It seems like only yesterday tax reform blotted newspapers and publications with derisive headlines ostentatiously for taking stark positions as a means to engender compromise. Well, those fights have come and gone and now the repercussions of those changes will last for years to come.
Now, taxpayers need to understand the new law’s changes and plan their financial situations accordingly. Businesses will certainly follow suit or risk leaving significant money on the table.
Many around the country benefited from changes seen under the new law and saw lower overall tax bills, assuming their tax situations remained similar to the previous year.
Companies, along with the wealthy, are undoubtedly the largest beneficiaries of the law, and have enjoyed numerous tax benefits. In particular, the largest among them being the significant drop in the corporate income tax rate from 35% to 21%, the new tax deduction tied to qualified business income, and the beneficial changes to accelerated depreciation.
That last item has been a fixture of the tax code since the 1980s and many businesses (as well as those employed in a trade or business) have taken advantage of this favorable tax treatment.
Accelerated depreciation differs from book depreciation, or the gradual expensing of an asset’s value over time, by accelerating the rate at which depreciation expense can be deducted against taxable income. Hence, accelerated depreciation.
Traditionally, companies invest in an asset, determine its expected useful life, and allocate depreciation expense equivalent to the loss in value across time. They track capital stock portfolios and use accelerated depreciation to speed up their expensing to the benefit of taxpayers taking it.
The IRS oversees the federal tax code, a system which uses the more rewarding accelerated depreciation treatment. The putative justification for this system being the inducement of companies to invest and expand their operations.
In so doing, this should have a better chance of accelerating growth in the economy. Or so the argument goes.
While there is much debate about the effectiveness of the Modified Accelerated Cost Recovery System (MACRS), bonus depreciation and the Section 179 expensing election, many company managers have taken advantage of the tax benefits given to them nevertheless. In truth, they would be fools not to seize the opportunity.
Despite the mixed reviews of whether accelerated depreciation effectively increases business investment in the economy, the system has provided companies with ample opportunity to use the time value of money to their advantage.
This is because companies can use MACRS depreciation, bonus depreciation, and Section 179 deductions to accelerate their depreciation expense as sizable tax deductions.
By using accelerated tax depreciation, businesses lower their tax burden today when a dollar is worth more while increasing it in the future when it is worth less. Stated simply, the total taxes paid remain the same but when the company pays them differs. This results in a lower net present value of the tax burden.
As highlighted above, changes made to tax law by recent legislation will certainly be of interest to businesses and will be implemented in their tax planning going forward. Of interest to this post will be the examination of the impact seen on accelerated depreciation as a result of tax reform.
This system has been in place in its current form since 1986 and represents a major way for companies to depress their taxable income and deliver a higher net income figure on their income statement.
Under traditional GAAP (Generally Accepted Accounting Principles) standards, depreciation expense is accounted for using the straight-line method, double-declining method, or other available alternatives.
However, come tax preparation time, companies may also take advantage of accelerated tax depreciation in the form of MACRS. Choosing this expense results in higher tax depreciation expense and lower taxable income, all things being equal.
As part of their regular guidance provided to taxpayers, the IRS publishes MACRS depreciation tables which many use for calculating their tax depreciation expense. Depending on property type, assets fall into certain categories and utilize mid-month, mid-quarter and half-year conventions for determining the tax depreciation expense.
Such asset types include automobiles, solar equipment (which also qualifies for the solar investment tax credit benefit), and residential real estate. For the last item, some real estate investors have utilized MACRS depreciation to offset their taxable income resulting from rental properties and can pay zero tax on their passive income.
The new tax law has not affected these tables nor any other provisions of the MACRS rules. However, the same is not true for two other forms of accelerated depreciation discussed below.
In the early years of the 21st century, bonus depreciation was a new accelerated depreciation provision passed into law. When this initially became law, companies could immediately depreciate 50% of the value paid for qualified capital investments for tax purposes in the year placed in service.
It’s not hard to see why this provision might be popular with businesses. The ability to instantly write-off half of an asset’s value for tax purposes stood to make a sizable dent in the taxable income reported to the IRS.
However, Congress did not intend for this provision to last beyond a certain period. When passed into law, a sunset provision would have phased out bonus depreciation and returned to normal accelerated depreciation rules.
And much like the thought of cutting entitlement programs put in place to provide for the common welfare of the population, taking this away from companies proved to be difficult. Companies enjoyed the free money and Congress responded by extending the popular provision multiple times.
Eventually, the decision was made to step down the tax benefit and no longer have this option available to taxpayers. The thinking here would be to avoid a cliff for corporations and their tax planning efforts. Perhaps unexpectedly, the cliff went the other way by actually ramping up bonus depreciation to a new level.
Now, TCJA allows “full expensing”, which is the ability for taxpayers to expense (write off) the entire cost of an investment in the year placed into service. The new tax law allows full expensing for only five years, which should entice businesses to accelerate investments they likely would have made later.
Effectively, this pulls forward investments taxpayers otherwise would have made in the future unsubsidized by bonus depreciation. This does not necessarily induce incremental investment above what originally had been in companies’ capital plans. At least not according to this company executive.
Section 179 Expense
Prior to the passage of TCJA, taxpayers could choose to expense qualified Section 179 property up to an annual limit of $500,000. The new tax law increased the limit four-fold to cover higher ticket price property placed into service during the tax year.
For section 179 expense, there is an element to be aware of for higher value items, however. This accelerated depreciation provision reduces dollar-for-dollar for each incremental dollar in value above $2 million.
For example, if a taxpayer places a $2,300,000 asset into service, only $1,700,000 can be expensed under Section 179. Also, Section 179 limits adjust for inflation.
Another change to this deduction comes with the change of scope for items to which it can be applied. Prior to the change, TCJA section 179 property included mostly depreciable tangible personal property. The new tax law reclassified many of the categories eligible for taking this deduction to more generalized classifications.
For example, prior to TCJA, only restaurant buildings or other land improvements to leased space qualified for section 179 expensing.
Said in plain English, those improvements made to prepare a rented space for better functionality.
Under TCJA, these narrow restrictions have been removed and a broader qualified improvement property category has replaced them.
Now, in addition to those restaurant and certain building improvements to leased space, certain structural components of a building like HVAC system, fire protection and alarm systems, and security systems also qualify for section 179 expensing.
More specifically, the law only stipulates now that these improvements cannot relate to residential rental complexes like apartment buildings.
Tax reform resulted in changes for many taxpayers, including companies and those employed in a trade or business. Many enjoyed lower tax rates, wider tax brackets, higher standard deductions, and less stringent while more rewarding accelerated depreciation options.
Regarding the primary accelerated depreciation options available to taxpayers, the new tax law led to some changes in accelerated depreciation for bonus depreciation and Section 179 expensing, while nothing much changed for MACRS depreciation.
In particular, bonus depreciation was expanded and extended to include full-expensing through 2022 while Section 179 increased the dollar threshold on assets and also generalized the property qualifications.
While unchanged under tax reform, taxpayers should also pay attention to depreciation recapture rules around Section 1231, 1245, and 1250 property with respect to gains and losses. This can also play into crypto taxes you should understand if you’re organized as a trade or business.
Despite having the rationale behind these tax provisions for incentivizing companies into making added investment in the economy, these programs were only augmented or changed in ways favorable to taxpayers.
Even with the uncertainty around their effectiveness in generating greater economic activity, doubtlessly, many companies will use the benefits to their advantage and will not question the gift they have.