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YOUR FINANCES
Take Advantage
of a Vanishing Tax Break
Happy New Year! While December has passed and it’s
too late to alter your business investment decisions for
2006, you can still take advantage of tax breaks on 2006
business investments and make plans for doing so in 2007.
In dealing with small business owners, I am often surprised
to learn that neither they nor their tax preparers are making
the most of the generous provisions of the tax code that
let you expense significant capital outlays immediately.
A little thoughtful planning around your investment in plant
and equipment now can really pay off. But delay could be
painful, because the current rules are set to expire after
2009.
Specifically, we’re talking about
provisions of Internal Revenue Code Section 179, which became
law in 2003 and were extended and made more generous in
2006. Under traditional IRS rules, businesses deduct a portion
of the cost of a capital assetanything from a drill
press to a delivery truckfor depreciation. Depreciation
is the amount by which the IRS allows an asset’s cost
to be expensed over the lifetime of that asset. The IRS
issues guidelines for determining the lifespan of capital
investments. Specific annual rates for each class of property
are provided by IRS tables. (Follow
this link to the lRS Web site.)
Under Sec. 179, however, a sole proprietor,
partnership or corporation can fully expense tangible property
in the year it is purchased. If the cost falls below a specific
limit, the entire purchase price can be deducted from the
gross profits of the firm or from the personal income of
the owner of an S Corporation. When Sec. 179 was enacted
in 2003, the limit on expensing was $25,000 a year; in 2006,
Congress enacted Enhanced Section 179, upping the limit
to $100,000 and allowing that amount to be adjusted for
inflation. This resulted in a deductible for calendar 2006
of $108,000. (We won’t know exactly what the adjusted
for inflation deductible will be for 2007 until it is announced
later this year.)
So, what does this opportunity
look like in practice? Here are two examples
A small business owner bought a high-capacity
printer/collator/binder unit in the fourth quarter of 2006
for $90,000 so that he could produce all of his direct-mail
marketing materials in-house. Under traditional depreciation
rules (MACRS, the Maximum Accelerated Recovery System rules),
he would have deducted 5 percent of the cost, or $4,500
for 2006, which is based on a useful life of five years
for the machine. However, since he meets the guidelines
for expensing, he can deduct the full $90,000 from 2006
taxes. If he’s the sole shareholder in an S Corporation
and receives pass-through income, and if he’s in the
40% tax bracket, he will realize $34,200 in tax savings:
$90,000 - $4,500 (the depreciation he
did not take) = $85,500
$85,500 x 40% = $34,200.
While he may be giving up some depreciation deductions
in the future, the owner still comes out way ahead, because
of the power of compounding on the resulting free cash flow.
This makes the decision to expense a capital purchase a
no-brainer for business ownersas long as they follow
through with the critical step of investing that free cash
flow in the business or in a retirement account (see previous
stories in this series). A good financial planner or CPA
can help you make the most of the cash flow.
Let’s consider one more example. When struggling
to grow her start-up business on a tight budget the company
owner furnished her whole office with used furniture. Now
that she has some steady cash flow, it’s time to upgrade
to furniture that better reflects her success and her tastes.
So, she spends $30,000 buying new office furniture. If we
take the depreciation on this purchase, assuming she bought
it in the third quarter of 2006, the expense would be only
$3,213. However, by electing to expense the purchase under
Section 179 she can deduct the full $30,000. As this business
owner, too, is in the 40% tax bracket, her tax savings come
to $10,715.
$30,000 - $3,213 = $26,787 X 40
$26,787 X 40 = $10,715
When I help small business owners create free cash flow,
as in these two examples, I always recommend they allocate
their newfound tax savings to helping fund their retirement
plans.
If you’ve made significant equipment purchases in
2006, sit down with your financial planner or CPA and see
if following this tax saving strategy is right for you.
Also, remember to make yourself a note that the current
IRS rules allowing for these big deductions expire at the
end of 2009, at which point the deductibility limit falls
back from the $100,000 limit to just $25,000. You’ll
want to keep this in mind as you do your short to mid-term
financial planning for your business regarding when might
be the best times for you to make significant purchases
for your business and benefit from taking advantage of a
high deductibility limit.
Guy McPhail, CPA, CFP®,
is president of Zdenek Financial Planning, LLC.
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