Richard “Rick” Carrier, Jr., CPA, is a member of BKD National Construction & Real Estate Group and BKD National Manufacturing & Distribution Group. He provides tax and consulting services to heavy civil, commercial and residential construction firms, furniture and plastic manufacturers and retail sales and distribution companies.
How to control your taxable income through two possible depreciation methods.
Long-term income tax planning will be somewhat challenging in 2011 due to the relatively short scope of current tax law. In the short term, most tax planning strategies revolve around controlling taxable income. One common way to control this is through depreciation methods, including bonus depreciation and units-of-production depreciation.
In late 2010, President Obama signed the Small Business Jobs Act of 2010 and the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010.
These acts contain several tax-related provisions including the following: an increase of Internal Revenue Code (IRC) Section 179 expensing limits for 2010, 2011 and 2012; a provision that makes qualified real property eligible for Section 179 expensing; and an extension of bonus first-year depreciation through 2012.
Bonus first-year depreciation, introduced in the Job Creation and Worker Assistance Act of 2002, was created to encourage economic growth. It has been modified and extended several times over the last nine years. Before the 2010 law, a taxpayer could expense 50 percent of the cost of qualifying assets placed in service after December 31, 2007, and before January 1, 2010. Qualifying assets generally included new machinery and equipment, most computer software and certain leasehold improvements.
The 2010 acts extend first-year bonus depreciation again by allowing taxpayers to expense 50 percent of the adjusted basis of qualifying assets placed in service through December 31, 2012. In addition to 50 percent bonus depreciation, taxpayers may expense 100 percent of an asset’s adjusted basis when the asset is placed in service from September 9, 2010, through December 31, 2011. The same assets qualified under pre-act law will qualify for bonus depreciation.
In 2010, contract cost allocation requirements allowed taxpayers to exclude the bonus first-year depreciation taken on qualifying property from the percentage-of-completion method. In 2011 and beyond, taxpayers subject to IRC Section 460 rules must allocate the bonus first-year depreciation to the contract’s cost and adjust the percentage of completion on that contract. As a result, bonus depreciation can result in increased income for taxpayers.
Besides Section 179 and bonus depreciation, other depreciation options are available that taxpayers may overlook. One option is a method based on the asset’s useful life (as opposed to the typical depreciation over a set number of years) commonly referred to as an asset’s “class life.”
One method of useful life depreciation is calculated based on the estimated units an asset can produce, which is called units-of-production depreciation.
Like most tax code exceptions, the IRS imposes restrictions on using the units-of-production depreciation method. The asset’s useful life must be estimable and set based on the unit of measure selected. The election must be made on the return filed for the year the asset is placed in service, and once this depreciation method is elected, it must be used for the asset’s entire life.
This method provides several advantages including the potential to depreciate an asset faster than what is allowed by class-life depreciation. This is possible when all the asset’s units are produced before the end of the asset’s required class life. Also, the asset’s depreciation expense more closely matches the revenue the asset generates, which is another benefit. And it is easier to track an asset’s depreciation for alternative minimum tax (AMT) and most state income tax purposes because the AMT and most state depreciation will match federal depreciation when using this method.
Potential disadvantages include possibly delaying the start of depreciation, and depreciation will stop if the asset is not used due to work delays—unlike class-life depreciation methods, the asset must be in use for depreciation expense to be claimed. The in-use requirement could result in a delayed recognition of the depreciation expense.
After the asset has been placed in service and has depreciated, it must remain in service and produce units of production to recognize the depreciation expense. In short, any work delays will result in delayed recognition of the depreciation expense.
Also, a decelerated depreciation (when compared to class-life depreciation) could result if the asset will be used for a time period greater than its class life. For example, most construction equipment has a class life of five years. If an asset has a productive period of eight years, the class-life depreciation method would result in a faster recognition of the depreciation expense.
These two depreciation methods can be useful tools for managing taxable income since the decision to elect or not elect bonus or units-of-production depreciation can be made up until filing a return. With the future possibility of higher individual income tax rates, taxpayers should carefully determine if electing either of these methods is the right decision for them in 2011.
Key Terms Defined:
Bonus Depreciation - An additional amount of deductible depreciation that is awarded above and beyond what would normally be available.
Units-of-Production Depreciation - A method in which depreciation is computed on the basis of an asset’s actual use, instead of the time in service, to match the depreciation expense with the revenue generated.
Construction Business Owner, November 2011