Using New Tax Legislation to Your Advantage

John Taylor (Sep, 2016)

As most of us know the Internal Revenue Code dictates what income taxpayers have to recognize, what deductions taxpayers are allowed to take against income, the credits taxpayers are allowed to take to offset tax, as well as tax rates for different levels of income.  The Internal Revenue Code is ever evolving and ever changing.  In the past couple of years the area that saw the biggest change and reform was in the area of depreciation and determining what assets should or should not be capitalized.  New changes to the Internal Revenue Code give taxpayers additional opportunities to potentially create more deductions and reduce taxes if used correctly.

De Minimis Expensing Safe Harbor

In late 2013 the depreciation rules were completely revamped by the "Tangible Property Regulations" for taxable years beginning on or after January 1, 2014.  Amid the new "Tangible Property Regulations" was the concept of a De Minimis expensing safe harbor.  Pursuant to Regulation Section 1.263(a)-1(f) of the Internal Revenue Code, taxpayers are allowed to take an expense amounts paid to acquire or produce units of tangible personal property if the amounts fall under the allowable capitalization policy for the taxpayer.  If the taxpayer has an "applicable financial statement" then they can elect to deduct up to $5,000 "per item, per invoice” as an expense in the current year.  Taxpayers without an "applicable financial statement" can expense amounts paid to acquire or produce units of tangible personal property up to $2,500 in the current year (this amount was increased from $500 by Notice 2015-82, effective for tax years beginning on or after January 1, 2016). 

The concept of "per item, per invoice" means that each purchase on an invoice or receipt is treated as separate items for determining if that item should be written off under the De Minimis safe harbor.  For example, if you buy ten laptop computers for $1,000 each then you will be able to treat each of the laptop computers purchased as a separate item. You will be able to expense the entire $10,000 purchase because each computer costs less than the De Minimis safe harbor of $2,500 or $5,000.

The purchases that fall under the De Minimis safe harbor must be expensed for both GAAP and tax purposes.  Therefore, companies that issue financial statements to third parties for review should be weary of how increasing the De Minimis safe harbor from $500 up to $2,500 or $5,000 will affect the bottom line, as well as meeting covenants.  However, the income tax savings could be significant.

Section 179

For expenditures that do not fall under the De Minimis safe harbor and have to be capitalized, a taxpayer may be able to utilize the expensing under Internal Revenue Code Section 179.  This will allow a taxpayer to take a dollar for dollar deduction for any qualifying expenditure in the year that the asset was purchased.

In 2016, the dollar limit for the amount of section 179 expense allowed to be taken in a tax year is $500,000.  The $500,000 expensing limit is reduced if the taxpayer places into service during the tax year section 179 property in excess of the "investment ceiling."  The investment ceiling for 2016 is $2,010,000.  The $500,000 expensing limit is reduced dollar for dollar, for every dollar that the taxpayer's section 179 property placed in service during that tax year exceeds the investment ceiling. 

With the passing of the Protecting Americans from Tax Hikes, or PATH Act, both the increased expensing limit and the increased investment ceiling were extended and made permanent.  Both of these limits were set to revert back to their significantly lower statutory amounts.  The PATH Act also indexed these amounts for inflation, meaning these amounts will increase over time.

Certain assets are not considered qualified property under Section 179.  The PATH Act eliminated the exclusion of air conditioning and heating units from the list of non-qualifying assets.  Starting with tax years beginning after January 1, 2016 air conditioning and heating units placed in service in will now be eligible for section 179 treatment.

Computer software and qualified real property (qualified leasehold improvements, qualified restaurant improvements, and retail improvement property) qualifying as section 179 property was also made permanent by the passing of the PATH Act.  Previous law limited the amount of section 179 that could be taken on qualified real property to $250,000 (despite the expensing limit on other property of $500,000).  The Path Act eliminated this $250,000 limitation for qualified real property for tax years beginning in 2015.

Bonus Depreciation

Another way for a taxpayer to accelerate deductions for expenditures that otherwise would need to be capitalized is through bonus depreciation.  This allows taxpayers to take an additional depreciation deduction in the first year qualified property is placed in service.  Currently the amount of additional first year depreciation that is allowed to be taken on qualified property is 50% of the cost of the asset.  Bonus depreciation is calculated after taking section 179, but before regular depreciation.

In order to qualify for bonus depreciation the asset must be new tangible property that has a life of no more than 20 years, or be "qualified improvement property."  The term "qualified improvement property" is a new concept created by the PATH Act.  Beginning for property placed in service on or after January 1, 2016, "qualified improvement property" replaces the former category of qualified leasehold improvements for bonus depreciation purposes.  Qualified improvement property is any improvement to the interior of any nonresidential real property that is placed in service after the building is placed in service.  Under the old qualified leasehold improvement category, in order to qualify for bonus depreciation an improvement would have had to be made pursuant to a lease, that portion of the building had to be occupied exclusively by the lessee, the improvements had to be placed in service more than three years after the original building was placed in service by any person, and the improvement had to be a structural component of the building.  These restrictions do not apply to the new category of "qualified improvement property."

The PATH Act also introduced a phasedown of the bonus depreciation provisions through 2019.  For qualifying property the phasedown is as follows:

(1)  a 50% bonus depreciation allowance for qualified property placed in service in 2015 through 2017;

(2)  a 40% bonus depreciation allowance for qualified property placed in service in 2018; and

(3)  a 30% bonus depreciation allowance for qualified property placed in service in 2019.

After the 2019 tax year the bonus depreciation provisions are set to expire.

Taxpayers should be aware of these new provisions when capital assets are being purchased in order to take full advantage of potential deductions.  It is even more critical to pay close attention to the rules as a new IRS guide has been issued instructing auditors on what to look for during examinations.  Auditors will be looking whether a taxpayer made a safe-harbor expensing election with their tax return for small purchases and improvements that are otherwise required to be capitalized.  Also, IRS agents will be looking into whether or not businesses were required to file accounting method changes in claiming depreciation deductions.  Please feel free to contact your Dermody, Burke & Brown tax advisor to further discuss any questions you may have.

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