Jan 29

A PATH to monetizing what the government is incentivizing; the favorable effect of bonus depreciation on taxable income.

To appreciate the government’s bonus depreciation-based incentives laid out in the “Protecting Americans From Tax Hikes (PATH) Act of 2015”, let’s start with the rudiments; a business uses money to make money. A business uses money in two ways; spending (incurring costs for materials and supplies consumed in the normal course of operations) and investing (incurring costs related to acquiring, producing or improving tangible real or personal property).

Let’s look at a couple of simple examples of how spending and investing costs are accounted for before describing deprecation related incentives.

For instance, if a $1M cost incurred in a given tax year is related to acquiring, producing or improving a building (Section 1250 property), and an in-whole depreciation approach is elected, then 1/39th of that $1M can be depreciated and therefore deducted annually from revenues given the IRS allows a 39-year recovery period for a commercial building.

If this same investment was put into manufacturing equipment, considered personal property (Section 179 and {most} Section 1245 property), then that $1M would be deducted from revenues on a fractional basis per the IRS’ guidance as to the life of that equipment. Say the recovery period is 5 years (versus 39 years for the building); only 1/5th of the equipment’s cost could be depreciated in the current year.

Say that $1M was spent on ”…materials and supplies (that) are incidental…e.g., pens, paper, staplers, toner,…then you deduct the materials and supplies costs in the taxable year in which the amounts are paid,…” [source]. So, in this case there would be a current-year 1:1 cost-to-deduction ratio (versus the deduction being 1/39th or 1/5th of the cost in the prior capital investment examples).

Short of diving down the proverbial rabbit holes as represented by IRS url hyperlinks herein, we can see the tax dynamics associated with the two core uses of money in a business; spending and investing, reflecting, respectively, 1:1 current-year impact on taxable income, and fractional impact (based on a property’s “life expectancy”, or recovery period) over time before ultimately reaching 1:1 impact on taxable income (once the recovery period passes).

The PATH Act of 2015 (effectively, of 2016) seeks to provide more business-favorable accounting options related to the handling of investment ‘costs’; the government’s way of encouraging investment related behavior.

With the foundational understanding gained from the preceding case examples, we can better understand the government’s offers to incentivize businesses to invest by allowing investment “costs” to be accounted for in a way that more closely represents the ‘right now and in-full’ accounting of spending costs which, as we’ll see, have a much more favorable near-term impact on taxable income.

For instance, in some cases the IRS allows for investment in property to be deducted disproportionately high in the first year; these “bonus depreciation” offers allow as much as 50 percent of the investment cost to be applied against the first year of the property’s life. So, using the $1M example from above, instead of deducting $200,000 of the equipment’s cost in the first year (of the 5-year life), the business, let’s call it ABC Widget Co., can deduct $500,000 in year one (from revenues). Let’s compare the effect on cash flow in year one if 35%-tax-bracket ABC Widget accepts the bonus depreciation offer; taxable income would be reduced by $500,000 versus $200,000 so ABC Widget’s tax rate would be applied against a taxable income amounting to $300,000 less than it would have been otherwise. ABC would have monetized this incentive to the tune of paying out $105,000 less in current-year taxes than it would have otherwise.

Though not technically ‘bonus depreciation’, let’s use the above example of investing $1M in a building to further illustrate how ABC Widget could monetize related government incentives. The IRS allows for certain components of that building to be segregated into recovery periods much less than 39 years for purposes of increasing current- and near-year ‘taxable-income-reducing’ depreciation deductions. The effect is greater cash flow and probably decreased debt servicing costs associated with borrowing working capital. For more details regarding the cash flow benefits of cost segregation see ##hyperlink “Are the net benefits of cost segregation worth it? A simple case study.”##

The PATH Act (of 2016, effectively) extends and modifies bonus depreciation incentives as detailed by the IRS [source]. The fundamentals behind the ‘why and how’ of bonus depreciation presented heretofore should help even the tax code amateur to now appreciate the government-extended favor behind these verbatim extractions from the IRS Bulletin:

Section 143. “The provision extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in 2019.” “…continues to allow taxpayers to elect to accelerate the use of AMT (alternative minimum tax) credits in lieu of bonus depreciation under special rules for property placed in service during 2015. The provision modifies the AMT rules beginning in 2016 by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation.”

Section 124 extends and modifies “…increased expensing limitations and treatment of certain real property as Section 179 property. The provision permanently extends the small business expensing limitation and phase-out amounts in effect from 2010 to 2014 ($500,000 and $2 million, respectively). These amounts currently are $25,000 and $200,000, respectively. The special rules that allow expensing for computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also are permanently extended.”

Section 123 extends the “…15-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements. The provision permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property.”

Can your business monetize these PATH Act incentives? To find out, Strtyde will perform a no-fee analysis to help determine 1) if a company qualifies, and 2) if the cost-to-benefit ratio for capturing the incentives makes sense. Contact us for more information.