A Trip To The Candy Store

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Living in the country as a child, I always looked forward to the occasional trip to the drug store, where I was eager to spend my very well-deserved earnings. (I refer to these as earnings as opposed to allowance, as I definitely earned them.) As a child, I was cursed with a sweet tooth, rightfully curbed by my parents’ rules of consumption.

On the car ride there, I would dream of what delights I could purchase with my dollar. One particular day, I dreamt of Dots, the gelatin-based candy enjoyed often while at the local theatre. I was in luck! The 40- cent boxes of Dots were now three for a dollar! I eagerly selected the three during a squeeze test, assuring their freshness. (Dots become particularly hard to chew if they are not fresh.)

While bragging to my father of my keen sense of business and thrift, my father (after confiscating the two surplus boxes of Dots) asked me why I purchased three boxes now instead of the single box? “Because they were cheaper,” I boasted. He then asked, “What is less, 40 cents or $1?” Clearly not understanding the brilliance of my purchase, I corrected my father saying, “Dad, what you mean is what is less, 33 cents or 40 cents?”

As usual, my father said what he had meant. From there he fired a number of questions at me. What would happen when we went to the carnival and I wanted my 60 cents for a ride? After eating the enormous box of Dots today, would I really want Dots again another day? What if a new candy came out before I earned my next fun money? Would I want to eat stale Dots by the time my parents released the extra confiscated boxes?

My father was trying to convey the use of my money was probably more valuable to me than something I may not use (or enjoy using) in the future. Even though I would only have 60 cents left on my dollar, it still left me possibilities and options for the future. Buying “extra” of something, at any price, I did not then or in the future need, was a poor use of my well-earned money. I would have preferred the money over the stale candy I may never eat or want.

Wolf in sheep’s clothing
Business owners are sometimes the kids at the candy counter in the drug store when it comes to business expenditures. They welcome any type of encouragement to purchase another piece of equipment they really want but absent a current need. Two examples of this, in action, are the misuse of Section 179 and Bonus Depreciation.

Misuse in this sense means a business owner purchased a business asset, not out of current need, but rather by the motivation to save tax dollars. At the end of the day, if owners thoroughly understood the rules of Section 179 and Bonus Depreciation and application, they may prefer to keep 60 cents of every dollar.

Business owners have often heard the last-minute recommendations of their tax preparer: “buy equipment because you can either give the money to the government, or you can give it to yourself.” However, this comment is a very rudimentary explanation of how Section 179 and Bonus Depreciation impact tax liability. Again, if understood, most business owners would probably prefer 60 cents on every dollar to go towards working capital, inventory, or even payroll. But when faced with the tempting recommendation to buy equipment, they often fail to understand that instead of spending a full $1, they could keep 60 cents.

The gist of Section 179
Section 179 allows business owners to deduct up to $139,000 (in 2012) of the asset’s purchase, price immediately in the year of purchase as opposed to deducting the purchase price over the lifetime of the asset (conventional depreciation).

A numeric example may help. Under conventional methods of depreciation, a seven-year class of property means the asset will be depreciated over seven years. A purchase of a $70,000 seven-year asset would result in $10,000 per year of depreciation deduction. However, under Section 179, the business owner would deduct the full $70,000 in the first year.

The technical details of Section 179
Qualifying asset purchase may be new or used. Such examples of qualifying property are equipment, vehicles over 6,000 pounds, furniture, computers or computer software and any other tangible personal property used in the business. The total amount of qualifying purchases may not exceed $560,000. This means if a company purchases more than $560,000 in qualifying assets, their $139,000 maximum deduction may not be limited to less than $139,000. (The deduction phases out dollar for dollar on total purchases over $560,000. For every dollar over $560,000, one dollar would be taken from the $139,000 maximum deduction.)

The skinny on “buy equipment or pay the government”
If the business owner truly needs the equipment, Section 179 provides an immediate deduction for the purchase. However, if the business owner does not need the asset currently, “buy equipment or pay the government” is somewhat misleading. On the surface, it appears the entire $70,000 from our example would either be paid to the government or for the purchase of the asset.

Let’s again apply this to a numeric example. If, instead of purchasing equipment, the owner allowed the $70,000 to be taxed as profit, what would be the tax consequences? Assume we are dealing with an effective federal corporate rate of 25 percent. This means the $70,000 would be subject to $17,500 of federal income tax. More importantly, the business owner would still have $52,500 remaining after tax. $70,000 – ($70,000 x 25%) = $52,500 left!

Please recall, with the purchase of the asset, the entire $70,000 would be used, leaving the business owner none of this $70,000. Yes, the owner would have a new asset, but if it currently lacks use or function, what is the true reason behind the purchase?

Most owners, when faced with the decision regarding cash flow, would prefer to have $52,500 of working capital instead of an asset they do not currently need!

Unfortunately, business owners often are excited to have someone give their professional blessing to purchase a truck, a new fork-lift, or any other piece of equipment they have coveted, but could not otherwise justify purchasing. A thorough analysis of the tax consequences may have led the same owner to determine they prefer the $52,500 in cash to expand a project, bid on a contract, make their payroll, or keep for emergencies.

Adding insult to injury—financing a purchase
Financed property, and in some cases leased property, will still qualify under Section 179. If the company needs the qualifying asset, this can be a tremendous benefit to the business owner. The owner could deduct the total purchase or lease cost within the first year; however, the cash outlay would be limited to the payments made in the first year. The net effect may result in a cash surplus.

But, many owners simply do not need the asset they are purchasing when motivated solely by Section 179. In that case, they are adding insult to injury, as they are not only now obligated to make repeating payments on an asset which may never be used, but they are paying interest on this unnecessary piece of equipment. In the long run, they are reducing their cash position unnecessarily, as the purchase was not needed. Every month they need cash and instead are making a payment on an asset they do not use, one can imagine the frustration.

Father knows best
Good deals are out there every day— retailers, wholesalers, auctioneers and even the Internal Revenue Code have good deals. However, a good deal is only a steal if you need what’s on sale Otherwise, you may miss an opportunity tomorrow that requires the cash more than the unused asset. Father always knows best!

About Elizabeth Fullington 5 Articles
Elizabeth Fullington is the Business Development Manager for STA. She is a CPA and JD, obtaining her undergraduate degree from Truman State University in Kirksville, Missouri, and law degree from the DePaul University College of Law In addition, Elizabeth has her Certificate in Taxation form the DePaul University College of Law.

1 Comment

  1. Greatly valued the style and content which enabled a clear understanding about real cash flow without talking down to the reader or getting into finance speak.
    Thanks

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