Businesses that want to accelerate year-end deductions by buying machinery and equipment have a formidable array of tax tools to work with this year: generous expensing under Code Sec. 179; an expensing safe harbor under the capitalization regs that has been liberalized for smaller businesses; and 50% bonus first-year depreciation for those eligible new assets that can’t be expensed under Code Sec. 179 or the regs’ safe harbor. The first installment of this 3-part Special Study explains how to make the most of Code Sec. 179 expensing. The second and third parts will cover the expensing safe harbor under the capitalization regs, and bonus first year depreciation, respectively.
Generous Expensing Limits can Generate Major Year-End Tax Savings for 2016
Under Code Sec. 179, a taxpayer, other than an estate, trust, and certain noncorporate lessors, can elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property (and certain qualified real property) placed in service during the tax year in the taxpayer’s trade or business. The maximum annual expensing amount generally is reduced dollar-for-dollar by the amount of Code Sec. 179 property placed in service during the tax year in excess of a specified investment ceiling. For tax years beginning after 2015, both the maximum annual expensing amount and the investment ceiling are adjusted for inflation. The amount eligible to be expensed for a tax year can’t exceed the taxable income derived from the taxpayer’s active conduct of its trades or businesses. Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding tax years.
Expensing limits. For tax years beginning in 2016:
- The dollar limitation on the expensing deduction is $500,000; and
- The investment-based reduction in the dollar limitation starts to take effect when expensing-eligible property placed in service in the tax year exceeds $2,010,000 (the investment ceiling).
For tax years beginning in 2017, the dollar limitation on expensing will be $510,000 and the investment ceiling will be $2,030,000.
Observation: For 2016, the Code Sec. 179 deduction doesn’t phase out completely until the cost of expensing-eligible property exceeds $2,510,000 ($2,010,000 (investment ceiling) + $500,000 (dollar limit)). For 2017, expensing won’t phase out until the cost of expensing-eligible property exceeds $2,540,000 ($2,030,000 (investment ceiling) + $510,000 (dollar limit)).
There is no pro rata reduction of the Code Sec. 179 expensing deduction depending on the portion of the year the asset is held. That is, if the deduction is allowable, the amount that may be expensed is the same regardless of when the property is acquired during the year.
Observation: The fact that the expensing deduction may be claimed in full (if the taxpayer is otherwise eligible to take it) regardless of how long the property is held during the year can be a potent tool for year-end tax planning. Thus, property acquired and placed in service in the last days of a tax year, rather than at the beginning of the following year, can result in a full expensing deduction for the earlier year.
Year-end move #1. Taxpayers should factor the annual expensing limits for 2016 and 2017 into their annual equipment-purchase plans.
Illustration 1: During the first eleven months of 2016, Widget, a calendar-year corporation, bought and placed in service $450,000 of production machines, which are expensing-eligible property. It plans to buy an additional $560,000 of production machines early next year. If it’s feasible to do so from the business standpoint, Widget should consider accelerating $50,000 of next year’s purchases into 2016 (and place those purchased assets in service before year-end). This way, Widget will be able to fully expense its purchases (total of $500,000 for 2016 and $510,000 for 2017).
Taxable income limit. The Code Sec. 179 expensing deduction is limited to taxable income from all of the taxpayer’s active trades or businesses. This means that the taxable income limit doesn’t bar an expense deduction just because the particular business in which the property is used doesn’t produce any net income. So long as the taxpayer has aggregate net income from all his trades or businesses, the deduction is allowed. In general, any amount that cannot be deducted because of the taxable income limit can be carried forward to later years until it is fully deducted.
Year-end move #2. Taxpayers should consider making the expensing election even in a year where a less-than-full tax benefit is derived from the election because of the taxable income limit. This way, the right to carry the expensing deduction forward to other years will be preserved.
Illustration 2: In December of 2016, Budget Products, a calendar year business, buys and places in service $500,000 of assets that are 5-year MACRS property subject to the half-year depreciation convention. The assets are used and thus not eligible for bonus depreciation. If Budget Products doesn’t elect to expense any part of the $500,000, then under the half-year depreciation convention (and under the 200% declining balance method), it is entitled to a $100,000 depreciation deduction for this property for 2016 ($500,000 × .20 first year allowance). On the other hand, electing to expense the cost of the assets would reduce business taxable income by $500,000. Moreover, even if Budget Products does not have sufficient taxable income to absorb the entire expensing deduction in 2016, the full amount of the excess will be available to offset taxable income in 2017.
Wages count for taxable income limit. Wages, salaries, tips and other compensation earned by employees are treated as taxable income for purposes of the above mentioned Code Sec. 179 taxable income limit.
Year-end move #3. Employees who run a sideline business may be able to reduce their 2016 tax bill by buying business equipment they need before the end of this year rather than in 2017.
Illustration 3: Jeff is employed as a website designer and earns $70,000 a year. In September of 2016, he starts a wedding photography business but will earn only around $2,000 from it this year. Jeff is planning to buy $5,000 of high-end photo and computer equipment for his sideline business. Because his website designer income is counted for purposes of applying the taxable income limit, if he buys and places the equipment in service this year, Jeff can expense the full $5,000 this year.
Investment-based phaseout of expensing. As noted above, for 2016, the maximum amount that can be expensed under Code Sec. 179 is reduced dollar-for-dollar for eligible property placed in service during the tax year in excess of $2,010,000.
Illustration 4: ABX Corp is a calendar-year taxpayer. In 2016, it buys and places in service $2,300,000 of expensing-eligible used 5-year MACRS property. ABX may only expense $210,000 of its 2016 purchases [$500,000 expensing limit – ($2,300,000 purchases – $2,010,000 investment ceiling)] and must depreciate the balance of its purchases over a period of years.
Amounts ineligible for expensing due to purchases in excess of the investment ceiling can’t be carried forward and expensed in a subsequent year. Rather, they can only be recovered through depreciation.
Year-end move #4. Businesses that are not equipment-intensive enterprises should try to avoid buying and placing in service more than the ceiling amount of expensing-eligible property during the year, if it’s possible from the business standpoint to defer additional purchases. In example 4, above, ABX could claim a $500,000 expensing allowance for 2016 if it deferred $290,000 of its purchases until 2017.
What’s eligible for expensing. In general, property is eligible for Code Sec. 179 expensing if it is:
- Tangible property that’s Code Sec. 1245 property (generally, machinery and equipment), depreciated under the MACRS rules of Code Sec. 168, regardless of its depreciation recovery period.
- Qualified real property, i.e. ,certain improvements to commercial property. Note that for tax years beginning before 2016, there was a $250,000 expensing limitation with respect to qualified real property.
- Off-the-shelf computer software.
- Air conditioning and heating units, for tax years beginning after Dec. 31, 2015.
Observation: There’s no requirement that the acquired property be new. Thus, taxpayers may claim Code Sec. 179 expensing for otherwise eligible used property.
Year-end move #5. As a general rule, to maximize the tax benefit to be gained through expensing, a taxpayer should make the expensing election for eligible property with the longest recovery period.
Illustration 5: In 2016, ABZ, a calendar-year taxpayer, buys and places in service $500,000 of new 5-year MACRS property and $500,000 of new 7-year MACRS property. It doesn’t purchase other property during the year and is subject to the half-year depreciation convention for 2016. If it elects to expense the 7-year property, ABZ can write off the balance of its purchases over the 5-year MACRS recovery period (effectively six years because of the half-year convention). By contrast, if it elects to expense the 5-year property, ABZ will have to write off the balance of its purchases over the 7-year MACRS recovery period (effectively eight years because of the half-year convention).
For more information about how to utilize quick writeoffs for capital goods purchases, contact Larson & Company today.