(NOTE: This is a continuation of a case study looking into tax implications of starting up a small business. This particular article deals with tax deductions for small business. Click here to go back to the start of the case study.)
Amy, in getting her business moving along, decided to pick up a new tablet to show off all the latest nail designs wherever she was. She spends $500 to get one that will meet all her needs, and goes to put the expense in her Excel sheet. Since she’s still figuring it all out, she decides to double check the Schedule C to see how she would classify this particular small business expense.
No matter how much she looks, she can’t find a tax deduction line that looks anything remotely like a tablet (or, you know, where you’d expense one). Before she throws the $500 in the “Other Expenses” category, she decides to swing by her accountant’s office on her way to convince Denver’s Pervy Blue Bear to power clash her nails with her rock hard fur.
“I want to deduct this,” she says as she throws her amazingly resilient tablet on the accountant’s cheap Ikea desk, “but I can’t figure out where it goes on the Schedule C.”
After taking a second to wipe off the sweat developing under his green visor, the accountant pulls out a little white book from his protected left shirt pocket. He flips to a page called ‘Small Business Depreciation’ and shows it to her. “That’s because it’s depreciated over time, so you can only deduct a portion every year. But, if you want, your small business status can allow you to accelerate the deduction under Section 179.”
Amy knocks the gnome sized book out of the way and shoots her accountant an annoyed look. “Explain it in a way that an actual human can understand it and I’ll consider not pouring Coke Zero over your white shirt.”
The overall concept of depreciation is fairly simple: if you buy an item that will benefit you for over a year, you have to take the expense related to that item (known as “fixed assets”) over time instead of in the year you buy it. While we could debate all day long what is considered “benefiting you over a year”, the guidance is mostly related to software and tangible big ticket items, like computers, office furniture, cars, etc. So, yes, while that red Swingline stapler might last well into the Robot vs. Zombie Wars, the IRS isn’t going to expect you to depreciate those $12 dollars for the next 20 years.
Instead of estimating the life of the item you purchased, the IRS has released a table including hundreds of items. Find your item on the table and note the “GDS (MACRS)” number. As a general rule, software is 3 years, equipment is 5 years, and everything else not attached to the ground is 7 years. If you are curious about those attached items or buildings, let me know in the comments and I’ll do a separate post about it. But those aren’t usually small business depreciation items, so I’m skipping it here.
With that MACRS number in hand, go to the MACRS table and use it to find the year. Then multiply the purchase price times the relevant percentage.
In Amy’s example, the tablet cost $500, and would be considered a 5-year property. For the first year, you’d multiply $500 x 20% to get the current year depreciation expense. Next year it would be $500 x 32%, etc.
If you sell or otherwise get rid of the tablet (in Amy’s case, after breaking it from throwing it around so much), you can dispose of it and take the remainder of the depreciation expense in that year. But we’ll talk about that another time.
Section 179 Expense
Many small businesses are struggling just get off the ground, and the difference between a $100 deduction and a $500 deduction can mean a lot. Because of this, Section 179 was introduced. This code section was intended to allow small business depreciation to be 100% of the value of the fixed asset in the year that it’s purchased. This would allow Amy to deduct the full $500, instead of being limited to $100.
Section 179 is limited based on the amount of assets you purchase during the year. The amount is a bit of a moving target. The 2013 limit was a $500,000 deduction if you buy less than $2m in fixed assets. As of writing, the 2014 amount plummeted down to only $25,000. This might change, and it might change retroactively to the beginning of 2014, but it’s impossible to know at this point. There is some rumblings in the House to get that amount increased, but so far there’s been no activity.(UPDATE: The House is trying to increase this limit again. Read about it here)
If you are just starting out your business, this is absolutely something you should seriously consider.
There are some years where Congress has introduced something called bonus depreciation. Bonus depreciation allows you to instantly deduct a portion of the fixed asset cost in the first year then depreciation the rest. The bonus depreciation rate as been at 50% for the past couple years through 2013. In Amy’s case, that would mean she can instantly deducts $250, then the remaining $250 she depreciates over 5 years (yes, she does get both bonus depreciation and regular depreciation on the remaining $250 in the same year).
This may or may not be completely irrelevant going forward. Right now, there’s no bonus depreciation allowed. The House has voted on making bonus depreciation permanent, but I have no idea if it’ll actually occur in our current political climate.
In an attempt to make things easier, the IRS recently released new regulations that allow items up to $500 to be expensed in the year they were purchased as a “de minimis” amount. I say “attempt to make things easier” because these so-called repair regulations ended up being insanely long and complicated.
If you are starting up your business and want to expense all purchases under $500 right away, you’ll need to make sure you have a WRITTEN procedure in place. If your business has already been running without this written procedure for a few years, then technically you have to file what’s called a change in accounting method. These are complicated forms which are basically impossible to understand unless you’re a tax accountant specialized in accounting methods. If you are interested in taking advantage of this deduction, I would absolutely recommend hiring a CPA to advise you through it. Keep in mind that this de minimis and the related rules are new territory, and the IRS likes to make examples out of people doing things the wrong way when new rules come on the market.
Reporting your Small Business Depreciation
When you have depreciation or Section 179 expense, you’ll have to fill out a Form 4562, which you’ll attach to your return. Section 179 expense goes on Part I. If you are taking bonus depreciation, it’s reported in Part II. If you have regular depreciation, it is reported in Part III Section B the first year (to break out what you’re putting in service), and Section A after that (no need to break it out anymore). De minimis items wouldn’t be reported here, since they aren’t depreciated.
Note that if you take Section 179, the property does not need to be reported in Part III, since this would double count the deduction. For bonus depreciation, after putting the 50% amount in Part II, you’d put the remaining 50% in Part III.
After all this is finally filled out, the total of all this depreciation should flow back to your expenses on the Schedule C.
Cars, Listed Property, and Other Issues.
Cars and other vehicles are considered “listed property.” This means that they fall under special depreciation rules that limits the amount of depreciation taken per year. I’m not going in detail into these items at this point, but if you do plan on depreciating your car, it’s something you’ll need to look into more.
Next, if you are one of the poor saps who has to suffer through the Alternative Minimum Tax (AMT), all this depreciation will have to be recalculated under a different set of rules. Again, this is a complicated issue outside the scope of this book.
Finally, states don’t necessarily follow the same depreciation rules as the IRS. Many states disallow bonus depreciation and Section 179 depreciation. This means you’d have to recalculate depreciation for your state return if you’re in one of those non-conforming states.
Depreciation is often one of the most complex items a company has to deal with. My goal with this book is to make small business taxes as straight forward as possible, which can still be quite complex. For most situations, small business depreciation will be as simple as deducting the full amount of the purchase as a Section 179 expense. It only gets more complicated once you get bigger. Hopefully by then you’ll have a little more money to spring for a CPA. And we’re tax deductible as a business expense.
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