Tax Implications of Depreciation: A Comprehensive Guide

by Natalie Nguyen

Depreciation is a key concept in accounting and finance, reflecting how an asset loses value over time due to factors like wear and tear, aging, or obsolescence. But did you know that depreciation also has significant tax implications? In this blog post, we’ll explore these tax aspects and their impact on businesses.

What is Depreciation?

Depreciation is the process of allocating the cost of a tangible asset over its useful life. It shows how companies account for the gradual loss of value in their assets.

Tax Deductions and Depreciation

For businesses, depreciation is considered an expense. Even though it’s a non-cash expense, it helps reduce taxable income. The IRS allows businesses to deduct this calculated depreciation from their corporate income taxes, which can significantly lower their tax liability and boost after-tax profits.

Bonus Depreciation

Bonus depreciation is a tax incentive that lets businesses accelerate deductions on “qualified property” in addition to regular depreciation when these assets are first put into use. This incentive encourages businesses to invest in new equipment.

Initially introduced through the Job Creation and Worker Assistance Act in 2002, this provision allowed businesses to deduct an extra 30% of the cost of eligible assets beyond the standard depreciation expense. In 2017, the Tax Cuts and Jobs Act increased the bonus depreciation rate to 100%. This rate started phasing out at the end of 2022, decreasing by 20% each year (80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026), with the provision set to expire by the end of 2026.

Eligible property for bonus depreciation includes depreciable assets with a useful life of 20 years or less, such as vehicles, furniture, manufacturing equipment, and heavy machinery. “Qualified improvement property” is also eligible for bonus depreciation.

Unfortunately, California does not conform to the federal bonus depreciation provision. While businesses can realize significant initial year tax savings at the federal level, they may find more tax savings at the state level in later years due to this lack of conformity.

Section 179 Deduction

As bonus depreciation phases out, small businesses can still leverage initial-year expensing through Section 179 of the Internal Revenue Code. Under Section 179, businesses can deduct the full purchase price of qualifying equipment bought or financed within the tax year, subject to certain limits and phase-outs. For the 2024 tax year, the federal deduction limit under Section 179 is set at $1,220,000, with a phase-out threshold starting at $3,050,000. For example, if a company purchases $1,000,000 in qualifying equipment before the end of 2024, it can deduct the entire amount from its gross income. However, if the purchase price reaches $1,500,000, it becomes subject to phase-out. Purchases exceeding $3,050,000 do not qualify for additional deductions and are handled using the standard depreciation method.

In California, the state conforms to Section 179 but caps the maximum deduction at $25,000 per year, phasing out completely when the total purchase price for the year exceeds $200,000.

Impact on Net Income

Since depreciation reduces taxable income, it also reduces the taxes a company owes, leading to a higher net income. However, it’s important to note that because depreciation is a non-cash expense, it doesn’t impact the company’s cash flow.

Understanding the tax implications of depreciation is crucial for businesses, as it can lead to significant tax savings and influence decisions regarding asset acquisition and disposal.

Photo Attribution:

MobiusDaXter, CC BY-SA 3.0, https://creativecommons.org/licenses/by-sa/3.0, via Wikimedia Commons

Boost Morale and Save Taxes with Achievement Awards

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Some small businesses struggle with employee morale for a variety of reasons, one of which may be economic uncertainty. If you want to boost employees’ spirits without a big financial outlay, an achievement awards program is a relatively low-cost fringe benefit that may be a win-win addition.

Under such an initiative, you can hand out awards at an appointed time, such as a year-end ceremony or holiday party. And, as long as you follow the rules, the awards will be tax-deductible for your company and tax-free for recipient employees.

Fulfilling the requirements

To qualify for favorable tax treatment, achievement awards must be granted to employees for either promoting safety in the workplace or length of service. The award can’t be disguised compensation or a payoff for closing a big deal. In addition, they must be tangible items, ranging from a gold watch or a smartphone to a plaque or a trophy. Examples of awards that would violate the rules are gift certificates, vacations, or tickets to sporting events or concerts.

Additional requirements apply to each type of award:

1. Safety awards. These can’t go to managers, administrators, clerical workers or other professional employees. Also, safety awards won’t qualify for favorable tax treatment if the company grants them to more than 10% of eligible employees in the same year.

2. Length-of-service awards. To receive such an award, an employee must have worked for the business for at least five years. In addition, the employee can’t have received a length-of-service award within the last five years.

Also keep in mind that the award must be part of a “meaningful presentation.” That doesn’t mean you have to host a gala awards dinner at the Ritz, but the award should be marked by a ceremony befitting the occasion.

Nonqualified vs. qualified

There are limits on an award’s value depending on whether the achievement awards program is nonqualified or qualified. For a nonqualified program, the annual maximum award is $400. For a qualified program the maximum is $1,600 (including nonqualified awards). Any excess above these amounts is nondeductible for the employer and taxable to the employee. If an employee receives multiple awards in one year, these figures apply to the total, not to each individual award.

To establish a qualified program, and therefore benefit from the higher limit, you must meet two additional requirements. First, awards must be granted under a written plan and the plan must be open to all eligible employees without favoritism. Second, the program must not discriminate in favor of highly compensated employees as to eligibility or benefits. For 2024, the salary threshold for a highly compensated employee is $155,000.

Awards of nominal value are generally not taxable. These are small, infrequent gifts such as a coffee mug, a t-shirt or an occasional meal.

Explore the idea

If an achievement awards program makes sense for your company, be sure that these requirements are met. Otherwise, you and your employees could suffer negative tax consequences. Contact the office for guidance in setting up a program that checks all the boxes.

408-252-1800

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Home Sale: Failure to Plan may Raise Your Tax Bill

Selling your home and handing over the keys

As the saying goes, there’s nothing certain in life except for death and taxes. But when it comes to selling your home, proactive tax planning can help you reduce your federal income tax bill.

A Costly Mistake to Avoid

Let’s say Tom is a soon-to-be married homeowner who’s looking to sell his principal residence. If certain tests are met, an unmarried individual may be able to exclude up to $250,000 of taxable gain.

Just before the wedding, Tom sells the home he’d purchased 20 years earlier. The home had appreciated by $500,000. He and his future wife, Stacy, plan to move into her much smaller fixer-upper home after the wedding.

As an unmarried taxpayer, Tom can exclude $250,000 of the gain from his home sale, leaving a taxable gain of $250,000 ($500,000 minus the $250,000 federal home sale gain exclusion). He owes 15% federal income tax on the gain, plus the 3.8% net investment income tax and state income tax.

Instead, suppose that Tom and Stacy had taken the time to seek tax planning advice. Their tax advisor would have let them know that the home sale gain exclusion for married couples is $500,000 if various tests are met, including that both spouses have resided in the home as their principal residence for at least two years.

Rather than sell Tom’s house before the wedding, they might have kept it and lived in it as a married couple for two years. That would have allowed them to avoid the full $500,000 in taxable gain and the resulting taxes when they later sold it. Even if Stacy had sold her fixer-upper home before the wedding, the gain would likely have been much smaller and may have been fully sheltered with her $250,000 home sale gain exclusion.

Slow Down and Seek Advice

Proactive tax planning is generally worth the effort, especially if you have a lot at stake and/or tax rates increase. Even if you don’t need advice on the subject of home sales, other issues may be much more complicated and a lack of knowledge could lead to costly mistakes. Contact the office to get the best tax planning results for your circumstances.

(408) 252-1800

Medicare Premiums may Lead to Tax Savings

If you pay Medicare premiums for health insurance, you may be able to combine them with other qualifying expenses and claim them as an itemized deduction for medical expenses on your tax return. This includes amounts for “Medigap” insurance and Medicare Advantage plans, which cover some costs that Medicare Parts A and B don’t cover.

Generally, you can deduct medical expenses only if you itemize deductions and only to the extent that total qualifying health care expenses exceeded 7.5% of your adjusted gross income. But, if you’re self-employed people or a shareholder-employees of an S corporation, you can generally claim an above-the-line deduction for your health insurance premiums, including Medicare premiums. That means it’s not necessary for you to itemize deductions to get the tax savings.

Contact the office with questions about claiming medical expense deductions on your personal tax return. Also, be sure to ask for help identifying an optimal overall tax-planning strategy based on your personal circumstances.

408-252-1800

What Expenses Can’t Be Written Off by Your Business?

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If you check the Internal Revenue Code, you may be surprised to find that most business deductions aren’t specifically listed there. For example, the tax law doesn’t explicitly state that you can deduct office supplies and certain other expenses. Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Basic Definitions

In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.

A necessary expense is one that’s helpful or appropriate. For example, a car dealership may purchase an automatic defibrillator. It may not be necessary for the business operation, but it might be helpful if an employee or customer suffers a heart attack. It’s possible for an ordinary expense to be unnecessary. But to be deductible, an expense must be ordinary and necessary.

A deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with the potential client should be OK with the IRS. (The Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained a 50% deduction for business meals.)

How the Courts May View Expenses

The deductibility of some expenses is clear, while others are more complicated. Not surprisingly, the IRS and courts don’t always agree with taxpayers about what is ordinary and necessary. To illustrate, here are three recent U.S. Tax Court cases in which specific taxpayer deductions were disallowed:

  1. A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles, but didn’t provide required details, including each vehicle’s ownership, cost and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs, but the court found they didn’t show related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39)
  2. The court ruled that a married couple wasn’t entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. In fact, invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they weren’t properly substantiated. (TC Memo 2023-80)
  3. A physician specializing in gene therapy deducted legal expenses of $360,295 for two years on Schedule C of his joint tax returns. The court found that most of the legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction for $13,000 for business-related legal expenses. (TC Memo 2023-42)

These cases and others should show the importance of maintaining careful, detailed records. Make sure that only business costs are claimed.

Proceed with Caution!

If an expense seems like it’s not normal in your industry or could be considered personal or extravagant, proceed with caution. Contact the office with questions about deductibility and proper documentation.

408-252-1800

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Sending the Kids to Day Camp May Bring a Tax Break

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Among the many challenges of parenthood is childcare for kids when school lets out. Babysitters are one option, or you might consider sending them to a day camp. There’s no one-size-fits-all answer, but if you do choose a day camp, you could be eligible for a tax break. (Unfortunately, overnight camps don’t qualify.)

Dollar-for-dollar Savings

Day camp can be a qualified expense under the child and dependent care tax credit. The credit is worth 20% to 35% of the qualifying costs, subject to an income cap. The maximum amount of expenses that can be claimed is $3,000 for one qualifying child or $6,000 for two or more children, multiplied by the percentage that applies to your income level.

For those qualifying for the 35% rate with maximum expenses of $3,000, the credit equals $1,050, or $2,100 for two children with expenses of at least $6,000. The applicable credit percentage drops as adjusted gross income (AGI) rises. When AGI exceeds $43,000, the percentage is 20% of qualified expenses, subject to the $3,000 or $6,000 limit.

Tax credits are particularly valuable because they reduce your tax liability dollar-for-dollar, that is, $1 of tax credit saves $1 of taxes. This is compared to deductions, which simply reduce the amount of income subject to tax. So, if you’re in the 24% tax bracket, a $1 deduction saves you only $0.24 of taxes.

Qualifying for the Credit

Only dependents under age 13 generally qualify. However, the credit may also be claimed for expenses paid to care for a dependent relative, such as an in-law or parent, who is incapable of self-care. Eligible care costs are those incurred while you work or look for work.

Expenses paid from, or reimbursed by, an employer-sponsored Flexible Spending Account can’t be used to claim the credit. The same is true for a dependent care assistance program.

Determining Eligibility

Additional rules apply to this credit. Contact the office if you have questions about your eligibility for the credit and the exceptions.

408-252-1800

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Tax Breaks for Increasing Accessibility

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Certain small business owners may qualify for tax breaks by making their premises accessible to people with disabilities. The CDC reports that 61 million people in the United States are affected by disabilities.

The Disabled Access Credit is a nonrefundable credit for up to 50% of eligible access expenditures made by qualifying small businesses in each year the costs are incurred. Also available is a barrier removal tax deduction when a business removes an architectural barrier and the removal improves access for persons with disabilities and the elderly.

Both tax benefits can be used in the same year if the requirements are met. To learn more: https://www.irs.gov/newsroom/tax-benefits-to-help-offset-the-cost-of-making-businesses-accessible-to-people-with-disabilities

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Boost Your Home Improvements with Tax Credits

hands holding a level for home improvement

For many homeowners, summer means it’s time to tackle home improvement projects. By investing in certain energy-efficient updates, taxpayers not only can lower their power bills but also can score some tax breaks.

The Energy Efficient Home Improvement Credit equals 30% of qualified expenses (up to $3,200) incurred to improve a home after Jan. 1, 2023. Examples include insulation and exterior doors or windows.

The Residential Clean Energy Credit is equal to 30% of qualified property installed in a U.S. home from 2022 through 2032. Examples include solar electric panels, solar water heaters and wind turbines.

Additional rules and limits apply to these credits. Here’s more: https://www.irs.gov/newsroom/irs-home-improvements-could-help-taxpayers-qualify-for-home-energy-credits

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There May Still Be Time to Lower Your 2023 Tax Bill

If you’re preparing to file your 2023 tax return, you may still be able to lower your tax bill – or increase your refund. If you qualify, you can make a deductible contribution to a traditional IRA right up until the original filing deadline, April 15, 2024, and see tax savings on your 2023 return.

For eligible taxpayers, the 2023 contribution limit has increased to $6,500, or $7,500 for taxpayers aged 50 and up on Dec. 31, 2023. If you’re a small business owner, you can establish and contribute to a Simplified Employee Pension (SEP) plan up to the extended due date of your return. The maximum SEP contribution you can make for 2023 is $66,000.

What determines eligibility? To make a fully deductible contribution to a traditional IRA, you (and your spouse, if you’re married) must not be active participants in an employer-sponsored retirement plan or, if you are, your 2023 modified adjusted gross income (MAGI) must not exceed the applicable limits:

  • For single taxpayers covered by a workplace plan, $73,000 (partial deduction available up to $83,000 MAGI).
  • For a married couple filing jointly, where the spouse making IRA contributions is covered by a workplace plan, $116,000 (partial deduction available up to $136,000 MAGI).
  • If the spouse making the IRA contributions isn’t covered by a workplace plan but his or her spouse is, $218,000 (partial deduction available up to $228,000 MAGI).

For married couples filing separately, where at least one spouse is covered by a workplace plan, the ability to deduct IRA contributions is extremely limited.

Contact the office if you want more information about this important topic to help you save the maximum tax-advantaged amount for retirement.

408-252-1800

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