Why new tax bill helps small businesses
The tax bill passed by the House and Senate in May of 2006 is good news for small businesses that plan to spend significant sums on equipment and other property in the next few years. However, some business owners may find it makes better long-term tax sense to not take full advantage of the new legislation.
Write off $108k worth of property
The Tax Increase Prevention and Reconciliation Act of 2005, as this legislation is formally known, allows businesses to take a 100% write-off on as much as $108,000 worth of qualifying property purchased 2006. (The ability to fully write off or expense this property, instead of taking a depreciation deduction over several years, is allowed under Code Section 179 and is commonly known as a Sec. 179 deduction.)
Qualifying property includes office equipment, furniture, computers and other "personal property." It does not include real estate or buildings.
The write-off is indexed annually for inflation and will be in place through 2009. That allows businesses to plan for significant purchases without worrying about running up against an immediate deadline for taking advantage of the tax break.
The write-off is reduced for any business purchasing more than $430,000 in qualifying property during the year. Obviously, this is not an issue for most small businesses. With the generous limits extended through 2009, many larger businesses that might have such significant expenses can plan to time their purchases to stay within the maximum deduction limits on a year-to-year basis.
The $430,000 limit is also adjusted annually for inflation. After 2009, the expense deduction limit is scheduled to fall back to $25,000, with that write-off limit reduced for any business purchasing more than $100,000 worth of qualifying property.
No "bonus depreciation" renewal
The higher limits for new equipment write-offs are separate from and do not revive the "bonus depreciation" rules that many businesses took advantage of through 2004. Congress previously had allowed small businesses to take a bonus depreciation deduction of 50% of the cost of qualifying property purchased after September 11, 2001. That permitted businesses to immediately write off half of the cost of qualifying property while still taking the appropriate usual depreciation allowed on the remainder of the property. Bonus depreciation ended as of December 31, 2004. The extension of the Section 179 expensing limits doesn't affect this.
When to pass
While the large Section 179 deduction is attractive, it isn't necessarily for every business. Some small business owners will find that it makes more sense to take ordinary depreciation rather than the maximum allowed deduction.
For example, let's assume we have a single-owner Limited Liability Company that is breaking even in 2006 before taking into consideration any depreciation or Section 179 deductions. The business is expanding, and needs to invest $50,000 in qualifying equipment before the end of the year.
The business could write off the full amount of that $50,000 investment in 2006. If the LLC owner reports the business revenues on Schedule C of his tax return, those losses would be applied against other income, if any, and could result in an overall Net Operating Loss for 2006.
A NOL can be useful. However, the deduction could wind up being more valuable if it was taken through depreciation over a period of years.
Using the same example, let's assume that the $50,000 is qualifying computer equipment that can be depreciated over five years. Let's also assume that the business is going to produce enough of a profit that the owner will be in the 25% federal income tax bracket in 2007 and future years.
In this case, two positive things happen. First, it's likely that more of the depreciation deduction will be applied against income in the taxpayer's 25% tax rate — instead of the lower 10% or 15% rates — than would be the case if the full expense and business loss were passed through to the taxpayer in one year.
Second, if the income for the owner or partner is going to be subject to self-employment tax, then the depreciation deduction effectively reduces that tax as well — a benefit that is like getting a 15.3% tax break on top of the 25% income tax break. If the deduction were taken in a year when the business had no self-employment profit anyway, there'd be no reduction in that tax.
The math will be different for owners of C Corporations and for income from pass-through entities that is not subject to self-employment tax. However, the principal of trying to have deductions match as well as possible against higher-taxed income levels still holds. You'll want to consult with your tax pro to run projections of tax liabilities and benefits under various scenarios.