125k for 2007, $250k for 2008 due to the Economic Stimulus Act), you could end up with a large loan to shareholder balance on your tax return.  This results mainly because most smaller S-Corporation owners take distributions based on cash flows and book net income; however, deductions like Sec 179 cause a distortion of net income on the tax return and a timing difference (as an asset that would have been depreciated over 5 years is now expensed completed in the current year).  If taxable net income is much lower than the book income that the distributions were based on, then you can end up with distributions in excess of your debt basis to the point where you have reduced retained earnings to zero and the excess distributions become a loan to shareholder account that technically you should be charging regular interest on (unless you want to take the excess distributions as capital gain).  The banker will then look at your return and see that you owe the company a large sum, and even though they understand Sec 179 and timing differences, they still do not like seeing this account when renewing a loan.  It is definitely something to consider if you have similar circumstances and you have to face renewal every year.

Bottom line – think before you 179 and always look to the “next year” and beyond.