It’s no secret that all of the assets so integral to the snow removal and ice management business are costly -- and getting pricier every day. Our tax rules give the business the option of immediately writing-off the entire cost of a newly-acquired asset. Or, with depreciation, the asset’s cost can be spread out to offset the revenue generated from it over its life.
Since newly acquired assets are typically more valuable than older ones, depreciation measures the amount of value an asset loses over time through wear-and-tear. Basically, it boils down to when is the best time to use the available write-offs.
On the one hand you have an immediate write-off for the entire cost of newly-acquired equipment or machinery using bonus depreciation or Section 179 first-year expensing. In an unprofitable year or if expecting more profitable years in the future when the write-off might reduce a higher tax bill, basic depreciation might be the best option.
Depreciation is the process of deducting the total cost of a business asset. Instead of writing the entire amount off in one tax year, portions of it are written-off or deducted over time.
The number of years over which an asset is depreciated is determined by its useful life. For tax purposes, assets are included in different classes with each class having its own useful life. A business that uses a different method of depreciation for its financial statement can decide on an asset’s useful life based on how long it is expected to be useful in the snow removal operation rather than the IRS’s prescribed “useful” life.
Usually, the cost of the asset, minus its salvage value, is divided over its useful life. That determines how much depreciation is deducted each year. There are a number of different methods of depreciation, including:
Straight-Line: Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life.
Declining Balance: The declining balance method is an accelerated depreciation method that records larger depreciation amounts during the earlier years of an asset’s useful life with smaller depreciation amounts during the asset’s later years, and
Sum-of-the-Year's Digits: Sum-of-the-years’ digits (SYD) is an accelerated method for calculating an asset’s depreciation. The method takes the asset’s expected life and adds together the digit for each year. If the asset was expected to last for five years, the SYD would be obtained by adding 5+ 4+ 3+ 2+ 1 to get a total of 15. Each digit is then divided by this sum to determine the percentage by which the asset should be depreciated each year starting with the highest number in Year 1.The SYD method is more appropriate than the commonly-used straight-line depreciation for assets that depreciate more quickly, have greater production capacity in its earlier years than when it’s aged. The total amount of depreciation is identical regardless of the method used.
REALLY SPEEDING UP WRITE-OFFS REALLY?
Depreciation is the recovery of the cost of the asset or property over a number of years, with a portion of the cost deducted every year until the cost is fully recovered. Or, the entire cost may be deducted in year one using these tax incentives:
Section 179. A snow and ice removal contractor can choose to recover all or part of the cost of qualifying property, up to a certain dollar limit, in the tax year the qualifying property is placed in service. The total cost that may be expensed under Section 179 is limited to the operation’s taxable income for the year.
Bonus Depreciation. There is a special depreciation allowance of 100% for some new and used property. Bonus depreciation enables a snow removal business to deduct a large percentage of the cost of purchased business assets such as equipment in the first year of their use. Bonus depreciation will remain at 100% through the end of 2022. It will then decrease by 20% each year. But this isn’t the only tax incentive for a contractor to purchase qualifying assets. There are also special rules and limits for depreciation of so-called “listed property,” such as automobiles. Computers and related peripheral equipment are no longer labeled as listed property.
VIVA THE CONFUSION
Most snow removal businesses can take 100% bonus depreciation this year and can always use the Section 179 expensing option. But many smaller businesses have other options.
Obviously, if equipment has an expected life of 12 months or less, it can be treated as an expense and immediately deducted. That’s true even if some last more than a year just as long as the “expected” life is less than one year.
Bonus depreciation is often confused with Section 179 deductions as the two serve similar purposes. Currently, both deductions can be used to write off the total cost of an asset purchase in the first year of the asset’s use.
One significant difference, however, is that Section 179 cab be claimed only if the snow and ice removal business has a taxable profit for the year. Bonus depreciation does not require the business to report a profit.
IGNORING FAST WRITE-OFFS
Depreciation, in one form or another, must be taken into account on the annual tax return with that wear-and-tear otherwise accounted for. Faster write-offs with Section 179 expensing and bonus depreciation are another story.
Writing off he full purchase price in the year of acquisition can mean saving tax dollars for that year and boosting cash flow -– if the business has profits or cash flow to take advantage of those immediate deductions. After all, faster write-offs mean trading immediate savings for deductions in subsequent years, so over the life of the asset tax savings from depreciation even out.
Of course, if the equipment purchases during the year are significant relative to pre-tax income, it often makes sense to pass.
DEPRECIATION RECOVERY CAN BE EXPENSIVE
Keeping in mind that what the tax laws giveth, the tax laws can taketh away, don’t overlook depreciation recapture. Quite simply, when an asset is sold or traded, the snow removal business might have to recapture some or all of the depreciation taken.
In the past, recapture could often be postponed by trading the equipment or property for new or related equipment or property as a like-kind exchange. Unfortunately, tax law changes in 2017 now allow like-kind exchanges only on real property such as land, buildings and other fixed property.
The restrictions on using like-kind exchanges to avoid that expensive depreciation recapture might not be so bad if the snow and ice removal operation buys new equipment -- and writes off the cost in the same year the old equipment is sold. The property sold must be at least equal the gain on the property sold and Section 179 or bonus depreciation used in the same year.
Before making a substantial investment in equipment or other property, every contractor should calculate how long will it take for the cash flows from the investment equal its cost?
Just because a tax deduction will result doesn’t always mean it will be a smart move. After all, the lower the tax bracket the snow removal and ice management operation is in, the less that deduction is worth.
Although there are a number of methods for analyzing the payback period of newly acquired business assets, in many cases, there will be no need for a sophisticated, or even any, analysis. The dollar threshold for analysis usually depends on how big the business.
One approach to analyzing the payback period ignores the time value of money and is a poor choice for longer-term projects, but is relatively simple: How long will it take for the cash flow generated from the asset to equal its cost.
Contributing Editor Mark E. Battersby writes for Snow Magazine's on matters of finance and accounting.