Accounting for the Material World
The Second Law of Thermodynamics states that any system, if left alone, will always move from order to disorder, over time. In other words, stuff breaks down as it gets old.
But before you start complaining again about your bum knee, consider how this principle applies to your business (or personal) finances. When you buy a house, or a car, its condition will only move in one direction (worse) because of use and time. Its various parts will need maintenance, repair, and, eventually, replacement. This is essentially the underpinning of the economic concept of what we call Depreciation. Of course, you are familiar with the general concept – over time, physical possessions become less valuable, because they break down.
How does this impact your finances? Suppose that on December 15, 2018 you buy a machine that has an estimated useful life of 10 years, for a price of $100,000. Let’s take a quick look at the impact from both Financial Accounting and Tax Accounting perspectives.
In financial accounting, it is simple. When you buy something that you expect to use over a long period of time (more than a year), you don’t expense all of the cost immediately – you expense it over that same period of time. Our $100,000 piece of equipment will not create expense of $100,000 all in 2018; it will be expensed (on your books, as Depreciation Expense) at a rate of $10,000 per year for the next 10 years. Remember that the purpose of Financial Accounting is to express reality in numbers. In this case, the reality is that we have purchased an asset and obtained a benefit from it – not all in one year, but for a 10-year span. Therefore, the cost of the asset should also be expressed over a 10-year span.
Our business, therefore, will have a tax deduction (expense) of $10,000 per year, for the next 10 years. More on that tax impact below. The other important concept to understand is that, in your business, you are likely to notice the following “give and take” between Depreciation Expense and Repair/Maintenance Expense:
When Depreciation expense is high, Repair expense is low; when Depreciation expense is low, Repair expense is high.
Why is that? Because at those times when you have a bunch of relatively new equipment, you are depreciating it (to reflect the reality that it gets used up, or breaks down, over time). As that equipment actually does start to break down over time, it requires repair. Older equipment is mostly or fully depreciated, so as Depreciation Expense goes away, Repairs Expense increases. A good rule of thumb is that when you start seeing more expense in Repair than Depreciation, it is time to think about replacing some equipment. At CLM Advisors, we often like to initiate a thought process with our clients about when it becomes more economical to buy new assets than to continue repairing old assets.
As you might imagine, the treatment of our $100,000 asset purchase is more complex in Tax Accounting, and requires sound advice. But it is not too difficult to understand basic principles.
In 1958, the federal government first created what is now known as Section 179 in the tax code. The premise of Section 179 was, and still is, to enable small businesses to take tax write-offs on asset purchases that are larger than those afforded by regular depreciation. For many years now, business owners have been able (with certain limitations, which have changed often) to deduct 100% of the cost of a qualifying asset purchases in the year that the asset is placed into service. For our $100,000 equipment purchase, this has a potentially huge impact. Suppose your total income (personal and business) places you in the highest 37% tax bracket. The $100,000 purchase, fully deductible, would reduce your taxes by $37,000 ($100k times 37%), yielding a net after-tax cost of only $63,000 for that machine.
Federal tax law also provides for “Bonus Depreciation.” This works in a way similar, but not identical, to Section 179. Prior to the most recent tax law changes, which were passed by Congress in December 2017, Bonus Depreciation was limited to 50% of the cost of a qualifying asset in Year 1 (the remaining 50% of cost would then be depreciated over the remaining useful life in future years). But with the new tax law, Bonus Depreciation is currently 100% of cost, until January 2023 when the percentage will start to decline again.
Consider, with the preferential tax treatment available through Section 179 and Bonus Depreciation, that a certain tax equality is achieved between Buyer and Seller. When you buy a $100,000 piece of equipment, the Seller most likely will have to pay income tax on the full $100,000 in the first year. You, as the Buyer, can use these tax provisions to deduct from your taxes the same $100,000 of cost, also in the first year.
Both Section 179 and Bonus Depreciation were significantly expanded by the Tax Cuts and Jobs Act of 2017, which in most cases is a help to small business owners starting with the 2018 tax year. You should consult your tax advisor for proper advice on how and when to use Section 179 or Bonus Depreciation (or both).