Tax Matters:

The Small Business Tax Deduction -- Make the Most of It

By Patricia E. Mohr, October 2004

[From SHRM's Consultants Forum]

Smaller HR consultancies, like any small business, can take advantage of recent changes in the tax code. If you need to upgrade your office with new equipment or computer software but are concerned about breaking your budget, it's time to factor the increased tax benefits you'll get by writing off the costs as expenses.

Last year, the Jobs and Growth Tax Relief Reconciliation Act raised the $25,000 expensing limit under the tax code's Section 179 to $100,000 (indexed for inflation) through 2005. And on Oct. 11, Congress passed the American Jobs Creation Act, which extends the $100,000 expensing limit through 2007. The Section 179 deduction applies to sole proprietors, partnerships and small corporations that report a net profit.

Small business proponents hailed last year's legislation as a victory. “Allowing small business owners to immediately expense critical investments has been and will continue to be a key component of growing our economy,” said Dan Danner, senior vice president of the National Federation of Independent Businesses.

Small businesses can now deduct more from their taxable income in the year they begin using new equipment. Usually, the cost of most items is deducted over several years, requiring businesses to keep detailed records of their purchases for each year they use the deduction. But many business owners are taking advantage of new Section 179 rules to deduct up to 100 percent of the cost of new equipment right away.

Some businesses will be able to decrease their taxable income by as much as $102,000 in 2004 using the new expensing limit (thanks to the inflation indexing).

Congress, in last year's tax bill, also allowed taxpayers to recover more of the cost of depreciable assets purchased after May 5, 2003, and before January 1, 2005 -- from 30 percent to 50 percent. Small business owners need to know the rules of both the new expensing limit and the depreciation allowance to judge when to take advantage of each. Most companies use a combination of both types of deductions to maximize their tax savings.

Taking the Deduction

The Section 179 deduction provides a stronger tax benefit in the year the business incurred expenses. It also requires less paperwork because it doesn't require the taxpayer to maintain as many records over long periods of time. Businesses that want to save more taxes upfront can take advantage of the higher limit by making an election on IRS Form 4562, Depreciation and Amortization.

The deduction can help lower your adjusted gross income, which could in turn lower your tax bill and help you qualify for additional tax deductions.

But only businesses that report a taxable income for the year can recover the full cost of business equipment in the first year. Because the deduction is intended to help small businesses, you will lose some of the tax benefit if your company invests more than $410,000 per year in new equipment.

For most small HR consultancies, this shouldn't be a problem. But if it is, you can regain the benefit by deducting the cost over several years using the depreciation method.

Stick with the Section 179 deduction for ordinary expenses of tangible products with a typical shelf life of one year or less. Computer software programs, office equipment and needed repairs that keep property in operating condition but don’t improve its overall value--such as interior or exterior painting--fit into this category. Keep in mind:

If you are considering upgrading your computer system, you should know that upgrades designed specifically for you won’t qualify for the full deduction. Only computer software programs available for sale to the general public meet the criteria. Also, you can't deduct the cost of air conditioning or heating units, or of any product the IRS will classify as an investment.

Home and Office: Be Wary of 'Double Dipping'

For many small or home-based business owners, the deduction is tricky because they use products for business and personal matters. This is especially true for consultants who use the same computer software programs at home and in the office. Be certain you'll use the equipment at least 50 percent of the time for business purposes before you elect the Section 179 deduction.

Monitor your personal use of these items and only claim the deduction for the portion that applies to its business use. For example:

You should also think about how you will use the equipment in the future. If you stop using the equipment for business reasons the following year and begin using it for personal matters, you have to recalculate the deduction taken the previous year. You'll have to reverse the effect of the deduction on your adjusted growth income on Schedule C, thereby increasing the amount of income tax and self-employment tax owed. In some cases, you could face interest payments or penalties if your estimated tax payments don't cover the additional taxable income.

This caveat is known as the “recapture” rule, and it applies to both the Section 179 deduction and the depreciation deduction taken for vehicles, cell phones and other communication equipment. If you would rather avoid the recapture rule problem, make sure you use the equipment for business reasons during its entire useful life.

Depreciating Assets over Time

Most business expenses are attributable to purchases of items that have longer shelf lives. With the same tax form used for expensing items, you can recover the cost of these capital expenditures over fixed periods of time. This is known as the depreciation method – or the Modified Accelerated Cost Recovery System (MACRS).

Companies that want to show they made higher profits for the current tax year might prefer this method. The IRS determines what the useful life is for each type of equipment and lays out a timetable for deducting its cost. You can recover the cost of cars and trucks, computers, printers and other office machinery over five years. Office furniture is classified as having a seven-year useful life. Nonresidential property purchased after May 1993 has a useful life of 31.5 years. But you can't deduct the cost of land because its value doesn't depreciate.

Like the Section 179 expensing method, you can only deduct a portion of the expense if you use the equipment for business and personal reasons. The IRS requires you to report a detailed account of your business use of vehicles, so keep track of the vehicle’s total mileage, business-use mileage and mileage spent commuting to work throughout the year.

The IRS determines the percentage of the overall deduction you can take per year but permits taxpayers to choose from several methods of calculating the depreciation over time. So you should consult IRS Publication 946, How to Depreciate Property, or talk to your accountant to determine the best method for your consulting business.

Patricia E. Mohr is a freelance writer covering public policy issues and the former senior Capitol Hill reporter for Tax Analysts in Washington, D.C.

Related Reading

Small Businesses Get a Tax Break Too, Inc.com

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