Small Business Taxes & Management^TM--Copyright 2003, A/N Group, Inc.

Growth Incentives for Business

Increase and Extension of Bonus Depreciation

In early 2002 Congress passed the Job Creation and Worker Assistance Act of 2002 which introduced the 30% bonus depreciation. The new law increases the first-year bonus depreciation to 50% from 30% and extends the deadline for the provision. The 50% bonus depreciation applies to new property purchased after May 5, 2003 and before January 1, 2005.

As with the 30% bonus depreciation, the 50% depreciation only applies to new property. Thus, a new truck qualifies, but not a used one. The exact wording in the law requires that the "original use" must start with the taxpayer.

The bonus depreciation only applies to property with a recovery period of 20 years or less, qualified leasehold improvement property, and certain other property. Thus, (with the exception of qualified leasehold improvement property) it does not apply to buildings. It doesn't apply to property purchased after May 5, 2003 if there was a written binding contract for the purchase of the property in effective before May 6, 2003. Thus, even that new truck may not qualify if you had a binding contract for the purchase before the applicable date. Generally, the property must be placed in service before January 1, 2005. (Certain property qualifies for an extension to January 1, 2006.) That means, equipment ordered in late December, 2004 and not in house before January 1, 2005 won't qualify. You can take the bonus depreciation on computer software, but not on listed property (e.g., autos) where the business use is 50% or less.

Example--Madison Inc. purchases bulldozer for $100,000. Madison elects to use $10,000 of the Section 179 expense option on the equipment, reducing the adjusted basis to $90,000. Madison then applies the 50% bonus depreciation, taking $45,000 of depreciation (50% of $90,000). The remaining basis, $45,000 is written off using the regular depreciation rules.

Unless you elect out of the bonus depreciation, you must take the 50% writeoff. You can elect out of the bonus depreciation for any class of assets. For example, you can take the bonus depreciation on furniture, fixtures, etc. property (7-yr property) placed in service during the year, but elect not to do so on cars, computers, etc. (5-yr. property). The election is made on your tax return by attaching a statement. You can find a sample statement at www.smbiz.com/sbfrm011.html.

Tax Tip--Why would you want to elect out? The bonus depreciation simply accelerates the normal depreciation deduction. That's good from a cash flow standpoint. All things being equal, getting a tax deduction today is better than one tomorrow. You'll have more cash upfront. But there are other factors. Taking a big deduction doesn't make sense if you'll end up in a low bracket this year only to be in a much higher one next year because you're left with a much lower depreciation deduction. You want to try and minimize your tax rate over as many years as possible. Best advice? Work through the numbers with your accountant.

Tax Tip--Like the 30% bonus depreciation, the 50% bonus is a major benefit to taxpayers who make qualified leasehold improvements. Leasehold improvements to nonresidential property are normally be written off over 39 years. That's a long time to recover your investment. (You can, of course, write off any undepreciated amount if you dispose of or abandon the improvement.) This provision allows you to write off 50% in the first year, a big advantage. But not all leasehold improvements qualify. Some improvements are really tangible personal property. They include movable partitions, carpeting, fixtures that aren't attached, etc. They're depreciated using the rules for personal property. Qualified leasehold improvement requirements:

• Only the interior portion of a nonresidential property qualifies.
  
• Additions that enlarge the building don't qualify.
  
• Elevators, escalators, improvements to the internal structure or structural components benefiting a common area don't qualify.
  
• The improvement must be made under a lease by the lessee, lessor, or sublessee and must be placed in service more than 3 years after the date the building was first placed in service.
  
• The lease may not be between related persons (defined in Sec. 267(b), but substituting more than 50% for the phrase 80% or more).

In order for autos to benefit from the increased bonus depreciation, the bonus depreciation that can be taken in conjunction with autos is increased from $4,600 (applicable for the 30% bonus) to $7,650. Thus, if the regular first-year depreciation limit for an auto is $3,060 (the amount for 2003 hasn't been published yet), it will be increased to $10,710 (3,060 + 7,650).

The new law makes conforming amendments to property in the New York Liberty Zone (Section 1400L).

Section 179 Expense Option Benefits Expanded

Dollar limitation increased. The Section 179 expense option allows a taxpayer to expense qualifying property (generally, tangible personal property) up to a certain dollar amount. The property to be expensed must be identified on the tax return. You can pick individual items from any property class. The maximum amount that could be expensed in 2003 was scheduled to be $25,000. Under the new law, the amount will be $100,000. The $100,000 maximum applies to taxable years beginning after 2002 and before 2006. Thus, for calendar-year taxpayers, the higher limit applies to 2003, 2004, and 2005.

Increase in phaseout start. The amount that can be expensed is phased out for taxpayers who place more than a certain amount of qualifying assets in service in any taxable year. Under the old law, the phaseout began at $200,000. The new law increases the limit to $400,000. The reduction is on a dollar-for-dollar basis. Thus, taxpayers who $425,000 in qualifying assets in service during the year can only expense $75,000. The effective dates are the same as above.

Computer software. Under the old law off-the-shelf computer software did not qualify for the Section 179 expense option. Under the new law such computer software is qualifying property. The effective dates are the same as for the increased dollar limitation.

Other points. Qualifying property is tangible personal property used in the active conduct of a trade or business. Air conditioning and heating units are specifically excluded. The $100,000 and $400,000 amounts will be indexed for inflation. Under prior law, once made, you could not revoke an election to expense any property, except by permission of the IRS. That could be a major disadvantage if you decide soon after the filing the return. You would have wasted part of the maximum amount that could be expensed. Under the new law, you can revoke the election with respect to any property. However, once such revocation is made, it is irrevocable.

Tax Tip--Now that the depreciation and expensing options are more generous, should you buy equipment? The changes make equipment purchases more attractive since you can write off the assets faster, increasing your cash flow through upfront tax savings. However, while the tax benefits lower the effective cost of the asset, the effect isn't substantial and varies with the class life of the property. The longer the life of the property, the bigger the benefit. You've still got to compute a rate of return using net present value, internal rate of return, or another technique.

Section 179 vs. bonus depreciation. While both the 50% bonus depreciation and expense option allow you to write off equipment much faster, there are differences between the two approaches. And there is some interaction. If you take the expense option, you'll have reduced your cost basis so that you won't be able to claim as much bonus depreciation. You don't want to use the Section 179 option on equipment that might be disposed of early in the life of the asset if you're over the $100,000 limitation. And you should use the option on the longest lived assets.

The Section 179 election can be made on new or used assets. The bonus depreciation only applies to new assets.

The Section 179 limitation applies at both the entity and shareholder or partner level in the case of passthrough entities. If the S corporation has only one shareholder and the shareholder has no other business interests, that's not a problem. But that's often not the case, so you've got to do some analysis before making the election. For example, if you own 100% of two S corporations each corporation could take the $100,000 expense option. But on your personal return you'll be limited to $100,000.

The amount expensed for Section 179 cannot exceed the net income from the business. Any excess can be carried forward to be used in a later year when the income limitation isn't exceeded. If you anticipate the income from the business to be low for a number of years yet you'll have significant qualifying asset purchases, you might want to forego the expense option rather than accumulate carryforward amounts.

Keep in mind that state law may not follow federal. In some cases your state may not allow the higher expense option or the 50% bonus depreciation. Check the rules carefully.

--Last Update 06/04/03