Thanks to the American Taxpayer Relief Act of 2012, managers, executives and owners who have hesitated or postponed making capital investments for their marine fabrication businesses through the recent economic downturn might now want to consider how the use of those tax incentives and others already on the books can substantially reduce the cost of equipment and other capital investments. Large purchases, including equipment acquisitions, are now easier—and less expensive—thanks to new tax breaks and financing options created by lawmakers.
Those incentives include a unique first-year write-off for so-called Code Section 179 equipment and property—the tax break that allows profitable businesses to write off large capital expenditures immediately, rather than over time, has also been resurrected to allow a 50 percent “bonus” depreciation for property placed in service through 2013.
Depreciation has many approved forms. The Modified Accelerated Cost Recovery System (MACRS) is the most commonly used. Under MACRS (and ACRS) the cost or other basis of an asset is generally recovered over a specific recovery period dictated by legislation. Depreciation based on a useful life is calculated over the estimated useful life of the asset actually used by the taxpayer, not over the longer period of the asset’s physical life.
Fortunately, the tax rules permit business owners to treat as an expense a portion of the cost of newly acquired equipment and business property. In other words, an expense deduction is available for fabricators and suppliers who choose to treat the cost of qualifying property and equipment, called Section 179 property, as an expense rather than a capital expenditure. Section 179 property is generally defined as new or used depreciable tangible property purchased for use in the active conduct of a trade or business.
A dollar limit is placed on the maximum cost of Section 179 property that a business may expense during the tax year. Currently, the higher expensing limits in effect in 2011 have been extended for expenditures made before Dec. 31, 2013. This means a fabricator may expense or immediately deduct up to $500,000 of the cost of equipment and other business property in 2013. The Section 179 deduction is subject to a phase-out if total capital expenditures exceed $2 million.
On the down side, the first-year write-off is also limited to the operation’s taxable income during the tax year. Any amount disallowed by the limitation may be carried forward and deducted in subsequent tax years, subject to the maximum dollar and investment limitations, or (if lower) the taxable income limitation in effect for the carryover year.
A marine fabrication business will usually reap the greatest benefit from Section 179 by expensing property that does not qualify for bonus depreciation, such as used property, and property with a long depreciation period. For example, given the choice between expensing an item of five-year property and an item of 15-year property, the 15-year property should be expensed, because it takes 10 additional tax years to recover its cost through annual depreciation deductions.
Buy or lease?
Even as credit becomes more readily available, the question of whether to buy or to lease equipment is facing many businesses. Deciding the best strategy is a tough move for anyone, and there is no one answer that fits every situation or business.
For most leasing situations, there are rules to help determine whether the transaction is a genuine lease or a disguised purchase. Usually, when it comes to determining who is the owner of the property for tax purposes, the IRS looks to the “economic substance” of the transaction—how it is structured and works, not how the parties involved characterize it.
There is no time limit on leasing; leasing is effective even where a business has already purchased equipment. These transactions, known as sale-leasebacks, are usually available for equipment purchased within the previous 90 days. Sale-leasebacks may also be used to legitimately shift the tax benefits from the business to its owner or shareholders.
Although one recent survey by the Equipment Leasing & Finance Association (www.elfaonline.org) found that almost 70 percent of those surveyed leased equipment, lease financing is generally more expensive than bank financing. It’s also true that, in most instances, leases are more easily obtained.
Thanks, again, to the American Taxpayer Relief Act, improvements made to leased property as well as improvements to retail and restaurant property are now a viable alternative for many businesses. Under the basic tax laws, leasehold improvements and building improvements must generally be depreciated over 39 years. A special 15-year, straight-line depreciation break for qualified leasehold improvements, restaurant property and retail improvements now exists.
While not exactly classified as equipment, these leasehold improvements can be written off or deducted over a 15-year period rather than the normal 39 years. Qualified leasehold improvements can also qualify for the 50 percent bonus depreciation. In fact, qualified leasehold improvements in amounts up to $250,000 may qualify for Section 179 expensing.
Repair or replace?
The out-of-pocket cost of repairing equipment is obviously less if the expenditure can be expensed and immediately deducted. Otherwise, fixing up, modifying or improving the property is a capital expense, with deductions spread over a number of years.
In an attempt to resolve the controversy over whether certain expenditures made by businesses are currently deductible as repair expenses, or whether they must be capitalized and deducted over the life of the underlying business asset, the Internal Revenue Service (IRS) has issued new guidelines.
According to the IRS, expenditures are currently deductible as a repair expense if they are incidental in nature and “neither materially add to the value of the property nor appreciably prolong its life.” An appropriate comparison when determining whether an improvement must be capitalized would be between the condition of the property immediately before the repairs with the condition of the property after the repair.
A safe harbor has been created for routine maintenance on property other than buildings. Routine maintenance includes the inspection, cleaning and testing of the unit of property and replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. Unfortunately, to be considered routine maintenance, the operation has to expect to perform these services more than once during the class life (generally the same as for depreciation).
The American Taxpayer Relief Act of 2012 renewed and expanded many tax breaks designed to help businesses reap benefits from capital investments in new equipment and business property. When combined with the existing tax rules for leasing and the new guidance that attempts to answer the “repair or replace” questions, there are many opportunities to reduce the out-of-pocket costs for acquiring equipment and business property. Contact a qualified tax professional to help you make sure you’re optimizing your financial operations.
Mark E. Battersby, based in Ardmore, Pa., writes extensively on business, financial and tax-related topics. Email him directly at MEBatt12@earthlink.net.