Software of the Month Club 1996 May

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@083 CHAP 9 ┌───────────────────────────────────────────────┐ │ DEPRECIATING ASSETS FOR TAX PURPOSES │ └───────────────────────────────────────────────┘ The Tax Reform Act of 1986 put an end to the highly favor- able "ACRS" (Asset Cost Recovery System) rules that had been enacted in 1981. Since January 1, 1987, taxpayers have had to learn a whole new, and more complex system of deprec- iation. Before then, virtually all assets a typical small business acquired were written off over 5 years, a few, like cars, over 3 years, and real estate over 19 years (or 15 or 18 years if acquired before May 9, 1985). You must still use the ACRS tables on assets placed in service be- tween 1981 and 1986, in general, however. ┌───────────────────────────────────────────────┐ │THE "MACRS" (MODIFIED ACCELERATED COST RECOVERY│ │ SYSTEM) DEPRECIATION SYSTEM │ └───────────────────────────────────────────────┘ Under the MACRS depreciation system, most assets are now assigned to 3-, 5-, 7-, 10-, 15- or 20-year recovery period categories, except for real estate, which is depreciated over 31.5 years, or 39 years if placed in service after May 12, 1993. Residential rental property is depreciated over a period of 27.5 years. Under the MACRS system, all per- sonal property in the 3-, 5-, 7-, and 10-year categories is depreciated using the old 200% declining balance method of depreciation from pre-1981 days, and 15- and 20-year prop- erty is depreciated under the 150% declining balance method. Real estate may now only be depreciated on a straight-line basis. Assets other than real estate are mostly assigned to the various recovery periods based on the old Asset Deprecia- tion Range ("ADR") system "midpoint class lives" that were published by the IRS back in the early 1970s. The "class life" guidelines vary from industry to industry and are quite numerous and technical. For the most part, you will need to rely on your tax adviser to tell you what recovery period applies to various depreciable assets you purchase in your business. However, the MACRS system does specific- ally assign some types of assets to recovery classes, such as autos and light trucks, which are now 5-year property (they were 3-year property under the former ACRS rules). Most of the "information-handling equipment" (other than computers) used in an office, such as calculators, typewrit- ers, etc., are 5-year property, and computers and peripher- als are generally 7-year property. Generally, under MACRS, a half-year of depreciation can be taken in the year an asset is first placed in service, re- gardless of whether it is put in service on the first day of the tax year or the last day (except for real estate). However, when more than 40% of such property is put in ser- vice in the last 3 months of the tax year, you are instead required to use a "mid-quarter" convention, which assumes that all the assets placed in service in each calendar quarter were placed in service at the midpoint of such quarter. Under recent final MACRS tax regulations [Regs. Section 1.168(d)-1(b)()(ii) ], no depreciation is allowed at all for property that is acquired and disposed of in the same taxable year, regardless of which convention applies. As such, such assets are ignored in determining whether the 40% limit has been exceeded and thus whether the mid- quarter convention applies to other assets acquired during the year. For real property, all real property that is placed in service in a particular month is assumed to have been placed in service at the mid-point of that month. ┌───────────────────────────────────────────────┐ │ DEPRECIATION LIMITS FOR LUXURY AUTOMOBILES │ └───────────────────────────────────────────────┘ Limits are placed on the amount of depreciation that can be taken each year on so-called "luxury automobiles" used in a business. In effect, if you buy an auto for business use (other than for hauling, or carrying passengers for hire), you are limited to the following maximum annual de- preciation deductions for cars placed in service in 1994, 1995 and 1996 (1996 numbers remain the same as for 1995): 1994 1995-96 ------ ------- 1st Year $2,960 $3,060 2nd Year $4,700 $4,900 3rd Year $2,850 $2,950 Each Subsequent Year* $1,675 $1,775 (* Until the entire cost is written off. This could take several decades for a Rolls-Royce.) The above amounts assume the car is used 100% for business. If you use it for business, e.g., only 80% of the time, then your maximum deduction would be 80% of the above numbers. Similar treatment is given to leases, based on the value of the car, except that you must include certain "phantom" income on your return from the IRS "inclusion amount" tables, for cars with above a certain value. Thus, a taxpayer who leases a car for business deducts the full amount of the lease payments, but then must add back to taxable income an "inclusion" amount for "luxury automobiles" that increases with the value of the auto in question (without regard to the amount of the lease payments). Both the above annual limits on auto depreciation and the leased car "inclusion tables" kick in at price levels that you or most ordinary citizens definitely would not consider "luxury car" prices. Congressmen apparently have a very different idea than most of us as to what constitutes a luxury automobile. (But then, if one is accustomed to being driven around in big, black chauffeured limousines, paid for by the taxpayers, how could one be expected to know how much a "luxury car" costs?) Taxpayers who do not wish to deal with the complexity of keeping track of automobile expenses and computing annual depreciation deductions for an auto used wholly or partly for business purposes may instead to elect to merely keep track of business miles driven, and deduct a flat 31 cents per business mile (in 1996 -- or 30 cents a mile for 1995). In some cases, this may even yield a larger deduction, for a lower-priced, gasoline-efficient automobile. ┌───────────────────────────────────────────────┐ │EXPENSING OF EQUIPMENT IN THE YEAR OF PURCHASE │ └───────────────────────────────────────────────┘ Small businesses are allowed to expense up to $17,500 a year of equipment, in the year of purchase, rather than depreciating it. Thus, for example, if you buy a $5,000 computer in your small business, you can "expense" its entire cost in the year of purchase, rather than depreci- ating it over a 7-year period. This would ordinarily improve your cash flow, by giving you a full $5,000 tax deduction right now, rather than a few hundred dollars a year over 7 years. This benefit phases out dollar for dollar if you acquire more than $200,000 of eligible property during the tax year. If your business acquires $217,500 or more of such eligible assets in one year, it won't be able to elect to expense ANY of it. Thus, a business that acquires a large amount of depreciable personal property each year is not able to take advantage of this tax break (but is still able to depreciate it). Eligible property is generally tangible personal property that would have qualified for the invest- ment tax credit under prior law. Note that this expensing election is not allowed if it would create a loss for the taxpayer -- it is only allowable to the extent the taxpayer has taxable income. ┌───────────────────────────────────────────────┐ │ AMORTIZATION OF INTANGIBLE ASSETS │ └───────────────────────────────────────────────┘ For all practical purposes, "amortization" is essentially another way of saying "depreciation," except that amortiza- tion implies that the cost of an item is written off in equal amounts over a period of years or months. This is really the same as "straight-line" depreciation. (Other depreciation methods, such as 200% declining balance, allow a bigger percentage write-off in the initial years after an asset is purchased.) Accountants like to use the term "depreciation" when referring to the write-off of TANGIBLE assets and "amortization" when referring to the write-off of INTANGIBLE assets. The Revenue Reconciliation Act of 1993 now provides for the amortization, generally over 15 years, of most kinds of INtangible assets, many of which, like "goodwill" value in the purchase of a business, were not depreciable or amortizable at all before the new law was enacted, on August 10, 1993. (And you can elect to apply the new law retro- actively to all intangible property acquired after July 25, 1991). Certain kinds of intangible property can be amortized over periods shorter than 15 years, like most computer soft- ware (36 months under the new law), but certain kinds of intangibles, like sports franchises or certain "self- created" intangibles, are not amortizable at all. @CODE: CA ┌───────────────────────────────────────────────┐ │ CALIFORNIA DEPRECIATION DIFFERENCES │ └───────────────────────────────────────────────┘ Over the years since the ACRS depreciation system came into being for federal tax purposes, one of the most important differences between federal and California tax law has been with regard to depreciation. However, in 1987 and 1988, California finally enacted legislation to allow unincorpor- ated businesses and S corporations to use the new MACRS depreciation for state income tax purposes. Even so, regu- lar corporations subject to tax in California are still prohibited from using either the ACRS or MACRS depreciation systems for state tax purposes (most regular corporations are subject to the California franchise tax, rather than income tax, on their income). Regular ("C") corporations still must use the old pre-1981 methods that were used for both federal and California purposes before 1981, unless ACRS or MACRS deductions are considered "a reasonable allowance." Also, while 1993 federal legislation increased the first-year depreciation write-off for machinery, equipment and other depreciable personal property from $10,000 to $17,500, no such increase was adopted for California individual taxpayers. Indeed, for corporations, California never even conformed to the $10,000 write-off, but still retains the old federal provision from many years ago allowing only "bonus deprecia- tion" in the first year of 20% or $2,000 of the cost of elig- ible depreciable assets. One benefit of California's failure to conform to federal depreciation changes, however, is that (non-corporate) tax- payers in California can still write off non-residential real property over 31 1/2 years, rather than the 39 year period now required under federal law. @CODE:EN