What Small Businesses Should Learn About Taxes and Depreciation
If you are a small business owner, you can understand how stressful and overwhelming it can be to complete and file your taxes each year. And to make things more confusing, there are specific aspects of filing your small business's taxes that might be even more complicated to understand, such as depreciation.
Depreciation offers small businesses a great way to recover or recoup the cost of eligible assets by writing off the related expense over the period of the useful life of these assets. When you run a small business, you can deduct most of your business-related expenses on your tax return. But rather than deducting the full cost of an asset the year you acquired it, depreciation lets you spread the tax deduction out over a span of time.
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What Is Depreciation?
We can define depreciation as a method used for allocating the cost of fixed assets or tangible assets over the assets' useful life. Depreciation is also a "non-cash" expense that allows small business owners to lower the value of an asset over a period of time, because of its age, obsolescence, wear and tear, or decay.
Assets usually depreciate for two main reasons. For example, an automobile you purchased and drove off the lot brand new will decrease gradually in value with every mile as well as the wear and tear on the tires, engine and other parts. In addition to that, assets also lose their value because they become obsolete. Better and newer models replace them. Last year's vehicle model is less compared to the latest model valuable because there is a newer and more desirable version in the market.
Section 179 of the Internal Revenue Code states that small business owners have the option to write off the first $18,000 of business equipment purchased for company use each year.
Types of Property That You Can Depreciate
Most of the items that you buy for your small business are durable and sturdy enough to last more than one year, but they tend to lose value gradually over time – whether it is because of wear and tear, decay, or other reasons. The main principle behind depreciation is that it allows you to deduct the cost of your assets over the course of their whole useful life rather than one year.
Business assets that you can depreciate include, but are not limited to:
Off-the-shelf computer software
Machines and office equipment
On the other hand, assets that you cannot depreciate include:
o Land, as it’s not subject to obsolescence and wear and tear like other assets
o Inventory, as it’s meant for sale, and
o Leased property, as you do not own it.
How Depreciation Reduces Your Tax Burden?
Most small business owners wonder how depreciation can lower their tax expense. We will explain. Depreciation works by reducing your total taxable income, and this, in turn, lowers your tax burden. Here is a simple example.
Let’s say that your small business earned $100,000 in net income the last year. However, you took a depreciation deduction of about $25,000 on the buildings you own. In this case, the IRS will tax you on $75,000 rather than $100,000 of income because of the deprecation deduction. Taking a business tax rate of 35%, you would end up saving $8,750 in taxes, which is great. Assuming that all the numbers remain the same next year, you will save about $5,250 due to the new 21 percent corporate tax rate.
Ways to Calculate Business Depreciation
The most common methods of depreciating business assets include:
Section 179 Deduction
Straight-line depreciation is one of the most common and simplest methods of calculating depreciation expense for your small business. To calculate the yearly amount you can depreciate, all you have to do is subtract your asset’s salvage or residual value from the cost and divide that value by the number of years in its useful life. Salvage value is the amount you could fetch by selling the asset at the end of its useful life.
For instance, if you buy a computer for $1,000 with a salvage value of $200 and a 5-year life, you would be able to deduct $160 each year in depreciation.
Depreciation expense can also be accelerated. This method allows your small business to deduct more of the asset’s cost in earlier years. Note that the two most common kinds of accelerated depreciation are bonus depreciation and Section 179 expenses.
You can refer to the IRS’s MACRS (modified accelerated cost recovery system in order to figure out your depreciation deductions.
Section 179 Method
With Section 179, a business can deduct the whole cost of its property in the first year it’s put into service. The Section 179 deduction method allows for more flexibility than other methods of depreciation. Keep in mind that Congress doubled the Section 179 limit to $1 million from $500,000 in prior years in 2018 qualified property. Also, the annual phase-down threshold that is based on investment increased to $2.5 million from $2 million.
Deducting the entire cost of your assets right away by applying Section 179, relieves some of your total financial burden by considerably lowering your tax bill that first year. Note that depreciating the cost, in contrast, would mean less relief for your business upfront, at a time when you may need it the most.
It is vital for all small business owners to contemplate purchasing assets and making the most of this first-year deductibility, which can reduce your taxable income.
Depreciation is something that small business owners should definitely appreciate as it lowers both the taxable income and tax liability. However, since you would rather spend your valuable time growing and expanding your small business than figuring out tricky and complicated tax issues and rules, hiring a competent tax professional is likely a good move. Halon Private Client comes with a dedicated CPA that can help make sure you are calculating depreciation accurately.