Special ‘Bonus’ Depreciation

By Ryan McEntire
Ryan McEntire, CPA, is a senior associate with the Lynchburg, Va., office of Brown, Edwards & Company LLP, a regional accounting firm with additional offices in Roanoke, Va., Bristol, Va., New River Valley, Va., and Bluefield, West Va. Contact them through their Web site at www.becpas.com or by calling (434) 948-9800.

In response to a weakened economy, the president and Congress crafted new laws during 2002 and 2003 to inject vitality into manufacturing and other capital-intensive sectors. These laws offer taxpayers unprecedented incentives to purchase new equipment before Jan. 1, 2005. Taxpayers (both equipment buyers and sellers) who know the rules can use these laws to their advantage.

The revised “Bonus” depreciation is equal to 50 percent of the purchase cost of the property. The Bonus depreciation is allowed off the top and the remaining basis of the asset is depreciated under normal MACRS (Modified Accelerated Cost Recovery System) rules. The increased first-year deduction not only can reduce your company’s taxable income for qualifying purchases, but also can allow your customers to offset some of the initial cost of purchasing your product with current-year tax savings.

Time Frame & Percentage
Assets purchased after Sept. 11, 2001, through May 5, 2003............. 30%
Assets purchased after May 5, 2003, and before Jan. 1, 2005.............50%

Bonus depreciation – qualifying property
The property must be new to use, not just new to the taxpayer.

The property must be ordered after Sept. 11, 2001, to qualify for the 30 percent deduction or after May 5, 2003, to qualify for the 50 percent deduction. Orders placed before Sept. 11, 2001, and placed in service after Sept. 11, 2001, do not qualify. Orders placed before May 5, 2003, and placed in service after May 5, 2003, qualify for the 30 percent deduction rather than the 50 percent deduction. Assets, except certain qualifying transportation assets, must be ordered and placed in service prior to Jan. 1, 2005, in order to qualify.

Qualifying property must have a MACRS recovery period of 20 years or less, be MACRS water utility property, be qualified leasehold improvement property or certain computer software. Most new manufacturing equipment, furniture, office equipment, etc. qualify for the “Bonus” depreciation.

In order for computer software to qualify for Bonus depreciation, the software has to be what is called “canned software.” Canned software applies to any packaged software that is ready to use by the consumer without substantial modification. This software is typically amortized over 36 months.

Customized software, internally created software and any property that is required to be depreciated under the alternative depreciation system (ADS) do not qualify for the Bonus depreciation deduction.

Automobiles
For passenger automobiles, which otherwise qualify as “Qualified Property” and are used more than 50 percent of the time for business, the first-year annual limit was increased to $7,960 for vehicles purchased after Jan. 1, 2003, but prior to May 5, 2003. The $7,960 is made up of the 2003 auto depreciation limit provided by the IRS of $3,360 plus the additional $4,600 allowance for Bonus depreciation. For vehicles purchased between May 5, 2003, and Dec. 31, 2004, the limit was raised to $11,010 to reflect the increase in the Bonus depreciation from 30 percent to 50 percent.

Change in IRC §179 small-business expensing
The IRC §179 expensing limits were increased for tax years beginning in 2003, 2004 and 2005. Prior to the change, qualifying taxpayers were allowed to expense up to $25,000 of qualifying purchases in the year of purchase. In order to qualify, the taxpayer had to have taxable income prior to the application of the deduction. There is also a dollar-for-dollar reduction of the expense for every dollar the purchase exceeds the $200,000 threshold. Therefore, if the taxpayer purchased $225,000 or more in assets, no IRC §179 deduction would be allowed.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 increased the expense limit from $25,000 to $100,000 and increased the yearly asset acquisition threshold from $200,000 to $400,000. This increase will greatly increase the number of taxpayers qualifying for the §179 deduction.

Qualifying purchases for §179 and Bonus depreciation
It is also important to note that “qualifying purchases” for §179 purposes and Bonus depreciation purposes can be different. One major difference is that used equipment does qualify for §179 but is not allowed under the Bonus depreciation deduction. There are other differences; however, most machinery, furniture and equipment do qualify for both §179 and Bonus depreciation. Land improvements (15-year property), however, qualify for Bonus depreciation but not §179. Please see Example 1, which demonstrates the first-year depreciation deduction calculation with and without the §179 expense deduction.

Relation between Bonus, Section 179 and regular depreciation
Taxpayers wishing to take IRC §179 depreciation will still be able to do so for qualifying assets. The Section 179 depreciation will be taken off the top, followed by the 30 percent or 50 percent Bonus depreciation, and then regular MACRS depreciation will be taken off the remaining basis in the asset.

Election out of using Bonus depreciation
The Bonus depreciation must be claimed unless the taxpayer specifically elects not to deduct. In order to elect out of the Bonus depreciation, a taxpayer must attach an election stating that the taxpayer intends to elect out of the Bonus depreciation for the assets or asset classes listed on the election. If the taxpayer does not take Bonus depreciation and does not elect out of Bonus depreciation, the basis in the assets must be reduced as if the Bonus depreciation deduction had been taken. So it is important to either take the Bonus depreciation deduction or elect out, otherwise a deduction could be lost.

Effect on alternative minimum tax
The Bonus depreciation is also allowed for alternative minimum tax depreciation, so no AMT adjustment will be required. Also, assets that have Bonus depreciation taken will be allowed to use the MACRS 200 percent double declining balance instead of the 150 percent normally required for alternative minimum tax depreciation.

Example 1 – five-year property
Assume a taxpayer (an S-Corporation) purchased a new piece of manufacturing equipment in July of 2003 that costs $200,000. The taxpayer had $250,000 of taxable income prior to the depreciation deduction for the asset. The deduction would be calculated as follows:

The depreciation deduction reduces the taxable income from $250,000 to $90,000 for a taxpayer qualifying for §179 expensing. The taxpayer qualifying for the §179 expensing is able to deduct $160,000 (80 percent) of the cost of the equipment in the first year. For taxpayers not qualifying for §179 expensing, the first-year deduction is still an incredible $120,000 (60 percent) of the cost of the equipment. Prior to the Bonus depreciation rules and the changes to §179 expensing, the taxpayer would have only been able to deduct 20 percent in the first year (30 percent with maximum §179 deduction).

Example 2 – land improvements (15-year property)
Assume the same facts in example 1, except the company instead purchased new signage and a parking lot in July 2003 that costs a total of $200,000. The taxpayer had $250,000 of taxable income prior to the depreciation deduction for the asset. Because land improvements do not qualify for §179 expensing, the following calculation demonstrates only the “Without §179” option.

The depreciation deduction reduces the taxable income from $250,000 to $145,000. The taxpayer is able to deduct 52.5 percent of the cost of the improvements in the first year compared to 5 percent before the Bonus depreciation rules were put into place.

The information contained in this article is a summary of the depreciation opportunities available to taxpayers and is not intended to be tax advice by Brown, Edwards & Co. LLP nor the National Precast Concrete Association. Please consult your tax advisor regarding your specific situation.