Tax Deductions Greater Than Lease Payments?
In our March 20 blog entitled “The Startup Restaurant Business Question,” we explained in detail how leasing restaurant equipment can be “extremely beneficial” as a business decision. Section 179 of the IRS tax code allows for potential tax deductions that oftentimes can be greater than actual lease payments. Given the tight margins in the restaurant business, anything that can save restaurants money is worth a closer look, right? The answer lies within Section 179 of the current tax code allowing specific tax deductions for depreciation as covered under the “Modified Accelerated Cost Recovery System” or MACRS.
MACRS, and what it means
MACRS recognizes that because many assets decline in value due to age and usage, they should be accorded tax deductions over time. In fact, the need to consider tax deductions for depreciation was recognized with the inception of the U.S. income tax in the early 1900s, and has been modified over the years to its present form, as adopted by the Tax Reform Act of 1986.
Depreciation of any asset may sound very technical to some, but it’s basic concept is simple. When you purchase property used for your commercial enterprise, such as kitchen equipment for your restaurant, that equipment has an estimated, useful work life. Ideally, the cost of such equipment should be spread out over a fixed amount of time representative of its “useful” or “economic” life. At tax time, your equipment cost can be applied to the revenue generated from using the equipment. Simply put, MACRS allows businesses to deduct the inherent cost of the asset’s reduction in value from the revenue it helps generate.
What Property Can Be Depreciated?
According to the IRS, legally depreciable property must meet the following requirements:
- you must own the property
- it must be used in your business or income-producing activity
- it must last for more than one year
- it must have a determinable useful life
That last point serves to prohibit depreciation of land because land generally always retains usefulness. You will also note that the “ownership” point generally prevents depreciation of property you might lease for your business, but that’s where Section 179 can come into play. MACRS also allows for depreciation of certain “qualified” rent-to-own property.
Basis for Depreciation
The basis for depreciation is essentially the cost of the property or asset, including costs such as sales taxes and shipping, multiplied by the percentage of its use in business or income-producing activity. Thus, in the case of restaurant equipment, the full adjusted cost would likely be used.
The recovery period is the number of years of active service an asset or property is expected to serve the business, and the number of years over which the taxpayer is expected to recover its cost. The IRS makes this simple to determine as various property falls under different classes with assigned recovery periods. For example, your commercial dishwasher might fall under the “5-year property” class, giving you a depreciation recovery period of five years.
Methodology for Calculating Depreciation
The depreciation of an asset’s value for tax purposes can be calculated by several different methods. MACRS allows for the use of “straight-line” and “declining balance” methods under its “General Depreciation System” (GDS), and the straight-line method specifically for its Alternative Depreciation System” (ADS). Section 179 relies on deducting the property’s depreciation value in the first year of service by treating it as a business expense rather than depreciable property. The following are a few depreciation examples:
- Straight-Line Method
The straight-line method allows you to deduct the same amount of depreciation each year during its useful life. This is done by determining the difference between the asset’s cost basis and any salvage value, then dividing this difference between the number of years of it’s useful life. Straight-line depreciation produces an annual constant write-off amount.
- Declining-Balance Method
The declining-balance method is an accelerated depreciation system that allows for a 150% or 200% increase of the straight-line depreciation amount claimed in the first year. The same amount will be applied in subsequent years to the remaining un-depreciated amount. This method produces an aggressive depreciation schedule with high write-off deduction amounts in the early years of useful life.
Section 179 Represents a “Win-Win!
While assets used for business decline in value over time and have a limited shelf life, the related Section 179 deduction was created as a business tax incentive and economic stimulus. This deduction encourages businesses to invest in themselves by purchasing or leasing equipment that can help their business grow.
It is really quite clever when you think about it. Your small business gets a significant tax break (SAVINGS) in the year it purchases or finances new (and/or used) equipment. This equipment then helps grow your business, and, as your company becomes more profitable, you will inevitably pay more taxes. It’s definitely a Win-Win situation for both the entrepreneur restaurant, as well as Uncle Sam.
Congress first recognized tax relief for business equipment purchases and leases as an economic stimulus back in 1958, when Section 179 was first enacted. Of course, given its implications to the government’s bottom line, Section 179 tends to undergo modification and tweaking every few years in order to ensure that the government’s portion of the “Win-Win” isn’t…well, let’s just say, compromised.
Our next blog will address Section 179 and how it’s a Win-Win for restaurants.
Finally, please note that the above information does not constitute “tax advice,” but is simply an informative blog drafted in order to alert you of potential savings for restaurants within the tax code. Be sure to conduct due diligence by discussing your restaurant’s tax situation with a qualified accountant.Pages: