Business Basics: Principles of tax depreciation

Many tax deductions were made permanent and several were extended for two or more years as part of the 2016 omnibus budget bill signed into law late last year. For landscape professionals, the most critical parts of the tax extender law are the Section 179 expensing and the bonus depreciation provision.

The big change this time around is the increased Section 179 equipment expensing limits of $500,000 are now permanent, so future year-end tax planning will have more clarity than it has in the past. The law also extends bonus depreciation while paring it down each year until it phases out in 2019.

What makes this law so important? Under Section 179 of the Internal Revenue Code, if a business and the assets it is acquiring meet certain requirements, those assets can be fully expensed in the year acquired. There is no requirement that cash be expended for those assets in the year of purchase, making financing and leasing even more attractive. It’s a subtle but powerful piece to the puzzle. If you’re in a 39.6 percent tax bracket and you finance a $100,000 piece of qualifying equipment, you have just reduced your federal tax liability by $39,600 without laying out any cash.

While Section 179 doesn’t increase the total amount that can be deducted over time, it allows a business to get the entire depreciation deduction in the year of acquisition—rather than taking it a little at a time over the term of an asset’s useful life (five to seven years for equipment and vehicles).

Caution: The accelerated write off of Section 179 and bonus depreciation can be a double-edged sword. The deduction is taken in full at the time of purchase, leaving no deduction in future years even though the asset is in service during those years.

So is purchasing equipment and taking an accelerated deduction at the end of a profitable year a better idea than depreciating that purchase over five to seven? Absolutely!

CPAs vs. MBAs

A colleague of mine wrote an article a little over a year ago in which he argued it’s a “flawed” recommendation for accountants to suggest that their clients purchase equipment at the end of a high-profit year. His argument suggested that making asset purchases promoted over investment in assets and would surely reduce return on assets. While MBAs like to focus on many ratios, return on assets is not one well suited to our industry. It’s better suited for manufacturing or other capital-intensive industries. Our industry is labor intensive and return on labor is a much better indicator than return on assets.

The two overarching factors that dictate success among my clients are high gross margins and high return on investment (ROI) on marketing dollars spent. When you have a profit at year-end, purchasing assets is an excellent way to have the government fund a significant part of your growth (through reduced taxes). Don’t let anyone tell you otherwise.

Here’s an example of how effectively purchasing assets in a profitable year increases short-term profits and the value of your firm. Let’s assume we have profit of $100,000 and our effective federal and state tax rate is 35 percent. Let’s also assume we have the opportunity to purchase a piece of equipment for $100,000.

Solution 1: Don’t purchase equipment. Pay $35,000 in taxes and leave the after-tax profit of $65,000 in the company for future investment or distribute it to ownership.

Solution 2: Purchase the equipment financing 100 percent of it using a capital lease, and take the full $100,000 deduction using the 179 deduction. With this approach, the business now has $65,000 for future investment or owner distribution and has an additional $35,000 to put to work as a result of reducing taxes down to zero.

Let’s invest that money in marketing and see what happens. Assumptions: We’re in the lawn care business, our cost per lead is $50 and we have a closing rate of 50 percent, making our cost per sale $100. Our average annual contract is $500.

With this investment, we’ll increase our annual number of lawn contracts by 350 ($35,000/$100 cost per sale), adding $175,000 of annual recurring revenue to the long-term value of our business, which, if valued at 0.9 or more times annual revenue (a popular multiple currently being paid for lawn care companies), the ROI approaches 500 percent. In addition to increasing the value of our company, we’ve also added more annual net income from these newly acquired customers for as long as we have them on our books.

By purchasing assets in a profitable year, we can increase profit, increase net income, increase the value of our company and use the money that would’ve otherwise been given to the government to fund these increases and purchase the assets needed to service our newly found increase in business.

Currently the highest federal tax rate is 39.6 percent. Add to that the top state rate, which can be 10 percent or more, and the top combined rate approaches 50 percent. Any serious discussion about company finances must consider the tax effect of various decisions as the government will either be your partner in profits, by having you pay taxes, or help you fund your business by allowing you tax deductions and credits.

The savvy operator will take advantage of the crucial help the government gave growing landscape industry firms when it passed the 2016 omnibus budget bill and related tax extender provisions.

Photo: istock.com/Stephan Zabel