Tax Reform – The Great, the Good and the Not So Good

The Tax Cuts and Jobs Act of 2017 (“Tax Reform”) provided one of the largest tax reductions in U.S. history. In addition to lower tax rates for individual taxpayers, the reduction of the federal corporate tax rate from 35% to 21% is a very big win for businesses.

Beyond the tax rate reductions, there are several other provisions that are of interest for businesses investing in equipment.

100% Expensing of Acquired Equipment

Bonus depreciation has been part of the federal tax code since 2001, allowing extra first year depreciation of acquired equipment in amounts varying from 30% to 100%. Bonus depreciation was subject to frequent extensions and even expired between 2005 and 2007. Tax Reform has significantly broadened the bonus depreciation rules, giving businesses greater options for reducing taxable income. Tax Reform provides for 100% bonus depreciation for qualified equipment purchases made after September 17, 2017 and through December 31, 2022. After 2022, the bonus depreciation rate declines by 20% each year (e.g., 2023 – 80%, 2024 – 60%, 2025 – 40%, 2026 – 20%). Unlike in prior years, businesses now have a greater sense of certainty that bonus depreciation will be available in the foreseeable future.

Another major change is that the acquisition of used equipment is now eligible for the bonus depreciation deduction. Previously, companies could only claim bonus depreciation on newly manufactured equipment. If the equipment is new to the taxpayer (i.e, not previously used by the taxpayer or a related party), bonus depreciation can be claimed. For a business looking at new-versus-used equipment acquisition options, the tax impact is now identical. The used equipment eligibility also paves the way for more cost-effective sale-leaseback transactions, since lessors can now claim bonus depreciation on equipment that it leases back to the original owner/user.

Like Kind Exchange for Equipment

Prior to Tax Reform, it was possible to defer gains on the sale of equipment if replacement equipment was acquired within a certain time frame. Tax Reform repealed this like kind exchange rule for equipment as a give-back for the enhanced bonus depreciation provisions. For equipment that was disposed of before 2018, a six-month replacement window for like kind exchanges has been provided for transition purposes.

Limitation on Interest Expense Deductions

Beginning in 2018, for most businesses with average annual gross receipts more than $25 million, the deduction for interest expense will be limited. The deduction for business interest expense cannot exceed 30% of adjusted taxable income, which is taxable income plus interest expense, depreciation, amortization, net operating loss deductions and the new 20% qualified business income deduction for pass-through entities, minus interest income and investment gains. An example of the calculation is presented below.

Company ABC’s has the following items of income and expense in 2018:

Sales $100 + Interest Income 5 – Cost of Goods Sold (70) – Interest Expense (15) – Depreciation (10) = $10 of Taxable Income before interest limitation

ABC’s allowable interest expense deduction is computed as follows:

Taxable Income before interest limitation $10 + Interest Expense 15 + Depreciation 10 – Interest Income (5) = $30 of Adjusted Taxable Income x 30% limit = $9 Interest Expense Deduction Limit

Based on the above, ABC’s interest expense deduction would be limited to $9 (versus the $15 incurred). As a result, its taxable income would be $16. Any interest expense not deducted because of the limitation is carried forward to future years and treated as additional interest expense subject to the limit.

While the new interest deduction limit will not apply to most small businesses and many larger businesses that are not highly leveraged, the limit is clearly an attempt to de-incentivize businesses from using debt as the principal component of its capital structure. Those businesses that are impacted should seriously consider leasing their equipment to reduce borrowings and nondeductible interest costs.

FSG Capital welcomes the opportunity to discuss your specific business needs and the impact of Tax Reform to maximize the benefit of your equipment investments.

Last modified: June 28, 2018