Revisit Decisions to Expense or Capitalize Property under New Tax Law (article)
Signed into law on Dec. 22, 2017, the new tax law known as the Tax Cuts and Jobs Act (TCJA) created a new deduction against qualified business income (QBI). New tax laws mean new opportunities for taxpayers. The QBI deduction provides sole proprietors, partners, and S corporation shareholders a 20 percent deduction that reduces individual taxable income. However, the deduction depends on the existence of sufficient "productive capital" in the business, namely employee wages or basis in tangible property. Taxpayers unable to increase wages may look to increasing investments in tangible property to maximize the QBI deduction. However, this may prove impractical due to cost or other constraints. This is where tax planning strategies can be utilized to maximize the QBI benefit using routine purchases of tangible property. Because the QBI deduction rules reward a taxpayer's possession of "unadjusted basis" in tangible property, businesses should explore strategies that result in an increased QBI deduction arising from routine purchases and other expenditures a business would make anyway.
Qualified property basis and the QBI deduction
Fundamental to these strategies is that an eligible business must have sufficient productive capital to allow its owners the full extent of the QBI deduction. For this purpose, the 20 percent QBI deduction for any trade or business is limited to the greater of:
- 50 percent of the business W-2 wages; or
- 25 percent of the business W-2 wages plus 2.5 percent of the unadjusted basis of qualified property.
Taxpayers potentially limited by the second condition will want to maximize the "unadjusted basis" in qualified property to take full advantage of the QBI deduction. The unadjusted basis of qualified property is the acquisition cost of all capitalized depreciable tangible property. Such property is counted towards the 2.5 percent calculation for the duration of the depreciable property life, or for 10 years if the depreciable life is less than 10 years.
Using the tangible property regulations
One strategy for maximizing the unadjusted basis of qualified property involves a fresh look at the tangible property regulations. Finalized in 2014, the tangible property regulations established new rules for expensing and capitalizing tangible property costs. The new guidance gives taxpayers the ability to deduct more costs than before, but the regulations also provide for capitalization of tangible property costs at a taxpayer's election.
The de minimis safe harbor (DMSH) election allows businesses to follow book accounting policies for expensing items that fall under a certain dollar threshold, even though such items must otherwise be capitalized for tax purposes. Safe harbor treatment is provided if the expensing threshold does not exceed $5,000 for taxpayers with applicable financial statements or $2,500 for taxpayers with no applicable financial statements. Previously, it was difficult to find a reason for taxpayers to not make the election, but the TCJA may have changed this. Failing to make the election requires taxpayers to capitalize more purchases for tax purposes. A taxpayer also could set the threshold at $0 or near $0 and have a similar effect. There is a definite trade-off here, where immediate tax deductions are deferred over several years. But the permanent benefits of additional QBI deductions may make up for the detrimental effect of slowed cost recovery on these purchases.
Turning the previous scenario on its head, the tangible property regulations also provide requirements to expense items meeting the definition of repair and maintenance costs. However, an election is available to capitalize repair and maintenance costs in lieu of the required expensing treatment. A business can elect to capitalize costs to repair or maintain a unit of property (such as a building) if such costs are capitalized on the business books and records. This is another way a taxpayer can increase the unadjusted basis of property without the need for additional purchases beyond what would have been made.
Materials and supplies are either deducted when used or deducted in the year acquired or produced. Items expected to last less than 12 months and items with a cost of less than $200 are some of the many items that meet the definition of materials and supplies. Whether the materials and supplies are deducted or inventoried, the cost does not count towards unadjusted basis since such items are not subject to depreciation. There is an election to capitalize materials and supplies, but this can only be used for rotable and temporary spare parts.
As summarized, a decision to not use the DMSH election and/or a decision to use the election to capitalize repair and maintenance costs allows a business to maximize the unadjusted basis of capitalized costs. Taxpayers and businesses making these changes would not need to seek permission to change a method of accounting, because these are annual elections. Furthermore, a decision to capitalize these items might not have any detrimental effect on the timing of cost recovery, because in many cases 100 percent bonus depreciation on these capitalized amounts will be available to accomplish the same effect as immediate expensing.
The benefit of capitalization
Elections available under the tangible property regulations provide potential solutions for businesses looking to increase the unadjusted basis of tangible property using routine expenditures. Prior to the TCJA's creation of the QBI deduction, traditional tax planning strategies favored expensing over capitalization for purchases of business property (a temporary benefit). The new QBI deduction changes this dynamic where a decision to capitalize purchases might be the difference between the 20 percent QBI deduction (a permanent benefit) and no additional deduction. Because the QBI deduction hinges on the capitalization decision for the property in this case, the potential tax benefits should be measured against the property cost. For assets treated as having a 10-year life, a capitalization decision could make the total benefit as much as 125 percent of the asset's cost. Taking it to the extreme, assets with a 39-year life could attract a total benefit equal to 197.5 percent of cost. These figures each assume Congress does not allow the QBI deduction to expire after 2025.
A decision to capitalize purchases that otherwise can be expensed involves a measurement of the current benefit for the immediate 100 percent deduction, as compared against yearly depreciation deductions and an incremental 2.5 percent QBI deduction each year. The decision is simpler for assets having lives shorter than 20 years that are eligible for bonus depreciation. Although comparable in result to an expensing decision, 100 percent bonus depreciation is based on the unadjusted basis of capitalized purchases. The existence of unadjusted basis for assets eligible for 100 percent bonus depreciation means there is no trade-off necessary to take advantage of the QBI deduction. For large real estate acquisitions and projects, cost segregation becomes vitally important in deciding which assets are eligible for bonus.
Like bonus depreciation, the Code Section 179 deduction allows an immediate deduction of property costs that would otherwise be depreciated over time. Unlike bonus depreciation, the Section 179 deduction is not defined as the immediate depreciation of capitalized basis. Instead, the costs subject to Section 179 are treated as expenses that are not chargeable to a capital account. Regulations provide a slightly different conceptual framework, where they articulate that depreciable basis is reduced by the Section 179 amount. This is an important distinction, where the law provides that amounts are not chargeable to a capital account (i.e., are not capitalized), and where the regulations provide for a reduction to depreciable basis (a result predicated on initial capitalization). In any case, the QBI criteria specifies that unadjusted basis is determined "immediately after acquisition." A Section 179 election is made with the filing of a tax return, a time that is later than immediately after acquisition. This observation, together with the guidance under the regulations, appears dispositive of the conclusion that purchases subject to Section 179 still are notionally capitalized upon acquisition, which allows such purchases to count towards the 2.5 percent QBI limitation.
The QBI deduction will expire after 2025, allowing only eight years of QBI deduction benefit for assets placed in service during the 2018 tax year. If the provision expires, the trade-off between accelerated cost recovery and additional QBI deductions could be affected for longer-lived assets that are not eligible for bonus depreciation. As mentioned, 100 percent bonus depreciation on capitalized purchases effectively eliminates the need for any trade-off, giving businesses the best of both worlds. State taxation complicates these considerations, however. Some states do not conform to federal bonus depreciation rules. A loss of the immediate state deduction would need to be considered in any analysis.
As can be seen, traditional tax planning strategies concerning tangible property must be revisited in light of the new QBI deduction. Contact your local CBIZ MHM tax professional to learn more about whether your business could benefit from these strategies, and whether a cost segregation study could be beneficial in maximizing that benefit.
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