Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
The Section 179 expense deduction appears to be one of the simplest and most beneficial provisions in business tax law. While the basics are simple, just like other provisions, there are twists that can trap the unwary. Fortunately, the traps are easy to avoid.
Most items of tangible personal property (equipment, desks, etc.) can't be expensed, but must be capitalized and depreciated over a number of years. Items with an expected life of more than a year must generally be capitalized. (There is no automatic de minimis rule.) That is, you can't simply decide to expense any piece of equipment with a value of less than, say $250. (You might for financial accounting purposes.) The Section 179 expense allowance provides two benefits. First, you get to write off the entire cost of the property in the year acquired--a big cash flow benefit. Second, and, in some cases just as important, you don't have to do the annual bookkeeping associated with depreciation. And, it's not unusual for a business to dispose of an asset long before it's depreciated. For example, a tool that's broken. If you don't remember to claim the disposition on your return, you won't get the benefit of the early writeoff. Another advantage is help in avoiding the mid-quarter convention for depreciation. This trap can result in a bookkeeping headache and a deferral of depreciation deductions.
Election. You must elect the Section 179 expense option. Fortunately, that's simple. You list on your depreciation schedule (Form 4562) the assets you wish to expense. You've got to provide:
The elected cost line allows you to deduct just a part of the cost of the asset. For example, you purchase an asset for $100,000 but you only want to take the expense option on $75,000. (We'll discuss reasons for that later.)
Listed property (autos, cameras, etc.) is reported separately on page 2 of the form. If you don't have enough lines on the form, attach a statement (here's where computers are particularly handy).
While that's all you need to report, you should keep a more detailed record--date acquired, complete description (Columbia Systems model XXP2 computer) so that you can identify the specific asset and match the original invoices. If you're audited, there's a high probability you'll be asked for details. If the asset is disposed of, make sure you record that too.
You've got to make the election on the return--it's not automatic. Forget to do it on the original return you filed? For tax years 2003 through 2010 you can make, revoke or change the election without IRS consent on an amended return. For tax years beginning after 2010 the election must be made on an original return or on an amended return filed by the due date (including extensions) of the original return. Permission to revoke or change the election requires IRS permission.
If you don't expense the entire cost of an item, the remaining basis is depreciated, beginning in the year the item is placed in service. For example, Madison puts in service a new server for $20,000 in 2010. It elects the expense option on $15,000. The remaining basis is $5,000 and Madison can depreciate $1,000 in 2010.
While the election is claimed by the business, in the case of S corporations, partnerships, LLCs and other pass-through entities, the deduction is taken by the partner or shareholder on his or her personal return. For example, Madison LLC takes a $20,000 election. Fred has a 60% interest in Madison. Fred's $12,000 deduction is passed through to him and reported on his Schedule E along with his share of Madison's profit (or loss).
Qualifying property. Generally, only tangible personal property (equipment, desks, etc.) qualifies. Other qualifying property includes single purpose agricultural structures and other tangible property integral to manufacturing and off-the-shelf computer software (check the rules for other qualifying property). Section 179 property does not include:
The lodging prohibition does not apply to property used by a hotel or motel in connection with the trade or business of furnishing lodging where the accommodations are predominantly used by transients (e.g., regular motel, bed and breakfast). And it does not apply to energy property (e.g. sollar hot water heater) used in a lodging facility. (There are other exceptions.)
Land improvements such as sidewalks, parking lots, etc. don't qualify. Like depreciation, you can only take the Section 179 election on property for the year it is placed in service. Generally, that's the year of acquisition, but not always. An item of property is placed in service when it's available for use. For example, you purchase a new machine on December 15th. The unit is delivered to your shop on the 27th of December, but a technician must connect the power and align the unit. He does that on January 6th. The unit is placed in service in January.
Limitations. There are two basic limitations on the election. First, the total writeoff for any one year can be no more than $500,000. (2010 amount. Go to Federal Depreciation Rates for the current-year limitation.) Second, the $500,000 is reduced, dollar for dollar, if the total amount of qualifying property placed in service during the year exceeds $2,000,000 (2010 amount). A couple of examples will make it clear.
Example 1--Madison Inc. buys $625,000 of qualifying property in 2010. It can take the Section 179 election on $500,000. The $2,000,000 doesn't come into play.The $2,000,000 limitation is there to skew the benefit to smaller businesses. For both the limitations, different restrictions apply to property placed in service by an enterprise zone business or a renewal community business. The dollar limit on the Section 179 deduction is increased by $100,000 (and the total property placed in service limitation increased by $600,000) for qualified Disaster Assistance property. Special rules apply if you're married, filing separate. Finally, for sport utility and certain other vehicles, you cannot elect to expense more than $25,000.
Example 2--Columbia Machine Inc. buys $2,075,000 of qualifying property in 2010. The maximum Section 179 election is $425,000 ($500,000 less $75,000, the excess over the $2,000,000 limitation).
The $500,000/$2,000,000 limitation applies to all members of a controlled group of corporations (regular, or C corporations). Thus, if you own 60% of Madison Inc. and 70% of Columbia Machine Inc. the single limitation applies to both corporations together.
Business income limitation. You can't take a Section 179 deduction for an amount that exceeds the income of the business. For example, before the 179 deduction, Madison had net income of $16,500. Madison's Section 179 deduction is limited to $16,500 for the year.
Of course it's not that simple. The first step is to group all the income and losses from the trades or businesses conducted by the entity. For example, if the S corporation also rents out a part of the building it owns, that income doesn't count (the rental is not a trade or business). Then there are adjustments to make. For example, don't count tax exempt income. Other adjustments depend on the type of entity. We'll deal with the most commonly encountered. Fortunately, chances are good you won't have to worry about the limitation. Better yet, if you're using computer software to prepare your return, the program should make the adjustments automatically.
For partnerships (and LLCs, etc.) and S corporations there are actually two limitations. The first is at the partnership or S corporation level; the second at the partner or shareholder level, i.e., on your Form 1040. An example below will make it clear.
For sole proprietorships, net income from a trade or business includes Section 1231 gains (or losses), and wages, salaries tips, or other pay earned as an employee. Compute your taxable income without regard to the Section 179 deduction, the self-employment tax deduction, any net operating loss carryback or carryforward.
For partnerships, figure taxable income without regard to credits, tax-exempt income, the Section 179 deduction and guaranteed payments (Sec. 707(c)).
For S corporations, the approach is similar. Compute taxable income before any credits, tax-exempt income, Section 179 deduction and deductions for compensation paid to shareholder-employees.
Example--On Madison's tax return for 2010, the net income shown was $26,000 (no adjustment needed for the Sec. 179 deduction since it's not used in computing taxable income). But Fred and Sue, each 50% shareholders in Madison, took a combined $50,000 in salaries. That amount is used in computing income, so it must be added back. Thus, Madison's adjusted income for limitation purposes is $76,000 ($26,000 plus $50,000 in salaries).
Example--Fred is the sole shareholder of Madison Inc., an S corporation. Madison's income for 2010, after adding back Fred's salary, is $50,000. Madison claims $50,000 of Section 179 deduction. Fred is also a 20% partner (and materially participates) in Columbia Machine LLC. Columbia has adjusted income of $100,000 and takes a $80,000 Sec. 179 deduction. Fred also has a sole proprietorship which lost $40,000 in 2010. Fred has $50,000 of Sec. 179 deduction passed through from Madison and $16,000 (20% of $80,000) from Columbia for a total of $66,000. His business income is $50,000 from Madison (profit and salary) and $20,000 from Columbia. But his $40,000 loss from his sole proprietorship brings his business income down to $30,000 ($50,000 + $20,000 - $40,000). Thus, he can only use $30,000 of the Section 179 deductions passed through to him.The overall limitation of $500,000/$2,000,000 (2010 amount) applies at the individual level also. Thus, if Fred is a shareholder/partner in more than one S corporation/partnership/sole proprietorship, the limit applies to him on his Form 1040.
Tax Tip--If some of your Sec. 179 deduction can not be used because of a limitation, you can choose which property. Note the information in your books and records. Which property to pick? Generally, longer lived property makes the most sense. But you should pick property you're unlikely to dispose of early or convert to personal use. For example, you generally keep a laptop only three years. Take the 179 election on the desks and chairs instead.Section 179 deductions that can't be used because of an income limitation can be carried forward indefinitely and used in future years. The downside is that you'll have to reduce your basis in the S corporation or partnership by the amount of the deduction passed through, even if the you can't use the deduction to reduce your income. And don't automatically assume you'll have income in future years that can be offset by the deduction. That caution particularly applies to start-up entities.
Tax Tip--If you can control the deduction (i.e., you have a voice in whether or not the election is made and how much) you want to work through the numbers before automatically taking the deduction. It makes no sense to take a $100,000 deduction that puts you in the 15% bracket in 2010 only find yourself paying taxes at 25% in the following year. You may want to take a lower (or no) Sec. 179 deduction and take depreciation on the assets to even out your income over several years.
Tax Tip--Some of the traps mentioned above become more important if the Sec. 179 deduction goes back to the lower levels of prior law.
Qualifying property. While qualifying property may be new or used, the property must be purchased from an unrelated party. For example, Fred owns 50% of the stock of Madison Inc. He buys a used tractor from Columbia Inc., which is 100% owned by his father. The tractor would not qualify. We won't go into the whole definition of related party. If you think there's an issue, talk to your tax advisor.
We highlighted purchased, because that's important here too. Sometimes property isn't purchased for the business. For example, Fred had a pickup truck he used for personal purposes. He contributed the truck to Madison Inc. in exchange for stock when starting the corporation. The truck does not qualify.
The definition of property qualifying for Section 179 is temporarily expanded to include certain real property-specifically, qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. The maximum amount with respect to real property that may be expensed is $250,000. The expanded definition applies to property for taxable years 2010 and 2011. In addition, Section 179 deductions attributable to qualified real property that are disallowed under the trade or business income limitation may only be carried over to taxable years in which the definition of eligible Section 179 property includes qualified real property.
Property acquired in a like-kind exchange qualifies only to the extent of the cash paid (or loan assumed) for the property. For example, Madison Inc. trades in a used backhoe for a new one. The dealer allows $11,000 trade-in allowance toward the $45,000 backhoe. Madison pays the difference, with cash of $20,000 and a loan of $14,000 (total $34,000). Madison can take a Section 179 deduction of $34,000.
Leased property. Generally, you cannot claim a Section 179 deduction for property leased to someone else. There are two exceptions. The first is for property you manufacture or produce. For example, you manufacture machine tools and lease them as part of your business. The second exception is for property you lease to others if the term of the lease (including options to renew) is less than 50% of the property's class life, and for the first 12 months after the property is transferred to the lessee, the total business deductions you are allowed on the property (other than rents and reimbursed amounts and depreciation) are more than 15% of the rental income from the property.
Tax Tip--This means that you generally won't be able to claim the Section 179 deduction on equipment you purchase personally (or through a partnership or S corporation) and lease to a related or unrelated party. Owning the property personally or through another entity may still make sense for other purposes. Talk to your accountant.Estates and trust. The Section 179 deduction does not apply to estates and trusts.
Partial business use. When you use property for both business and nonbusiness purposes, you can elect the Section 179 deduction only if you use the property more than 50% for business in the year it is placed in service. if you use the property more than 50% for business, multiply the cost of the property by the percentage of business use to determine the business cost qualifying for the deduction.
Fred buys a new truck for his sole proprietorship for $22,000. In the first year he uses it 60% for business. Because it is used more than 50% it qualifies for a partial deduction of $13,200 (60% of $22,000).Recapture. This is the nasty trap. You may have to recapture the Section 179 deduction if, in any year during the property's recovery (depreciation) period, the percentage of business use drops to 50% or less. In that year, you include the recapture amount as ordinary income in Part IV of Form 4797. You also increase the basis of the property by the recapture amount. (If you sell or otherwise dispose of the property, use the rules for recapturing depreciation under Section 1245 property.) If the property is listed property (auto, etc.) and the business use drops to 50% or less, use the rules for recapturing excess depreciation.
You compute the recapture amount by first figuring the depreciation that would have been allowable on the claimed 179 deduction. Use the year the property was placed in service through the year of recapture. Subtract the depreciation amount from the Section 179 deduction claimed. This the recapture amount.
Example--In February 2008 Madison Inc. placed in service a tractor costing $30,000. The tractor is 5-year property and not listed property. Madison claimed a $20,000 Section 179 deduction and used the property 100% for business in 2008 and 2009. In 2010, the business use dropped to 40% and the personal use was 60%.The recapture can come as a shock and could boost your income in a year you really don't need the extra income. For example, business is off 40% in 2010. Cash flow has been even worse. You sell some equipment and convert a truck to personal use. The equipment sales generate cash, but they also could generate recapture income. The conversion of the truck to personal use generates no cash, only recapture income. The result could be substantially more income, and taxes, than you anticipated. As always, work through the numbers.
Section 179 deduction claimed $20,000 Less: Allowable depreciation on $20,000: 2008 (20% x $20,000) $4,000 2009 (32% x $20,000) 6,400 2010 (19.20% x 40% (business) x $20,000) 1,536 11,936 2010 Recapture amount 8,064For 2010 Madison must include $8,064 in income. Note, we only had to deal with $20,000 (not the total $30,000 cost) since that was the amount of Section 179 deduction taken. There could be similar recapture for depreciation, but we won't deal with that here.
Tax Tip--If you're going to convert a vehicle to personal use, consider selecting a vehicle that's beyond its recovery period.Mid-quarter convention and AMT. The mid-quarter convention applies to all property placed in service during the year if more than 40% of the total depreciable basis is placed in service in the fourth quarter of the year. (Real property is excluded from the calculation.) For example, Madison is a calendar-year corporation. It purchases a total of $100,000 of property for 2010, but $52,000 was purchased in October. The rule applies and now you have to depreciate assets placed in service in each quarter using a different rate. Not only a nuisance, the assets placed in service in October will generate little depreciation in 2010.
You can avoid this trap by electing to expense some of the late-year purchases. These will be taken out of the equation. Using the example above, Madison elects to expense $40,000 of the October purchases. Now the total purchases for the year are $60,000 and you won't have to use the mid-quarter convention.
One of the preference items for alternative minimum tax purposes is accelerated depreciation. The Section 179 expense option is not considered a preference item. That could help you avoid or reduce an AMT problem.
State rules. Not all states recognize the same limits for the Section 179 election. For that matter, not all states recognize some of the federal accelerated depreciation methods. Check the rules in your state.
The list below is intended as a quick checklist for professionals as an aid to requirements, traps and planning points.
Copyright 2010 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 10/12/10