First-Year Bonus Depreciation and Sec. 179 Expensing: Manufacturers Beware of the Pitfalls
Many manufacturers are eligible for tax write-offs for certain equipment purchases and building improvements. These write-offs can do wonders for a manufacturer’s cash flow, but whether to claim them isn’t always an easy decision. In some cases, there are advantages to the regular depreciation rules. So, it’s critical to look at the big picture and develop a strategy that aligns with your company’s overall tax-planning objectives.
Taxpayers can elect to use the 100% bonus depreciation or the Section 179 expensing election to deduct the full cost of eligible property up front, in the year it’s placed in service. Alternatively, they may spread depreciation deductions over several years or decades, depending on how the asset is classified under the tax code. Note that 100% bonus depreciation is available for property placed in service through 2022. Then, allowable bonus depreciation will be phased down to 80% for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026. After 2026, bonus depreciation will no longer be available.
In March 2020, a technical correction made by the CARES Act expanded the reach of bonus depreciation. Under the act, qualified improvement property (QIP), which includes many interior improvements to commercial buildings, is eligible for 100% bonus depreciation retroactively to 2018. So, taxpayers that placed QIP in service in 2018 and 2019 may have an opportunity to claim bonus depreciation by amending their returns for those years. If bonus depreciation isn’t claimed, QIP is generally depreciable on a straight-line basis over 15 years.
Sec. 179 also allows taxpayers to fully deduct the cost of eligible property, but the maximum deduction in a given year is $1 million (adjusted for inflation), and the deduction is gradually phased out once a taxpayer’s qualifying expenditures exceed $2.5 million (also adjusted for inflation).
While 100% first-year bonus depreciation or Sec. 179 expensing can significantly lower your company’s taxable income, it’s not always a smart move. Here are three examples of situations where it may be preferable to forgo bonus depreciation or Sec. 179 expensing:
- You’re planning to sell QIP. If you’ve invested heavily in building improvements that are eligible for bonus depreciation as QIP, you may be stepping into a tax trap by writing it off if you plan to sell the building in the near future. That’s because your gain on the sale — up to the amount of bonus depreciation or Sec. 179 deductions you’ve claimed — will be treated as “recaptured” depreciation that’s taxable at ordinary-income tax rates as high as 37%. On the other hand, if you deduct the cost of QIP under regular depreciation rules (generally, over 15 years), any long-term gain attributable to those deductions will be taxable at a top rate of 25% if the building is sold.
- You’re eligible for the “pass-through” deduction. This deduction allows eligible business owners to deduct up to 20% of their qualified business income (QBI) from certain pass-through entities, such as partnerships, limited liability companies or sole proprietorships. The deduction, which is available through 2025, can’t exceed 20% of an owner’s taxable income, excluding net capital gains. (Several other restrictions apply.) Claiming bonus depreciation or Sec. 179 deductions reduces your taxable income, which may deprive you of an opportunity to maximize QBI deductions. And since the QBI deduction is scheduled to expire in 2025, it makes sense to take advantage of it while you can.
- Depreciation deductions will be more valuable in the future. The value of a deduction is based on its ability to reduce your tax bill. If you think your tax rate will go up in the coming years, either because you believe Congress will increase rates or you expect to be in a higher bracket, depreciation write-offs may be worth more in future years than they are now.
Timing is Everything
Keep in mind that forgoing bonus depreciation or Sec. 179 deductions only affects the timing of those deductions. You’ll still have an opportunity to write off the full cost of eligible assets over a longer time period. Our tax advisors can analyze how these write-offs interact with other tax benefits and determine the optimal strategy for your company’s situation.
Sidebar: Can you deduct the cost of your website?
There was a time when websites were nothing more than “online brochures.” But today, they’re indispensable tools that many manufacturers use for critical business functions, including marketing and advertising, communications, supply chain management and e-commerce. Websites are especially important in the COVID-19 environment, as manufacturers rely more heavily on virtual rather than in-person interactions.
Developing an effective website can require a significant investment, but are those costs deductible for federal tax purposes? The IRS hasn’t published any website-specific guidance, but general guidance on the tax treatment of hardware and software is instructive.
Hardware. Servers and other hardware used to maintain a website are treated like other computer equipment, which is typically depreciable over five years. But it may be possible to deduct 100% of the cost in year one if you qualify for bonus depreciation or the Section 179 expensing election.
Software. Off-the-shelf software is generally amortizable over 36 months. Like hardware, however, it may also be eligible for bonus depreciation or Sec. 179 expensing. Internally developed software is typically amortized over 36 months, but, in some cases, it may be written off more quickly. For example, if your website is used primarily for advertising, it may be possible to deduct software development costs currently as “ordinary and necessary business expenses.” And certain development costs may qualify as deductible research expenses.
Other options. If you engage a vendor to set up and operate your website, the payments are likely deductible business expenses. And if your business is new, you’ll be eligible to deduct up to $5,000 in start-up expenses, including website costs, in year one.
The tax treatment of your website depends on your company’s circumstances, so be sure to consult your tax advisor.