Depreciation: Lower Net Income, Without Giving up Cash

Jan 10, 2002

The Bottom Line Depreciation is a legal method by which businesses can write- off the value of an asset purchase, over time; hence lowering the corporate tax burden.

Corporations pay out large sums of money for operating expenses. The simple day to day functions of a business take lots of cash to pay for and they include everything from salaries, to office supplies, to maintenance. Expenses, of course, are a direct offset to sales revenue and they reduce taxable income.

There are some types of expenses that reduce corporate income (and, therefore, corporate taxes), even though no actual cash ever changes hands. One such expense is depreciation. This type of expense is included in the corporation’s income statement, even though it has nothing to do with real cash flow.

What is Depreciation?

Depreciation is an allowable expense that allows a business to “write- off” the purchase value of a capital asset over time. A capital asset is defined as any asset that is used in the normal functions of a business. Examples of property that can be depreciated include buildings, equipment, furniture and fixtures, and other tangible assets, as well as certain intangible assets, like patents and copyrights.

Depreciation is based on the actual purchase price of an asset. Tax laws then allow a business to write- off the purchase, up to the full amount of the original purchase price, over a period of time.

Methods of Depreciation:

Most businesses depreciate assets using the straight- line method of depreciation. This method involves taking the purchase price of the asset (less its estimated salvage value, if there is any) and dividing by the number of years of its useful life, then writing off an equal amount of expense each year. For example, if a business buys several large machines at a cost of $100,000, with an estimate useful life of 10 years, the write- off per year would be $10,000, using the straight- line method of depreciation.

There are other methods of depreciation that are more complicated, and most are not as widely used as the straight- line method. Examples would include the double declining balance method; sum of the year’s digits; and accelerated cost recovery. These other methods vary slightly (they emphasize writing off the asset faster, at higher rates in the initial years), but they are still limited to the original purchase price of the asset.

Can Individuals Depreciate Property?:

IRS guidelines, relating to depreciation, only allow its use when an asset is being used for business purposes. Thus, you cannot depreciate your house or household contents, because you don’t use your residence home for official business. However, if you purchase property and use it as rental income, then you can begin to depreciate, because the asset is now being used as an income- generating asset.

Once an asset has been fully depreciated, the tax benefits from depreciation come to an end. This holds true, even if the business continues to use the asset to generate income. Also, if an asset is sold before it has been fully depreciated, then the business owner forfeits the opportunity to take any more depreciation allowance for that property. Using my above example, if the machinery was sold after 7 years, the depreciation allowance would end, at that time. The remaining $30,000 in potential depreciation write- off would be lost.

Why Does Depreciation Exist?:

Some people think that depreciation is unethical and should be eliminated as a tax write- off. These individuals argue the point that depreciation does not really represent a real expense. No actual money ever changes hands, so why should we allow corporations to use depreciation as a write- off? Having depreciation, the critics argue, is just another write- off for corporations, adding to their already- too- high corporate earnings.

This argument does have some validity. With no cash flow changing hands, there isn’t really any expense incurred. But the reason that depreciation remains legal is because it encourages businesses to invest. It lowers the net cost of an expansion, a large purchase of equipment, an acquisition of a new building, etc. For example, if a new building is going to cost a company 2 million dollars, the net affects of depreciation will reduce the future taxes of the corporation by anywhere from 15 percent to 40 percent, depending on the corporate tax bracket. Therefore, the net present value of this 2 million dollar building is going to be somewhere in the range of 1.2 to 1.8 million. With this type of savings, the odds that the corporation will go ahead with the expansion are greatly improved.

Final Thoughts:

Depreciation can make a substantial difference in the computation of corporate taxes. It lowers net income, even though it has no effect on actual cash flow. It helps companies save taxes so that they (hopefully!) will expand operations, hire more people, and spur economic growth.

If you’re a business owner and you want more information on depreciation, you should consult IRS publication 946. If you already know about your depreciation allowances and you want to submit them with your tax returns, then you need to fill out IRS form 4562.

Whether or not depreciation should be an allowable corporate write- off is debatable, and there are valid points to be made on both sides. Many people in Washington talk about tax reform, but they usually don’t mention the elimination of depreciation in their proposals for change. Even the most anti- corporate politicians have decided to leave this alone. It could be because of political pressure, ideology, corporate pressure, or a combination of factors. Whatever the reason, I don’t expect depreciation to come to an end anytime soon. It encourages corporate investment, so it will likely remain a valid tax write- off for corporations.

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