For the last five years, manufacturers have enjoyed a bonus depreciation tax incentive. The Tax Cuts and Jobs Act of 2017 (TCJA) increased bonus depreciation by allowing business taxpayers to deduct 100% of eligible asset expenses upfront from their taxable income rather than having to depreciate the cost over several years.
The intent was to leave business owners with more cash to invest in their businesses and spur capital purchases. This accelerated depreciation has been a significant tax saving for manufacturers that purchase equipment.
The full 100% bonus depreciation tax benefit ended on Dec. 31, 2022, and will continue to ramp down by 20 points annually through 2026. The phase-out may impact manufacturers who regularly make large-ticket capital equipment purchases and have relied on bonus depreciation to lower their taxes.
Manufacturers should know the changes and proactively plan for the phase-out. Now may be an ideal time to consider upgrading or adding equipment to minimize tax liabilities before time runs out. Here are things to remember for tax planning in the years ahead to ensure you take advantage of the phase-out.
Timeline for Phase-out
On Jan. 1 of 2023, bonus depreciation dropped 20 points to 80%, with 20-point drops scheduled every year after—ending on Dec. 31, 2026.
Bonus Depreciation and Section 179 Deductions
Although bonus depreciation allowance decreases, companies may still qualify for Section 179 deductions, which should be fully available in future tax years. Section 179 of the IRS tax code is another way to write off the total purchase price of qualifying equipment or software on your business income tax return.
While both are accelerated depreciation schedules, bonus depreciation allows you to deduct a percentage of an asset’s cost. Section 179 allows you to deduct a set dollar amount.
In addition, Section 179 comes with more limitations. It:
Limits deductions. For 2023, the IRS has capped the Section 179 deduction limit at $1.16 million on purchases costing no more than $2.89 million. The amount is adjusted annually for inflation and begins to phase out, dollar for dollar, as total purchases exceed $2.89 million. The Section 179 deduction limit completely phases out once a company spends $4.05 million on equipment this year. Bonus depreciation has no such cap.
Has limited use. The 179 deduction is limited to reducing taxable income only and can’t be used to generate a net taxable loss for any given year. Manufacturers may carry excess 179 deductions forward to future tax periods for use. Bonus depreciation is not limited in this way and can generate a tax loss.
How It Works and an Example of Potential Savings
You can combine bonus depreciation and Section 179 deductions to claim both in the same tax year and maximize tax savings. Suppose you claim them for the same asset. In that case, you must use Section 179 first, then bonus depreciation, and then regular depreciation (if needed).
Although 2023 has an 80% first-year depreciation, you may still claim that extra 20% over the asset’s useful life if you don’t qualify to take the Section 179 expense.
Types of Assets that Qualify for Depreciation
Depreciation typically uses the standard depreciation rules, as listed in the Modified Accelerated Cost Recovery System (MACRS). The IRS uses the MACRS depreciation schedule, which includes all categories of business equipment. Regular depreciation will remain available to businesses and is calculated over several years—as fixed by law—for a particular asset without limits or phase-outs.
Most types of new or used tangible property are eligible for bonus depreciation, including machinery, vehicles, furniture and equipment. Real property generally qualifies for standard depreciation only.
Looking Ahead—Tax Strategies for Bonus Depreciation Phase-outs
Given the bonus depreciation schedule and intricacies of Section 179, manufacturers should proactively plan when making big asset purchases. It’s not just about this year but planning for the next few years to ensure you’re optimizing tax benefits. Here are a few strategies to consider:
Time your asset acquisitions for maximum tax benefit. Assets must be in service to be eligible for bonus depreciation or Section 179 benefits. For example, if you plan to purchase new equipment in Q1, it must be operational by Dec. 31 of that year. On the other hand, if you don’t need the deduction or if you are unsure that an asset will be in service by the end of the calendar year, it may make sense to delay the purchase.
Consider a cost segregation study. If you plan to build, expand, acquire or consolidate your physical premises. A cost segregation study accelerates depreciation expense by classifying specific building components, such as electrical and plumbing systems, as personal property. Manufacturers can depreciate these over five, seven or 15 years rather than 39 years for commercial buildings.
Work with your tax advisor on your overall tax income projection. Larger manufacturers must plan for the long haul since they likely can’t leverage Section 179. A tax advisor can help file Form 4562, which covers Section 179 expenses, bonus depreciation and standard depreciation under MACRS.
Plan Your Tax Strategy with Help from Aldrich
If you have questions about minimizing your tax liability with bonus depreciation and Section 179 deductions, or how they might fit into your overall tax strategy, let’s talk.
This article was originally featured in the Portland Business Journal on Sept. 1, 2023. You can read it here.