Right now in the U.S., you can deduct up to $500,000 of new or used equipment purchased in the year it goes into service but that will drop to $25,000 in 2012. Should you go buy a bunch of equipment IF nothing changes? Not so fast.
As I have argued for years; Section 179 depreciation does not CHANGE the AMOUNT of depreciation you may deduct, rather is simply shifts WHEN the deduction occurs. Further, taking it often HURTS a business. Huh?
If a business BORROWS MONEY to purchase equipment (and this includes leases), then the small business is generally better off NOT taking Section 179 which shifts much, if not all, depreciation deductions into year one and leaves none for years two through five (assuming five year lease or note).
On the flip side, if a business pays CASH for equipment, then take the deduction. Basically, my advice is to follow the cash.
So, in a simple five-year example where $100,000 of equipment is purchased in year one (excludes down payments and interest), the entire $100,000 is typically available as an offset to earnings. If you were a solely-owned S Corporation with an income tax rate of 30%, then it would be like getting a $30,000 tax credit for paying out no more than $20,000 cash ($100k / 5 years = $20k) and often much less if the equipment is purchased late in the year. What’s worse, I see many taking the cash windfall and then spending the money on something else.
So, many accountants will encourage their clients (you) to buy some equipment so that the tax bite on your upcoming spring income tax bill won’t be as much and the accountant looks good (way we judge accountants is by the amount we have to pay at the end of the year rather than the total amount we have to pay or other measurements).
Okay, now in years two through five, you have to pay out $20,000 per year with no offsetting deduction. In short, that’s $20k of expenses you have that you don’t get to deduct. So, in year two, if you are still in that 30% tax bracket, you pay out $20k of cash to retire the note but you have no offsetting depreciation deduction, so the $20k drops down to the bottom line as INCOME and then you pay out $6k ($20k x 30%) in taxes.
So, while in year one, you are net cash positive by $10k or more; in years two through five you could be paying $20k in payments and also $6k in taxes you wouldn’t have to pay had you not opted for Section 179.
So, does it matter that Section 179 is scheduled for dramatic reduction right now ($500k to $25k)? In the vast majority of cases, I don’t think so. Fact is, most business owners will be better off cash-flow wise when they save their depreciation deduction to match the cash when it goes out.
For more details on Section 179, Click Here.
In short, follow the cash. If you pay cash for equipment then deduct as much as you can as soon as you can. If you finance (borrow or financing lease), you’re better off taking depreciation that more closely matches your cash out.
Tom Crouser
