Every business uses some equipment, whether it’s just a smartphone, tablet, or laptop. Many businesses use vehicles or machinery. The National Federation of Independent Business (NFIB) reports that 63% of small businesses made capital outlays on equipment in January 2020.
Whether you’re buying items for the first time or upgrading to new and more efficient equipment, cost is always a factor. Whatever type of equipment is involved, tax law provides a number of write-off incentives that can ease your outlays.
Overview: What does the government classify as equipment in the section 179 deduction?
The term “equipment” in tax law is very broad. It includes tangible property -- what you can see and touch -- with a useful life of more than a year. Cost doesn’t matter; it can be inexpensive or pricey.
Equipment includes smartphones, copiers, hand tools, appliances, and office furniture. It also includes sophisticated machinery, such as 3D printers, robotics, and devices for medical and dental offices. It also includes vehicles used in business, including cars, trucks, and vans.
Write-off options for your business equipment purchases
The general rule is that you can’t simply deduct the cost of equipment as you can with purchases of copier paper, paper towels, and other materials and supplies. You usually have to depreciate the cost of equipment over a set number of years fixed by the tax law.
However, in addition to or in lieu of regular depreciation (explained below), you may be able to write off the purchase price entirely in the first year by relying on other tax incentives for buying equipment.
All of these write-offs apply whether the equipment is new or pre-owned and whether the purchase is financed in whole or in part (financing write-offs are discussed later). It’s very confusing to decide which deductions and write-offs to use; it’s something to discuss with your CPA or other tax adviser. But it’s important to first understand your options.
1. Section 179 deduction
This deduction, also called first-year expensing, is a write-off for purchases in the year you buy and place the equipment in service (i.e., it’s operational for business use).
There’s an annual dollar limit on what you can deduct (for example, in 2020, it’s up to $1,040,000 unless total equipment investments for the year exceed a set amount). You have to be profitable to use the deduction, and you need to elect it; it’s not automatic.
2. Bonus depreciation
This deduction, also called the special depreciation allowance, is another first-year write-off. There’s no dollar limit, and through 2022, it’s 100% of your cost. The deduction applies automatically, but you can elect not to use it.
For example, if you’re just starting out and don’t get much tax savings from the deduction now, you may not want to use bonus depreciation and instead “save” depreciation allowances (explained next) for future years as offsets to your greater revenue at that time.
3. Regular depreciation
This is an annual allowance that spreads deductions for the cost of equipment over a number of years fixed by law for the particular type of item. You can find rules for regular depreciation, as well as the Section 179 deduction and bonus depreciation, in IRS Publication 946.
4. De minimis rule
Instead of capitalizing the cost of equipment, which means adding it to your balance sheet, you can elect to treat equipment as non-incidental materials and supplies (items you keep track of but can deduct in full upfront).
As a small business, the de minimis safe harbor rule limits you to deducting up to $2,500 per item or invoice (a higher limit applies to large corporations with audited financial statements or certain government filings). You must elect this option by attaching a statement to your tax return that says you’re using the de minimis rule.
Special equipment purchase and deduction rules for vehicles for the section 179 deduction
Passenger cars (light trucks and vans are included as such) are subject to special rules that can limit deductions for purchases. In applying the rules discussed earlier, factor in:
- Dollar limits for expensive vehicles: You may not be able to take a full depreciation allowance if it’s more than the applicable dollar limit.
- Special rules for heavy SUVs: The Section 179 deduction generally is barred for vehicles. However, for those weighing more than 6,000 pounds -- many SUVs meet this weight threshold -- there’s a limited dollar amount ($25,900 in 2020). This can be combined with bonus depreciation, effectively allowing the entire cost of a vehicle to be deducted up front.
- Standard mileage rate: If you opt to deduct the cost of business driving by using an IRS-set standard mileage rate (e.g., 57.5 cents per mile in 2020), then you can’t deduct any depreciation for the purchase. The write-off for the cost of buying the vehicle is factored into the standard mileage rate.
If you buy a vehicle by trading in your old one, you likely have to report a gain on the sale of the old vehicle. Any allowance you receive toward the purchase price is treated as an amount received on the sale. If and to the extent it exceeds your basis in the old vehicle, it’s a taxable gain.
For example, say you had an old vehicle for which you paid $30,000, but because of depreciation, it now has a basis of $5,000. If the dealer gives you an $11,000 allowance toward the purchase of a new vehicle, you have a gain of $6,000 that’s taxable now ($11,000 minus $5,000).
State tax traps and the Section 179 deduction
Income tax rules on the state level may vary from those on the federal level.
For example, California and New Jersey have their own rules. You should explore whether or to what extent you can claim the Section 179 deduction or bonus depreciation on your state income tax return in order to know the full extent of your available tax breaks for equipment purchases.
Deducting financing costs of equipment
If you finance your purchase, whether through your line of credit, vendor financing, a credit card purchase, or some other way involving interest, you can deduct the interest payment.
Large businesses are subject to limits on the deduction for their interest costs, but small businesses -- those with average annual gross receipts in the three prior years not exceeding a set dollar amount (e.g., $26 million in 2020) -- are not. Farming and real estate businesses that exceed this gross receipts test can elect to be exempt, too.
Financing can be used to provide a cash-flow benefit while enabling you to obtain the equipment you need. For example, say in December you buy a machine costing $10,000, and you finance 80% of it, charging it to a business credit card.
As long as you can begin to use the machine in your business before the end of December (assuming your business uses a calendar year and not a fiscal year), you can deduct the $10,000 using the Section 179 deduction or bonus depreciation even though you’ll pay the credit card bill in January of the following year.
Assuming you report on the cash method of accounting (and not on the fiscal year), you can deduct $10,000 in the year of purchase even though you only had a $2,000 outlay (the amount of the purchase price that you didn’t put on your credit card).
Reimbursing employees for their equipment
Your business may require employees to provide their own tools. Chefs often have their own knives. Many construction workers have their own tools. In the past, if employees bought their own equipment, they could deduct the cost as a miscellaneous itemized deduction on their personal returns.
However, due to the suspension of this deduction for 2018 through 2025, many businesses are reimbursing employees for the cost of their tools.
If you want to do so, it’s advisable to use an “accountable plan,” which is an arrangement benefiting both employer and employee:
- Reimbursements are not treated as taxable compensation to employees.
- The reimbursements are deductible by the employer but are not subject to employment taxes.
For reimbursements to be treated as having been made under an accountable plan, certain conditions must be met, explained in IRS Publication 463.
Final words on business equipment purchases
Buying equipment and upgrading your existing equipment can produce several benefits for your business, including increased efficiency and better employee morale.
Fortunately, tax breaks can help you afford the equipment you need. Talk with your tax advisor to determine which breaks you can use so you can budget accordingly.
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