I recently received another question about the Section 179 expensing election that should be useful in clarifying some of its technical applications for the benefit of the many other tax pros who read this.

The question:

I have been advised that multiple corporations owned by the same person or up to the same five persons, will be considered a controlled group and will be taxed as a one large corporation. Tax wise, they would be limited to only one Section 179 expenses election and there net income would be grouped together for tax purposes. Would you be so kind to help me understand this matter a little better.

My response:

You are correct that among a group of C corps, the $100,000 Sec. 179 must be allocated.

My comment was meant to contrast with the use of pass through entities, such as S-corps, where the net effect is to limit the total combined Sec. 179 deduction to $100,000 on the 1040. A majority of my clients have closely held C corps, where the corp can claim up to $100,000 and they can also claim another $100,000 on their 1040s. If they had used an S corp or 1065 LLC, their total Sec. 179 would be only $100,000. This in effect allows a doubled maximum amount ($200,000).

I still see too many people jumping into S corps without considering the fact that C corps can reduce their taxes dramatically over an S.

I do occasionally speak with a client who thinks he can do even better by setting up several C corps and claiming $100,000 on each of their 1120s. When I explain the limit of one $100,000 to be spread among all of the controlled corps, they drop that idea.

I hope this clears up any confusion.

The newly increased limits on the Section 179 expensing election have generated some confusion. One is the effective date, mainly for corporations that have fiscal years ending in a month other than December, which is how I advise most of my C corp clients to set theirs up. Since almost all of my C corp clients are wisely using a non 12/31 fiscal year, I have had to break the bad news that the tax returns I am now preparing, for years ending in 2003, have a Section 179 limit of $24,000. The new $100,000 limit will apply to the next year, that starts in 2003 and ends in 2004.

There is also some confusion regarding the purpose and benefits of the Section 179 expensing election, such as in this email I received last week from a reader:

With the new limit of $100,000 to expense equipment – – – –

Is my understanding correct that you can only expense items purchased up to $100,000 so long as it does not result in a negative or loss for the business. Any amounts that can not be expensed must then be depreciated as normal over their life. If this is truly the case – what good does that do for the small business guy – who does not make enough to expense anywhere near that amount against?

My response:

You are correct that the Section 179 expense allowable in any single year is limited by the overall taxable income. Any excess can be carried over to future years; or what often do, is opt out of the Sec. 179 and claim normal depreciation, that often gives a higher net loss, which can be carried back to recover previously paid taxes.

The reasoning and potential benefit behind having larger immediate deductions for new equipment purchases is to avoid the situation where a small business owner has plowed all of his/her profits and liquid cash into those purchases. If they are not immediately deductible, there could be a paper net taxable profit; yet there might be no cash left with which to pay the taxes. This kind of thing does happen a lot, plus situations where there is a paper taxable profit, but because the owner used all of the available cash to stock up on inventory (not deductible until sold), there was no money left to use to pay the taxes. Including the cost of new equipment along with other operating expenses does usually give a better representation of net cash generated from the business and thus makes it easier to pay the taxes on any net income.

I’ve added a page to my main site with the 2004 tax rate schedules and related figures in the easier to follow format I have been using for the past several years.

I also updated the page on the Section 179 expensing election for the 2004 inflation adjusted limit of $104,000, as well as explanations of the phase-out of the Sec. 179 deduction and a general description of what kinds of things qualify for this expensing election.

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Bush sees tax cuts spurring job creation – We’ll have to see if this happens. However, the quadrupled Section 179 deduction (to $100,000 per year) is a very big incentive to buy new business equipment. I know that a lot of people are checking the weights of new vehicles more closely than ever to make sure they are over the 6,000 pound threshold that makes them eligible for the full Section 179 expense.

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Corporate Choice – I’m still as big a supporter of using C corporations as before the new tax law, especially with the quadrupled Section 179 expense deduction. An owner of a C corp can claim up to $200,000 per year, while an S corp owner is limited to only $100,000. Many people, including Forbes, aren’t looking at the big picture and are falling for the lure of the more taxing S corps and LLCs, which are basically identical to S corps.

Small Businesses Reap Benefits Of White House Tax Package – As the DemonRats feared, quadrupling the Section 179 expensing allowance to $100,000 per year, and allowing additional extra depreciation in the first year, is encouraging a lot of small businesses to make new purchases, giving the economy a healthy boost. 

Secret Tax Hike – As I’ve explained on several occasions, our rulers have been very sneaky in adding much higher effective income tax rates than you can find in any of the official tax rate schedules.  By phasing out several deductions and credits for people considered by our rulers to be evil rich, the effective marginal tax rates can be much higher than the normal top rates.  They like to call it “means testing,” indicating that those with increased means of support (income) shouldn’t receive the same tax breaks as the little people.  I prefer to call it “mean testing,” indicating the practice of penalizing success.  This new tax law is no exception to that concept, with several new phase-out rules.  Class warfare is still a very real part of our tax system.

Same As Cash

I have been receiving some questions as to whether the Section 179 expensing election requires that you pay for the asset, such as a vehicle weighing more than 6,000 pounds, in full or if you can finance it.  This brings up one of the biggest mistakes I see people make, causing them to overpay their taxes, both because of ignorance and lousy bookkeeping.     

For income tax purposes, how you finance a purchase is irrelevant for purposes of deductibility, including the Section 179 election, which is now up to $100,000 per year.  It is exactly the same whether you pay cash or put zero money down and take out a loan for 100% of the price. 

Likewise, using a credit card is considered to be the same as paying cash for income tax purposes, regardless of when the card is paid off. You can literally go to a store, such as Best Buy (where we bought our three most recent computers) on December 31, use your credit card to buy $50,000 of computers and other business equipment, and you can claim a Section 179 deduction for the full $50,000 on this year’s income tax return, as long as you plug them in and start using them before midnight.  An often overlooked requirement of the Section 179 deduction is that the asset be placed in service during the tax year for which the deduction is being claimed; not just paid for.  The credit card bill won’t be received until next year; but that doesn’t matter for tax deductions.    

A lease of a vehicle or other business equipment does not qualify for the Section 179 unless it is a disguised purchase, such as a lease to own with a one dollar buy-out at the end. 

If you have a loan for the purchase, you can then also deduct the interest as a business expense on the same schedule where you claimed the Sec. 179.  Likewise, finance charges on deductible credit card purchases can also be deducted.  This is another often overlooked deduction by people, and even tax pros, who believe that vehicle and credit card interest are always nondeductible personal interest. 

As I have said too many times, most people miss out on claiming their full possible deductions because of crappy bookkeeping (to use the technical term).  They only look at just their checks paid out for the previous year and miss out on the purchases made through loans and credit cards.  That is why it is so important to have everything properly set up on QuickBooks.  It does a beautiful job of combining purchases made through all of those means into the proper years. 

New Tax Rates

I’ve updated the 2003 tax rate schedules to reflect the new law.  I also added a lot of info at the bottom of the page on the new special rates for dividend income and long term capital gains. The lower rates on dividends kick in as of January 1, 2003; but the lower long term capital gains rates don’t apply until sales made after May 5, 2003. For installment sales, we will need to keep track of separate totals for principal received between 1/1/03 and 5/5/03 and what is received from 5/6/03 through 12/31/03 so that the proper rates can be applied.  We can expect a very messy Schedule D for 2003.

I also updated the Section 179 info to reflect this new tax law.

The New Tax Law

While looking over the details of the new tax law, and updating them on my main website, I had a few observations, especially in regard to how those of us living in the real world (as opposed to the fantasy world in which our rulers reside) will deal with it. 

Overall, it is a very good step in the right direction of lower taxes.  The most amazing change was the quadrupling of the Section 179 expensing election from $25,000 ($50,000 for owners of C corporations) to $100,000 ($200,000 for owners of C corps).  This is much more generous than the $30,000 to $75,000 figures that had been included in the early versions of the bill as it worked its way through the sausage factory, digestive system, of DC.  This should encourage a lot of capital spending on new business equipment, including evil SUVs, if they weigh more than 6,000 pounds. 

Besides raising the annual deductible amounts, this new law made some other nice changes to the Section 179 rules.  For 2004 and 2005, the annual amounts are to be adjusted for inflation.  Up until now, the Section 179 election was only allowed on originally filed tax returns.  People who overlooked it were not allowed to claim it on amended returns.  This new law allows the Section 179 expensing election to be claimed or revoked on amended returns for 2003, 2004 and 2005.

There are several aspects of the new law that leave a lot to be desired.  The short time horizon, with all of the changes disappearing after 2004 or 2005, does make long range planning a bit tenuous.  We have to hope that the GOP’s strategy of bringing this matter back up for a vote in 2004 will have the desired effect of making those opposed have to defend raising everyone’s taxes. 

The failure to eliminate the double taxation of corporate income is very disappointing. The compromise, to tax dividends at the special long term capital gains rates of 5% and 15%, is just one more example of how our rulers never miss an opportunity to make things more complicated in the tax system.  This will obviously be great for stimulating more business for us tax pros and our software suppliers.  I’ve even heard predictions of a 25% increase in H&R Block’s stock price due to this new tax law requiring more people to seek out their help in preparing tax returns.

The biggest failure of this new law is its attempt to remove the marriage penalty.  The marriage penalty is a very real aspect of our tax system.  I have seen countless couples either get divorced or refuse to get married just because the thousands of dollars in additional taxes they would be required to pay for the privilege of being married.  As I have always advised, if our rulers really wanted to eliminate this penalty, they would just allow people to compute their taxes under both methods, married and as if they were single, and pay the lower amount. 

However, our rulers always come up with some half-assed token deduction for married couples that is just a drop in the bucket toward wiping out the actual penalty.  This new law’s approach is no better.  In fact, this new law even adds new marriage penalties with the phase-out amounts for the new tax credits and deductions that are in the law to prevent the evil rich from receiving any of the tax breaks.  The phase-out amounts are much higher for two single people than for a married couple.  How our rulers can claim to be removing the marriage penalty while actually adding new penalties is a skill that only politicians seem to have.  A disconnect between their perception and the real world reality in which the rest of live. 

KMK

We are getting closer to an actual tax cut bill.  As soon as the differences are hammered out between the House & Senate versions, we can start making plans on how to best utilize the new changes, especially in regard to corporate dividends and the much higher Section 179 expensing election.

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