As a small business owner, you have the ability to depreciate assets differently depending on your financial situation and business goals based on IRS publication 946 as some may give you more cash flow now and others provide it over multiple years. Two examples of this are 100% bonus and straight line depreciation.
- 100% bonus depreciation is best for a small business that wants the highest tax deductions and cash flow in a single year by writing off the entire purchase price of an asset in year 1.
- Straight line depreciation is better for a company that wants low deductions for stable profits across many years since it depreciates the asset in equal amounts each year.
While depreciation choices impact small business profit and cash flows directly, they indirectly impact a business’s ability to qualify for small business loans or attract outside investors depending on how the company uses the deduction.
Here are two scenarios for 100% bonus depreciation:
- 100% bonus depreciation is better for a new business using equipment financing for their production line as they will break even faster, letting them reinvest the cash saved from taxes into more inventory that can be sold. This leads to more customers, faster revenue growth, and less time to turn a profit.
- 100% bonus depreciation can hurt a mature business’s ability to get equity financing for expansion by making the small business unprofitable and unappealing to investors. Investors get paid from future profits, but large depreciation expenses can create a net operating loss (NOL) that the company carries forward to reduce future profits as well. This means it could be years before the company has any profits to pay investors.
To qualify for depreciation, a business asset must have “a useful life” greater than 1 year, making it a capital expenditure, and it must wear out over time. Examples of assets that don’t get depreciated are:
- Inventory because it’s expensed as of Cost of Goods Sold (COGS), even if it remains on the books for more than a year. There’s also a process separate from depreciation to write off inventory when it’s not sold.
- Land doesn’t wear out according to the IRS, so it has an infinite useful life and does not qualify for depreciation.
If you’re thinking about buying new assets for your small business this year, here’s how to start thinking about which depreciation model makes sense depending on your financial goals. By knowing these, you can discuss them as part of a multi-year tax strategy with your tax professional and make sure they match your situation given other expenses and deductions.
100% Bonus Depreciation: Maximizing Cash Flow This Year
100% bonus depreciation is the best choice to maximize this year’s cash flow since you deduct the entire purchase price from your pre-tax income, so you pay the lowest tax. Bonus depreciation can also create a loss where you pay no taxes this year and carry the loss forward to lower taxes in future years.
The One Big Beautiful Bill Act (OBBBA) made 100% bonus depreciation the default depreciation method for most business assets unless you choose to opt out. This means you’ll automatically take the maximum deduction and get the highest cash flow this year unless you tell the IRS you want a different depreciation method.
Before doing this, go over all of your asset purchases as part of a companywide tax strategy because you can’t opt out for individual assets and not others in the same “asset class” listed in IRS pub 946. Opting out of bonus depreciation for new carpet and appliances for rental properties means you must also opt out of bonus depreciation for trucks purchased in the same year since both assets fall under the “5-year class.” Fortunately, there is another depreciation option you’ll learn about later that lets you go asset by asset.
The OBBBA also lets you opt in to 100% bonus depreciation for assets that wouldn’t otherwise qualify as long as they are qualified production property (QPP) used entirely for production. Buildings and improvements are two examples that don’t automatically qualify, but if the building is a factory or the improvement is a parking lot for a factory, then they are QPP and you can opt in to 100% bonus depreciation. If 25% of the building is used for admin and warehousing, then you’re able to use bonus depreciation for 75% of the building that’s used as the factory.
Other examples of assets that don’t qualify for bonus depreciation are:
- Residential real estate you rent out.
- New headquarters and admin offices.
- Assets used mostly outside of the US.
While bonus depreciation gives you the maximum cash flow by taking the biggest deduction this year, it might also create an operating loss you don’t want or your assets might not qualify for it. That’s where Section 179 elections and other depreciation methods come in.
Section 179: Minimizing Taxes Paid Without Large Losses
Section 179 has three benefits that help small businesses minimize their current year tax bill but prevent them from becoming unprofitable due to a large depreciation expense:
- Deduct any amount between 1%–100% of an asset purchase in year 1 and carry forward any unused portion of the deduction.
- Choose individual assets within the same “asset class” without affecting other assets (unlike bonus depreciation where all assets in the same class must be the same).
- This applies to assets that don’t qualify for bonus depreciation.
Small businesses can maximize cash flow and minimize taxes paid without suffering a loss because Section 179 lets the business deduct any amount less than or equal to the price of the asset as long as it doesn’t create a loss on the company’s income statement. If a 50% deduction takes the company’s taxable income to $0, then the remaining 50% of the Section 179 deduction gets carried forward for lower taxes and higher cash flow next year.
Companies can also use Section 179 for specific assets without impacting depreciation choices for other assets. A trucking business that purchases a new semi-truck and new computers can use Section 179 to fully write off the computers in year 1 and opt out of bonus depreciation for the semi-truck. This saves them money on taxes by deducting 100% of the computers plus the first-year depreciation on the semi. It also stabilizes cash flows across the next 4 years (the depreciation timeline for trucks) and lets them avoid a loss for the year’s income statement.
Section 179 also minimizes a small business’s tax burden by giving them a large deduction without creating a loss when their assets don’t qualify for bonus depreciation like:
- A new security system for a rental property.
- An HVAC system replacement for headquarters.
- Getting a new roof on a warehouse.
- Investing in a parking lot expansion at the headquarters building.
- Upgrading a drainage system for a golf course.
Bonus depreciation and section 179 cover the vast majority of small business assets, but not all. There are other depreciation methods for assets that don’t qualify or for when a company wants to spread the depreciation expense over as many years as possible.
MACRS: Keeping Depreciation Expense Low to Keep Profits High
When higher profit is more important than actual cash flow, using the Modified Accelerated Cost Recovery System (MACRS) for depreciation is the best choice because it spreads the depreciation expense across the most years possible, so each year’s income statement shows the highest profit possible. MACRS is also the way companies must depreciate assets that don’t qualify for 100% Section 179 or bonus depreciation including:
- Residential real estate.
- Non-manufacturing commercial buildings.
- HVAC, security systems, new roofs, and other improvements to non-manufacturing properties (these qualify for Section 179 in general, but you have to use MACRS if you exceed the 179 limits).
Within MACRS, there are 3 options to determine the depreciation amount each year:
- A 200% declining balance gives companies the highest depreciation deduction in the early years and is good when the company wants slightly higher depreciation deductions in early years while still spreading out the full cost across an asset’s useful life.
- A 150% declining balance does the same thing except it gives a lower deduction in the early years and more in the later years versus a 200% declining balance.
- Straight line is where a company deducts the same amount of depreciation each year across the life of an asset and is best when a business wants the highest profits possible in year 1 since it gives the lowest depreciation expense.
Not all property qualifies for all 3 options, so check the tables in IRS pub 946 to see which options apply to your assets. In rare cases, your business might have depreciable assets that need a different way to calculate depreciation. These will be unique to your specific business, so discuss them with a tax professional to stay compliant with the IRS.
Other Depreciation Methods
There are other depreciation methods, but they are rarely used by small businesses and you would only choose one if you have an incredibly unique asset or business situation. Talk with your tax professional if you think any of these apply to you because they require explicit documentation with the IRS to stay compliant:
- Units of production depreciation is where you would estimate the useful life of equipment by the amount of product it can produce instead of the number of years. You have to justify the decision to the IRS, and it’s usually reserved for equipment that is rarely used. This could be a special kind of timber saw that degrades with each 1,000 cuts it makes.
- The income-forecast method is used for intangible assets in the list below. Since each asset is unique, talk to your tax professional about how to forecast income over the next 10 years and apply it to depreciation:
- Motion picture films or videotapes
- Sound recordings
- Copyrights
- Books
- Patents
- Sum-of-the-Years’ Digits depreciation is not allowed by the IRS for tax reasons and is used by companies that must report separate financial statements using Generally Accepted Accounting Principles (GAAP) in addition to their tax filings with the IRS.
The right depreciation method for your small business depends on your objectives, which assets you purchased this year, and your financial situation. 100% bonus depreciation will be best for most companies’ capital expenditures when they want the biggest deduction for the most cash flow and tax savings. Other companies will prefer straight line under MACRS when the goal is to keep depreciation expenses low and keep profits high. Talk with your tax professional about the right combination of methods based on all the assets you purchased this year and what your long-term tax strategy is.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
