Your Business May Be Paying Too Much Tax
Congress Authorizes 30% Depreciation Bonus, Other Incentives
By Milt Zall
Businesses received the lion’s share of tax breaks contained in a new law passed recently to extend unemployment insurance benefits and stimulate the economy. Two of the breaks – the temporary 30 percent depreciation "bonus" and the five-year carry back period for net operating losses – apply retroactively to affect 2001 tax returns. Others significantly benefit certain business transactions. In addition, those businesses affected by the 9/11 tragedy in New York City have a set of special tax breaks tailored to their specific needs.
Your business is entitled to an additional 30 percent first-year depreciation deduction on qualifying property/equipment used in your shop with a normal depreciation period of 20 years or less; computer software (new software as well as updates to existing software); and leasehold improvements. The property/equipment must have been acquired after Sept. 10, 2001 and before Sept. 11, 2004.
"Qualifying Property" is defined as depreciable property that is purchased for use in the active conduct of your trade or business. A leasehold improvement means any improvement to an interior portion of a commercial building property, provided certain requirements are met. According to tax publisher CCH Inc., the date of acquisition of property is not necessarily the date it is "placed in service" for tax purposes. A property is considered placed in service for depreciation purposes when it is ready and available for use.
Original use of the property must begin on or after September 11, 2001 and the property must be placed in service before January 1, 2005. Since this provision applies to property placed in service after September 10, 2001, you may qualify for the bonus depreciation on your 2001 return. If you’ve already filed your 2001 tax return, you must file an amended 2001 return to claim the depreciation bonus.
The small business expensing election (Section 179) is $24,000 for 2001 and 2002. It’s scheduled to rise to $25,000 in 2003. Property/equipment you purchase – for example, surfacing equipment, boring machines, cleaning equipment, etc. – may qualify for both the 30 percent depreciation bonus and the Section 179 expensing election. If your business is located in New York City’s "Liberty Zone" – southern Manhattan – you can expense $35,000.
EXAMPLE 1 — Assume that on March 1, 2002, a machine shop that keeps its books on a calendar year acquired and placed in service a crankshaft grinder that cost $75,000. Under the new law, the shop is allowed an additional first-year depreciation deduction of $22,500. The remaining $52,500 of adjusted cost or basis is recovered in 2002 and subsequent years in accordance with the depreciation rules of present law.
EXAMPLE 2 — Assume that on March 1, 2002, a machine shop acquires and places in service boring bars that cost $50,000 and the property qualifies for the expensing election under Section 179. Under the new law, the shop is first allowed to expense $24,000 of the equipment purchase under Section 179. The shop then is allowed an additional first-year depreciation deduction of $7,800 based on thirty percent of $26,000 ($50,000 original cost less the Section 179 deduction of $24,000) of adjusted basis.
Finally, the remaining adjusted basis of $18,200 ($26,000 adjusted basis less $7,800 additional first-year depreciation) may be recovered in 2002 and subsequent years in accordance with the depreciation rules of present law.
Under pre-2002 Tax Act law, a net operating loss (NOL) generally could be carried back two years and forward 20 years. The new law temporarily extends the carryback period from two to five years for losses arising in 2001 and 2002. In addition, three-year NOLs, like casualty losses, can be carried back five years.
The new law also allows you to take an NOL deduction to reduce your alternative minimum taxable income up to 100 percent instead of the 90 percent allowed under existing law.
The tax law limits the amount of depreciation you can claim for a "luxury" car used in your business. The IRS says the cost of a "luxury car" is not an ordinary and necessary business expense and shouldn’t be fully deductible. So, if you purchase a car for business use, you’re only allowed to depreciate the cost of what the IRS considers an "ordinary" car, and the IRS says, that’s a car that costs up to $15,500.
Ordinarily, the maximum first year depreciation amount you could take for a car purchased in 2002 would be $3,060. Under the new law, luxury cars and other vehicles subject to the $15,500 "cap" on depreciation will be able to claim an extra $4,600 in the year the vehicle is placed in service if the vehicle is purchased between September 11, 2001 and Sept. 10, 2004. The $4,600 is in addition to the $3,060.
SEP Deduction Limits
Under present law, the annual limitation on the amount of deductible contributions to a Simplified Employee Pension (SEP) was 15 percent of compensation. Under the new law, the annual limitation on the amount of deductible contributions that can be made to a SEP has been increased from 15 percent of compensation to 25 percent of compensation.
Elective deferrals are no longer taken into account in applying simplified employee pension (SEP) deduction limits for employer contributions.
An employer may deduct contributions paid to a SEP but not in excess of 25 percent of the compensation paid to employees during the tax year. For purposes of the 25 percent deduction limit, under pre-2002 Act law, employee elective deferral contributions to a 401(k) plan were treated as employer contributions and, thus, were subject to the 25 percent deduction limit.
Elective deferrals are not taken into account in applying the 25 percent limit. As a result of this change, even an owner of a one-person shop may now be able to offer a 401(k) plan to himself. A sole proprietor earning $100,000 should be able to contribute — wearing first his employer hat and then as an employee — roughly $28,000 in 2002 into a tax-deferred 401(k) plan.
The 2002 Act provides that an eligible participant who will reach age 50 by the end of the tax year can make catch up contributions at the beginning of the tax year, rather than only at his 50th birthday.
Pension Plan Startup Costs
Under pre-2002 Act law, an eligible employer can claim a credit in an amount equal to 50% of its qualified startup costs in each of the first three years of the plan, up to a $500 per year maximum.
The 2002 Act clarifies that this credit for new retirement plan expenses applies in the case of a plan first effective after Dec. 31, 2001, even if adopted on or before Dec. 31, 2001.
If your business adopted a small employer pension plan on or before Dec. 31, 2001 and are eligible to claim a credit for startup costs, but did not do so, you should file an amended return in order to claim the credit.
Milton Zall is president of Zall Enterprises, an editorial consulting firm based in Silver Spring, MD. He writes about taxes, investments, technology and HR/business issues, as well as other topics, for trade and consumer publications. He has a Bachelor’s degree and an MBA in Economics, is a Certified Internal Auditor and a Registered Investment Advisor and can be reached via email at email@example.com.