Just as companies are able to take deductions for business expenses, tax laws allow companies to take deductions for major capital expenditures and spread them out over the years of the asset’s useful life. This depreciation offers businesses an opportunity to lower their taxes in a variety of ways. For business owners large and small this can be confusing so please consult with your Pennsylvania Accountant before proceeding.
Assets that can be depreciated
Depreciable assets must fulfill several requirements:
- The business must own the property
- It must be used in a business venture that is intended to earn money
- It must have a useful life that is measurable and is greater than one year
While in accounting we refer to these as assets, for tax purposes they are referred to as “property.” Thus, assets that cannot be depreciated include intangible assets, such as trademarks and patents; equipment used to build capital improvements; and land.
Additional items that do not fulfill the criteria of depreciation include rental property and any property bought and sold or discarded within the same year. These items can usually be expensed, but not depreciated. However, if an item is leased and the agreement ends in the purchase of the item, it can be depreciated. Otherwise, it is treated as a rental expense.
Options for depreciation
The general calculation of depreciation is:
Subtract the salvage value from the total cost of the asset (asset basis) and divide that number by the number of years of the asset’s useful life
Options for depreciation include the straight-line depreciation method and a variety of accelerated depreciation methods.
In the straight-line method, the result of the above calculation would be deducted in each year of the asset’s useful life. For instance, for a $10,000 machine with a $1,000 salvage value and a 10-year lifespan, the yearly depreciation for each of the 10 years would be $900 ($9,000 / 10).
There are two options for accelerated depreciation that are just accelerated versions of the straight-line method: 200% or 150%. In the example above, 200% depreciation would mean depreciating in 5 years (thus $1,800 per year for 5 years). A 150% acceleration would be over 7.5 years.
The Double-Declining Balance method is calculated a little differently:
2 X the straight-line calculation % X beginning net book value
In this case, the straight-line percentage, disregarding salvage, is 10% per year ($10,000/10 years). So in this method, (2 X 10%) X $10,000 would be $2,000 the first year. But in year two, since the book value is now $8,000, depreciation would be 20% X $8,000 = $1,600.
The Sum of the Years’ Digits (SYD) method is as follows:
Where n=the number of years, n(n+1)/2=SYD
Appreciable percentage = est. # of years of life remaining/SYD
Thus, in year one, where SYD = 55 (10*11/2) and 10 years estimated remaining, 10/55 = 18% depreciation. In year two, with 9 years remaining, 9/55 = 16% depreciation.
For some purchases, Section 179 deductions may allow tangible assets to be written off in full in the year they were purchased.
Your goal as a tax accountant
The total tax deductions will be the same regardless of which method is used, and the final book value of the asset will be its salvage value. But it’s up to you, as your client’s tax expert, to advise on which method is best for the company.
Speeding up the depreciation may benefit your client in the short run by showing lower profit on the income statement, thus lower taxes in the early years. However, your client would then not have depreciation to offset taxes in the later years. Therefore, as the tax accountant, you want to discuss with your client future purchase plans and short- and long-term goals for the company to determine which depreciation method benefits the company’s finances. By laying out the options with the numbers, like those above, you will help your client visually see the effect of the different options and make a wise choice, with your expert guidance.
By providing your clients with the big picture of depreciation and working it into their businesses’ financial plans for the future, you will become a trusted and indispensable advisor, solidifying long-term relationships and growing your practice.