The law authorizes two ways for small businesses to write off their outlays for purchases of equipment and other kinds of personal property. One is depreciation; the other is first-year expensing.
The “standard route” allows businesses to recover what they spend on equipment through depreciation deductions over varying periods that are as short as three years and as long as 39 years, with the majority closer to three than to 39. Most small business equipment is depreciable over five years to seven years. For example, it is five years for computers, copiers, cameras, tape recorders and the like, and seven years for furniture such as desks, chairs, file cabinets and safes.
Internal Revenue Code Section 179 allows all kinds of businesses, whether full-time and long-established or part-time and just launched, to dispense with depreciation deductions and take advantage of first-year expensing, should that prove to be more advantageous. Electing to do so entitles them to instantly write-off the entire cost in the first year the equipment is “placed in service,” meaning made ready and available for a specific use, whether or not actually used, rather than the year it’s purchased or paid for.
To illustrate, equipment ready to operate by December 31 generates a deduction for this year, though not paid for until after the year closes. Conversely, there is no deduction this year for equipment bought in December but not installed until next year.
First-year expensing is subject to several limitations. The key stipulation sets a dollar cap on the deduction. The maximum amount allowable is indexed—that is, adjusted annually to reflect any inflation. The ceiling is $108,000 for 2006, up from $105,000 for 2005.
Here’s how freelancer Karen Reiter’s decision to deduct outlays immediately will work wonders for her business’s overall tax picture and cash flow. Karen operates her business as a sole proprietorship, which is legalese for someone who is the lone owner of a full-time or part-time business that is not formed as a corporation or a partnership. She falls into a top federal and state tax bracket of 35 percent for 2006 and needs to replace lots of equipment. Her total purchase cost of $30,000 include computers and peripheral equipment such as printers and monitors, as well as desks, appliances and carpets. Karen needn’t depreciate these items over five- or seven-year periods. Assuming it is advantageous for her to use first-year expensing for the $30,000 expenditure, that trims taxes by $10,500.
It makes no difference that Karen finances the purchase (interest charges are 100 percent deductible) or that her payments extend beyond 2006. So her equipment expenditures can generate a positive cash flow, assuming that her tax savings of $10,500 exceeds her out-of-pocket payments for 2006.
Other fine print specifies that Karen cannot acquire the equipment by trade-in or lease. She must use it more than 50 percent of the time for business.
There is a spending cap on property. For 2006, it is $430,000, up from $420,000 for 2005. As soon as acquisitions surpass the cut-off amounts, the deduction for first-year expensing begins to phase out, or disappear, on a dollar-for-dollar basis. Change the amount Karen spends on equipment from $30,000 to $440,000 for 2006. Then her deduction ceiling drops from $108,000 to $98,000 ($108,000 minus $10,000, the excess of $440,000 over $430,000). The phase-out is complete once expenditures exceed $538,000.