YEAR-END PLANNING: MAKING THE MOST OF QUICK WRITEOFFS FOR CAPITAL GOODS PURCHASES PART I

Transcription

1 YEAR-END PLANNING: MAKING THE MOST OF QUICK WRITEOFFS FOR CAPITAL GOODS PURCHASES PART I Although bonus first-year depreciation and more-generous Code Sec. 179 expensing limits have been extended before, another lease on life for these tax breaks is far from certain this time around. Unless Congress acts, additional depreciation deductions under Code Sec. 168(k) in the placed-inservice year equal to 50% of the adjusted basis of qualified property won't be available after this year. Also, the Code Sec. 179 expensing limit is set to plummet to $25,000 for property placed in service next year. Thus, enterprises planning to purchase machinery and equipment during the remainder of this year or early the next should try to accelerate their buying plans, if doing so makes sound business sense. This is the first installment of a multi-part Practice Alert on how businesses may be able to lock in accelerated deductions by buying qualifying assets this year and placing them in service before year-end. Part I, in this article, concentrates on how to make the most of the 50% bonus first-year depreciation allowance for qualified assets placed in service this year. Buy Depreciable Property and Place It in Service This Year to Lock in 50% Bonus First-Year Depreciation Under current law, a 50% bonus first-year depreciation allowance applies to qualified property acquired and placed in service after Dec. 31, 2011 and before Jan. 1, 2013 (before Jan. 1, 2014 for certain specialized property). (Code Sec. 168(k); Reg (k)-1(d)(1)) The adjusted basis of qualified property is reduced by the additional 50% depreciation deduction before computing the amount otherwise allowable as a depreciation deduction for the tax year and any later tax year. If Code Sec. 179 expensing is claimed on qualified property, the amount expensed comes off the top before the additional 50% first-year depreciation allowance is computed. Then the taxpayer computes regular first-year depreciation (and depreciation for future years) with reference to the adjusted basis remaining after expensing and after the additional 50% first-year allowance. There is no alternative minimum tax (AMT) depreciation adjustment for property written off under Code Sec. 168(k), which provides for the additional 50% first-year depreciation allowance. RIA illustration 1: ABC, Inc., a calendar-year business, needs to buy $500,000 of five-year MACRS property. If it does so before Jan. 1, 2013, and places the property in service before that date, ABC may claim a first-year depreciation allowance of $300,000 [($500, = $250,000 bonus depreciation) + ($500,000 $250, = $50,000 regular first-year depreciation)]. This assumes that the half-year convention applies for 2012 (conventions are discussed below). If it waits until 2013 to buy the assets, and bonus first-year depreciation isn't extended, ABC's regular firstyear depreciation allowance using the half-year convention would be only $100,000 (20%). RIA observation: The bonus depreciation deduction is determined without any proration based on the length of the tax year. As a result, accelerated first-year deductions are available even if qualifying assets are in service for only a few days in RIA caution: Accelerating a purchase into 2012 may not always be a good idea. For example, it may not produce good results for a taxpayer that has an about-to-expire net operating loss. On the other hand, if accelerating the purchase will produce a net operating loss for 2012 that can be carried back to 2010, and the taxpayer had income taxed at the highest rate in that year, then this may be a good reason to make the purchase in 2012.

2 How to qualify for bonus depreciation. In general, an asset purchased in 2012 qualifies for the bonus depreciation allowance under Code Sec. 168(k) if: It falls into one of the following categories: property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less; computer software other than computer software covered by the amortization of goodwill and other intangibles rules of Code Sec. 197; qualified leasehold improvement property (i.e., certain interior improvements to nonresidential buildings); or certain water utility property. It is placed in service before Jan. 1, 2013 (certain aircraft and certain property with a long production period may be placed in service before Jan. 1, 2014). Its original use commences with the taxpayer. Original use is the first use to which the property is put, whether or not that use corresponds to the taxpayer's use of the property. The 50% additional first-year depreciation allowance applies to qualified property unless the taxpayer elects out. The election out may be made for any class of property for any tax year, and if made applies to all property in that class placed in service during that tax year. (Code Sec. 168(k)(2)(D)) RIA caution: A taxpayer that elects out of additional first-year depreciation for a specific class of property is subject to the AMT depreciation adjustment for property in that class. That means AMT depreciation is computed using the 150% declining balance method (switching to straight line in the year necessary to maximize the allowance), except that straight line is used for property for which straight-line depreciation must be used for regular tax purposes. The recovery period is the same for AMT and regular tax purposes. For eligible qualified property (generally, qualified property eligible for bonus depreciation) that is originally used and acquired after Dec. 31, 2010 and placed in service before Jan. 1, 2013 (Jan. 1, 2014 for certain long-production period property and certain aircraft), corporations can elect to forego bonus depreciation and accelerated depreciation in exchange for an increased AMT credit limitation. (Code Sec. 168(k)(4)) Last year for extra-generous luxury auto depreciation limits? If bonus first-year depreciation deductions come to an end at the close of 2012, so will the extra-generous first-year dollar limit on autos, light trucks, and vans subject to the Code Sec. 280F luxury auto rules. Under Code Sec. 168(k)(2)(F)(i), the first-year depreciation deduction for new vehicles that qualify for bonus depreciation is $8,000 more than the first-year depreciation limit that would otherwise apply. For new vehicles bought and placed in service in 2012, and that qualify for bonus first-year depreciation, the boosted first-year dollar limit is $11,160 for autos (not trucks or vans), and $11,360 for light trucks or vans (passenger autos built on a truck chassis, including minivans and sport-utility vehicles (SUVs) built on a truck chassis). The regular first-year luxury auto limits (e.g., for vehicles not eligible for bonus depreciation, or for which the taxpayer elects out of bonus depreciation) are $3,160 for autos and $3,360 for light trucks or vans. However, under current law, these boosted dollar amounts apply only for vehicles bought and placed in service before As a result, taxpayers thinking of buying a new auto, light truck or van for trade or business use should buy the vehicle and place it in service this year if they want to maximize first-year deductions. RIA observation: Heavy SUVs those that are built on a truck chassis and are rated at more than 6,000 pounds gross (loaded) vehicle weight are exempt from the luxury-auto dollar caps because they fall outside of the Code Sec. 280F(d)(5) definition of a passenger auto. Under Code Sec. 179(b)(6), not more than $25,000 of the cost of a heavy SUV may be expensed under Code Sec The balance of the heavy SUV's cost may be depreciated under the regular rules that apply to five-year MACRS property (e.g., a 20% first-year depreciation allowance if the half-year

3 convention applies for the placed-in-service year). However, with the 50% first-year bonus depreciation available for qualified assets bought and placed in service in 2012 (in addition to the $25,000 expensing allowance and regular depreciation), taxpayers buying and placing in service new heavy SUVs in 2012 may be entitled to write off most of the cost of the vehicle in the first year. Effect of half-year and midquarter conventions on year-end planning. The half-year convention generally applies in the computation of depreciation deductions for property (other than real property) first placed in service during the current tax year. Under this convention, a business asset placed in service at any time during the tax year is generally treated as having been placed in service in the middle of that year. (Code Sec. 168(d)(1)) However, the half-year convention only applies if property depreciable under Code Sec. 168 and placed in service during the last three months of the tax year (other than property expensed under Code Sec. 179, residential rental property, nonresidential realty and certain other excluded categories) doesn't exceed 40% of all of such property placed in service during the entire year. If it does, then a midquarter convention applies. (Code Sec. 168(d)(3)) Under that rule, personal property placed in service during any quarter of the tax year is treated as if it had been placed in service at the middle of the quarter in which it was placed in service. RIA illustration 2: Widget Inc., buys one depreciable asset during 2012, a $5,000 used machine that's five-year property under MACRS. Assume Widget isn't eligible for Code Sec. 179 expensing. If it places the asset in service during the first three quarters of its tax year, the first-year depreciation allowance is $1,000 (20%). If it places the asset in service during its 4th quarter, the writeoff is slashed to $250. RIA observation: The standard wisdom has been that businesses should try to avoid final quarter purchases because doing so could trigger the midquarter convention. However, the availability of bonus first-year depreciation this year on most new machinery and equipment purchases (see discussion above) substantially diminishes the hazards of buying in the last quarter. The 50% firstyear bonus depreciation allowance is available even if the midquarter convention applies. In that case, the midquarter allowance is taken on the adjusted basis of the property after reduction for the bonus depreciation allowance. RIA illustration 3: Acorn Inc., a calendar-year corporation, is close to buying $500,000 of new five-year property. This will be its only equipment purchase for the year and Acorn isn't eligible for Code Sec. 179 expensing. Even though it waits until the last quarter to buy the assets and place them in service, Acorn's first-year depreciation allowance still will be $262,500 [($500, = $250,000 bonus first-year allowance) + ($500,000 $250, = $12,500 regular first-year depreciation allowance under the midquarter convention)]. If the bonus depreciation rules didn't apply, its depreciation allowance would be only $25,000 (5% of $500,000). If it waits until 2013 to place the property in service, and Congress doesn't extend bonus depreciation, Acorn's depreciation allowance will be only $100,000 (20% of $500,000). RIA observation: Use of the bonus first-year depreciation allowance has no effect on the determination of whether or not the midquarter convention applies. The 40% test is computed with reference to the adjusted basis of non-realty assets placed in service during the year, without reduction for the bonus depreciation allowance. RIA observation: It may be possible in some cases to avoid application of the midquarter convention by electing to expense under Code Sec. 179 property placed in service during the last quarter. On the other hand, deliberately exceeding the 40% limit to trigger the midquarter convention may be a sound strategy where the taxpayer has placed a large amount of property in service during the first quarter of the year. For instance, if a calendar-year taxpayer placed a large amount of fiveyear recovery property in service in March of 2012, triggering the midquarter convention for 2012 will produce a 10 1/2 month regular first-year depreciation deduction for that property.

4 YEAR-END PLANNING: MAKING THE MOST OF QUICK WRITEOFFS FOR CAPITAL GOODS PURCHASES PART II Although bonus first-year depreciation and more-generous Code Sec. 179 expensing limits have been extended before, another lease on life for these tax breaks is far from certain this time around. Unless Congress acts, additional depreciation deductions under Code Sec. 168(k) in the placed-inservice year equal to 50% of the adjusted basis of qualified property won't be available after this year. Also, the Code Sec. 179 expensing limit is set to plummet to $25,000 for property placed in service next year. Thus, enterprises planning to purchase machinery and equipment during the remainder of this year or early the next should try to accelerate their buying plans, if doing so makes sound business sense. This is the second installment of a two-part Practice Alert on how businesses may be able to lock in accelerated deductions by buying qualifying assets this year and placing them in service before year-end. Part II, in this article, concentrates on how to make the most of the current, generous Code Sec. 179 expensing rules that might not survive in the extender legislation to be debated this fall or early winter. For Part I, covering the 50% bonus first-year depreciation allowance set to expire at the end of this year, see 45. Making the Most of the Current Code Sec. 179 Expensing Limits for 2012 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 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. The amount eligible to be expensed for a tax year can't exceed the taxable income derived from the taxpayer's active conduct of a trade or business. 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 For tax years beginning in 2012: (1) the dollar limitation on the expense deduction is $139,000; and (2) the investment-based reduction in the dollar limitation starts to take effect when property placed in service in the tax year exceeds $560,000 (the investment ceiling). (Code Sec. 179(b)(1) and Code Sec. 179(b)(2)) Those limits are much less generous than the $500,000 expensing limit and $2,000,000 investment ceiling that applied for 2010 and However, the 2012 limits are far more generous than the dollar limits scheduled to apply under current law for tax years beginning in 2013: a $25,000 expensing limit, and a $200,000 investment ceiling. (Code Sec. 179(b)) RIA observation: Under the current limits, the Code Sec. 179 deduction doesn't phase out completely until the cost of expensing-eligible property exceeds $699,000 ($560,000 (investment ceiling) + $139,000 (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. If the deduction is allowable, the amount that may be expensed is the same regardless of when the property is acquired during the year. (Code Sec. 179; Reg (c)(1)) RIA recommendation: The fact that the expense deduction may be deducted in full regardless of how long the property is held during the year can be a potent tool for year-end tax planning. Thus,

5 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 expense deduction for the earlier year. Year-end move #1. Where possible, taxpayers should factor the annual expensing limits for 2012 and 2013 into their annual equipment-purchase plans so as to maximize the writeoff for this year and the next. RIA illustration 1: During the first eleven months of 2012, ABC, a calendar-year corporation, bought and placed in service $100,000 of expensing-eligible property. It plans to buy an additional $64,000 of expensing-eligible property early next year. If it's feasible to do so from the business standpoint, ABC should consider accelerating $39,000 of next year's purchases into 2012 (and place the additional assets in service before year-end). This way, ABC will be able to fully expense its purchases (total of $139,000 for 2012 and $25,000 for 2013). Taxable income limit. The Code Sec. 179 expensing deduction is limited to taxable income from any 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. (Code Sec. 179(b)(3); Reg (c)(1)) 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. (Code Sec. 179(b)(3)(B)) Year-end move #2. Taxpayers should consider making the expense 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 taxpayer's right to carry the expensing deduction forward to other years is preserved. RIA illustration 2: In December of 2012, Widget Products, a calendar year business, buys and places in service $130,000 of qualified 5-year MACRS property subject to the half-year depreciation convention. The asset is used and thus isn't eligible for bonus depreciation. If Widget Products doesn't elect to expense any part of the $130,000, then under the half-year depreciation convention (and under the 200% declining balance method), it is entitled to a $26,000 depreciation deduction for this property for 2012 ($130, first year allowance). On the other hand, electing to expense the cost of the asset would reduce business taxable income by $130,000. Moreover, even if Widget Products does not have sufficient taxable income to absorb the entire expensing deduction in 2012, the full amount of the excess will be available to offset taxable income in Wages count for taxable income limit. Wages, salaries, tips and other compensation earned by employees count for purposes of their Code Sec. 179 taxable income limit. (Reg (c)(6)(iv)) Year-end move #3. Employees who run a sideline business may be able to reduce their 2012 tax bill by buying business equipment they need before the end of this year rather than in RIA illustration 3: Jane is employed as a website designer and earns $70,000 a year. In September of 2012, she starts a photo sideline business but will earn only around $2,000 from it this year. Jane is planning to buy $3,000 of high-end photo and computer equipment for her sideline business. If she buys and places the equipment in service this year, Jane can fully offset her $2,000 freelance income and $1,000 of her regular employment income. Investment-based phaseout of expensing. As we've said, for 2012, 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 $560,000. RIA illustration 4: XYZ Corp is a calendar-year taxpayer. In 2012, it buys and places in service $600,000 of expensing-eligible used 5-year MACRS property. XYZ may only expense $99,000 of its 2012 purchases [$139,000 expensing limit ($600,000 purchases $560,000 beginning-of-

6 phaseout amount)] and must depreciate the $501,000 balance of its purchases over a period of years. RIA caution: Amounts ineligible for expensing due to excess investments in expensing-eligible property 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. What's eligible for expensing. In general, property is eligible for Code Sec. 179 expensing if it is: tangible property that's Code Sec property (generally, machinery and equipment), depreciated under the MACRS rules of Code Sec. 168, regardless of its depreciation recovery period (Code Sec. 179(d)(1)(A)(i)); for any tax year beginning in 2010 or 2011, up to $250,000 of qualified real property (Code Sec. 179(f)(1)); and if placed in service in a tax year beginning before 2013, off-the-shelf computer software. (Code Sec. 179(d)(1)) RIA observation: There's no requirement that the acquired property be new. Thus, taxpayers may claim 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. RIA illustration 5: In 2012, ABZ, a calendar-year taxpayer, buys and places in service $135,000 of new 5-year MACRS property and $135,000 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 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 6 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 8 years because of the half-year convention).