Category: Tax

June 24, 2024 | by Atherton & Associates, LLP

Nearly every business asset, from machinery to office equipment, inevitably faces obsolescence. Technology advances, operational needs change, and items wear out, requiring continual investments in the very items necessary to run your business. Fortunately, the tax code recognizes this economic reality, offering tax breaks for depreciation. 

But there’s more than one way to account for depreciation, and understanding how to leverage various depreciation methods can maximize your tax savings – transforming a simple accounting practice into a strategic advantage. 

Depreciation basics

Put simply, depreciation is a way for businesses to account for the loss of value that occurs over time with capital assets. As long as the expense helps your business make money and you will use it for a year or more, you can likely depreciate it. But there are rules about what is depreciable. For example, inventory, land, and assets held for investment can’t be depreciated. 

Certain assets, due to their short useful life or low cost, are directly expensed rather than depreciated. If the asset doesn’t deteriorate over time, like land, or is relatively liquid, like inventory, it’s not depreciable. 

The Modified Accelerated Cost Recovery System (MACRS) is the default method of depreciation for most assets under the tax code. It accelerates depreciation, providing larger deductions in the earlier years of an asset’s lifespan. However, businesses have the flexibility to choose other methods to maximize their tax savings. 

Accounting for depreciation

There are several ways to deduct depreciable assets, each with its own rules and benefits. However, once a depreciation method is applied, you are generally required to stick with that method for the duration of the asset’s life. 

The Section 179 deduction enables businesses to expense the cost of qualifying assets immediately, but there are limitations. Likewise, bonus depreciation allows businesses to deduct most of the cost of an asset in the first year, according to a set percentage. And, there are other less commonly used methods to calculate depreciation based on different formulas.

Section 179 deduction

The Section 179 deduction isn’t really a method of calculating depreciation. Rather, it allows businesses to immediately expense up to $1.22 million of the purchase price of qualifying assets (as of 2024). Qualifying property includes tangible assets such as computer software, equipment, and machinery. Certain improvements to non-residential real estate, such as roofs, HVAC, security, and fire protection systems, also qualify. However, it generally cannot be taken on rental properties.

Vehicles used more than 50% for business purposes are eligible for the Section 179 deduction, but the deduction amount can vary significantly based on the type and usage of the vehicle. For instance, the deduction for vehicles weighing less than 6,000 lbs. is capped at $19,200, and vehicles weighing 6,000-14,000 lbs. are capped at $30,500. Heavy vehicles above 14,000 lbs. can potentially qualify for the full deduction amount up to the $1.22 million limit. 

The deduction begins to phase out dollar-for-dollar once total asset purchases exceed $3.05 million. If, for instance, you placed $3.10 million of assets in service this year, the deductible amount would be reduced by $50,000, so you could only deduct $1.17 million instead of the full $1.22 million. 

Additionally, Section 179 cannot be used to create or increase a net operating loss. This means the deduction is limited to the amount of taxable income, and losses can’t be carried forward to future tax years. 

Bonus depreciation

Bonus depreciation is another way to write off the majority of an asset’s cost upfront. In 2024, businesses can deduct 60% of the cost of qualifying assets without any upper limits. However, bonus depreciation is phasing out by 20% annually and will phase out entirely by the end of 2026 unless new legislation extends it. 

Unlike Section 179, bonus depreciation can be used to create a net operating loss and can also be carried forward. Better yet, businesses can use Section 179 and bonus depreciation in the same year.  On each individual asset, Section 179 must be applied first to expense all or a portion of the cost basis, before applying bonus depreciation to the balance. If the business is operating near a loss, Section 179 can only be used to reduce taxable income to zero. Any remaining cost can then be addressed with bonus depreciation, potentially creating a loss that offers tax savings in future years. 

For example, consider a business that purchases $500,000 in qualifying property but only has $100,000 in taxable income for the year. Using Section 179, the business can immediately expense $100,000, reducing its taxable income to zero. Bonus depreciation can be applied to the remaining $400,000 resulting in a loss that can be carried forward to offset taxable income in the future. 

However, these deductions must be used judiciously to avoid “double-dipping” or claiming more than one type of depreciation for the same dollar spent on an asset. 

Other depreciation methods

While Section 179 and bonus depreciation are popular for their ability to offer substantial tax cuts upfront, several other methods are available that calculate the rate of depreciation differently. These methods generally offer varying rates of acceleration, differing primarily in the timing and size of the deductions. Straight-line depreciation, however, is distinctive for its simplicity and predictability. 

This method spreads the cost of an asset evenly across its useful life and is the only option available for depreciating intangible assets like patents or copyrights. And, unlike accelerated depreciation methods, it reduces the risk of depreciation recapture. This occurs when an asset is sold for a price higher than its depreciated value, which can result in the IRS “recapturing” some of the accelerated depreciation benefits previously claimed. This recapture is taxed as ordinary income. With the straight-line method, the asset’s book value decreases at a slower, more consistent rate, more closely aligning with its actual market value over time. 

Choosing the best option

The best choice for your business will depend on several factors, including your total investment in depreciable assets, current income, and future income projections. 

Here are a few scenarios to show each strategy in action: 

• Section 179. A business purchases $500,000 in new machinery. Profits are substantial and stable. Section 179 will allow the business to expense the entire amount in the first year, providing immediate tax relief that can be reinvested into the business quickly. 

• Bonus depreciation. A startup in its early stages expects to ramp up its earnings significantly over the next few years. It invests $2 million in high-tech equipment. Using bonus depreciation enables the startup to deduct 60% (or $1.2 million) of the investment immediately, even if it creates a loss. That loss can be carried forward to offset taxable income in future profitable years. The remaining 40% of the assets’ cost can also be depreciated over time. 

• Straight-line depreciation. A business acquires vehicles, intellectual property, and equipment totaling $100,000. The company enjoys moderate, stable income but has minimal tax liabilities for the current year. They’re also unsure how long they will keep the vehicles before reselling. Straight-line depreciation can be applied to the IP assets and ensures the company benefits from predictable tax relief in the future when tax liabilities may be greater. It also reduces the risk of recapture if the company decides to sell the vehicles within the next few years. 

Best practices

Effective management of depreciation not only impacts your tax obligations but also plays a crucial role in optimizing cash flow. Here are a few best practices applicable across all depreciation methods that can enhance your financial strategy: 

• Time your purchases. If you anticipate tax liabilities as you approach the end of the fiscal year, consider acquiring necessary assets during this period. This approach allows you to claim deductions for the full year, even if the asset was only in service for a short time. 

• Reinvest early savings. Initial savings from accelerated depreciation or Section 179 should be reinvested into the business. This can fuel growth and prepare the business for future periods when tax liabilities may increase. 

• Leverage technology. Consider purchasing or working with professionals who use software to track depreciation schedules. This can ensure accuracy and save time and resources. 

Consult with tax professionals

While seemingly simple, depreciation involves complexities that are best navigated with professional guidance. Our expert advisors can tailor your depreciation strategy to maximize tax benefits based on your specific business needs. 

If you’d like to learn more, please contact our office. We’ll help you turn depreciation into a strategic advantage while staying compliant with evolving regulations. 

June 20, 2024 | by Atherton & Associates, LLP

The Tax Cuts and Jobs Act (TCJA) introduced many changes in late 2017, but many provisions were temporary, with an approaching expiration as early as January 1, 2026. 

The good news is that not everything will change. One of the most significant and lasting changes introduced by the TCJA was the restructuring of the corporate tax rate. Prior to the TCJA, C-corporations faced a graduated tax rate structure with a top rate of 35%. The TCJA implemented a flat 21% tax rate, regardless of the amount of corporate taxable income. Unlike many other provisions of the TCJA, this change is permanent and will not expire at the end of 2025. 

However, businesses will need to prepare for the provisions that are set to change, taking advantage of existing opportunities while they are still available. 

In this article, we’ll briefly explore some of the major changes and provide actionable recommendations to help you prepare financially. 

Qualified business income (QBI) deduction

The TCJA introduced a deduction of up to 20% of qualified business income for owners of passthrough businesses, including partnerships, S corps, and sole proprietorships. In 2026, passthrough business owners will no longer be able to claim this deduction. 

Business owners of affected entities should consider strategies to maximize the use of the QBI deduction before it expires. This may include accelerating income into years where the deduction is still available. Also, speak with a tax advisor about ways to optimize business expenses and deductions in other areas to offset the increased tax burden once the QBI deduction is no longer available. 

Bonus depreciation

Under normal depreciation rules, businesses must deduct the cost of new investments over a period ranging from 3 to 39 years, depending on the asset. However, the TCJA allowed for an additional first-year depreciation deduction, known as bonus depreciation. Between 2017 and 2023, businesses could take a 100% first-year deduction on qualified property. This change could also be applied to used property, which was a departure from previous rules. 

This provision started phasing out in 2023, and currently, businesses can only take a 60% first-year depreciation deduction. In 2025, this will drop to 40%, and in 2026, the deduction will drop to 20%. After 2027, normal depreciation rules will apply.

To maximize tax benefits, plan significant purchases of qualified property to take advantage of the higher bonus depreciation rates before they phase out.

Opportunity zones

Opportunity zones were created under the TCJA to spur economic development and job creation in distressed communities by offering tax incentives to investors. Capital gains from investments in these zones can be deferred and excluded from income if specific requirements are met. 

The ability to defer capital gains by investing in opportunity zones will expire after December 31, 2026. After this date, there will be no tax benefits available for new investments in opportunity zones.

Work with a tax advisor to understand the specific requirements and benefits of Opportunity Zone investments and to ensure that any investments made comply with IRS regulations to maximize the tax advantages before they expire.

Employer credit for paid leave

The TCJA introduced a business tax credit for wages paid to employees on family and medical leave. Employers can currently claim a credit of up to 25% of wages paid for up to 12 weeks of leave, provided the leave is not mandated by law. This credit encourages employers to offer paid leave benefits beyond what is legally required.

Starting in 2026, this tax credit will no longer be available. 

Continue to take advantage of this credit while it is available, but consider how the loss of this credit will impact your business in the future. You may need to plan adjustments to manage these costs more effectively. Talk to a tax advisor about other tax-advantaged strategies to support employee well-being once this credit expires. 

Fringe benefits exclusions

Not all of the impending changes are bad news for employers. Under the TCJA, employer-provided reimbursements for bicycle commuting and moving expenses are included in taxable income for employees (with the exception of moving expenses for the Armed Forces). 

Beginning in 2026, the TCJA’s restrictions will expire, and these fringe benefits will once again be excluded from taxable income. Specifically, up to $20 per month for bicycle commuting expenses and all qualified moving expenses will not be subject to income or payroll taxes. 

In the future, you may consider enhancing your employee benefits package by providing some of these fringe benefits. This may even help offset some of the losses experienced from other changes. 

Limit on losses for noncorporate taxpayers

Under the TCJA, noncorporate taxpayers, such as sole proprietors, partnerships, and S crops, can generally deduct business losses from their taxable income. However, there is an annual limit on the amount of loss that can be deducted: $610,000 for married taxpayers and $305,000 for other taxpayers. 

Starting in 2029, the limits on the deduction for business losses will be relaxed, enabling noncorporate taxpayers to offset more income. 

Preparing for the post-TCJA landscape

As we approach the sunset of the TCJA, it’s crucial to consider how the upcoming changes might affect your tax planning and business strategies.

This article provides a brief overview of some of the key changes and potential benefits that businesses will encounter. However, it does not cover every possible recommendation or strategy. 

For more detailed and personalized guidance tailored to your specific situation, please contact one of our expert advisors.

May 20, 2024 | by RSM US LLP

Executive summary: Introduction to CODI

Cancellation of Debt Income (“CODI”) can have significant tax implications for various entities, depending on their classification for federal income tax purposes, as well as their solvency and bankruptcy status. Understanding the tax treatment of CODI for partnerships, S corporations, and C corporations is vital for taxpayers to make well-informed decisions and optimize their tax positions. With analysis and illustrative examples, this article provides an introductory guide for navigating CODI in different entity structures.

General cancellation of debt provisions

CODI is a fundamental concept in federal tax law, wherein debtors recognize income when they settle their outstanding debt obligations for an amount less than the adjusted issue price (“AIP”). This principle was formally established in the landmark case Kirby Lumber¹ and later codified in section 61(a)(11)² by including CODI as a part of a taxpayer’s gross income. For instance, if a debtor owes $100 of debt but settles it for $60, the debtor generally recognizes $40 of CODI as taxable income.

Certain exclusions are provided, which allow CODI to be excluded from taxable income to the extent a debtor is insolvent.³ The amount excluded by reason of the insolvency exception cannot exceed the amount by which the taxpayer is insolvent immediately prior to the discharge.⁴

Another prominent exclusion is the bankruptcy exclusion, in which CODI is excluded if the discharge occurs in a “title 11 case.”⁵ The term “title 11 case” means a case under the Bankruptcy Code⁶ [1] if the taxpayer is under the jurisdiction of the court; and the discharge of indebtedness is granted by the court or pursuant to a plan approved by the court.⁷ Where a debt cancellation occurs during the bankruptcy process, but not pursuant to a plan approved/granted by the court, the bankruptcy exclusion does not apply.⁸ If the debt discharge occurs pursuant to a plan approved by the court, the level of insolvency of the debtor is irrelevant to the amount of the exclusion. In other words, the burden of proof is on the taxpayer to establish the amount of insolvency outside of a title 11 bankruptcy case.⁹ One benefit of a title 11 bankruptcy filing is the absence of the requirement for the taxpayer to establish the amount of insolvency.

Generally, where an exclusion (i.e., bankruptcy or insolvency) applies, tax attribute reduction is required under section 108(b), which provides mechanical ordering rules.¹⁰

Additionally, as a way to prevent debtors from avoiding CODI by transferring their indebtedness to related parties, the Code treats the acquisition of outstanding debt by a related person as if the debtor had acquired the debt.¹¹ This means that if a party related to the debtor acquires the debtor’s debt at a discount, the debtor is deemed to have realized CODI.

Partnerships

When a partnership’s debt is forgiven, the consequences are shaped by the interplay of general discharge of indebtedness principles and the rules governing allocation of partnership income and liabilities. For federal income tax purposes, partnerships pass through items of income, gain, deduction, loss, and credit to individual partners. Consequently, when income arises from the discharge of partnership indebtedness, such income is determined at the partnership level, and each partner is responsible for reporting their distributive share of the income on their own income tax returns. Such income is allocated in accordance with the partnership agreement and reflected on Schedules K-1 issued by the partnership to its partners.

The insolvency and bankruptcy exclusions are applied at the partner level and each partner’s individual situation determines eligibility to exclude CODI.¹³ As such, even in situations where the partnership itself is insolvent, the insolvency exclusion is unavailable to a partner to the extent that the partner is solvent. Likewise, a partner will generally only qualify for the bankruptcy exclusion if they are a party to the bankruptcy (or join in a bankruptcy filing with the partnership).¹⁴

This allocation of CODI impacts each partner’s basis in the partnership interest, effectively increasing it by the amount of their share of income.¹⁵ However, this increase in basis is generally, accompanied by an offsetting reduction due to the partnership tax rules treating a decrease in a partner’s share of partnership liabilities as a distribution of money.¹⁶ As a result, partners must include in their income their pro rata share of the discharged debt without enjoying a net basis increase that usually accompanies other types of partnership income.

As mentioned above, to the extent there is CODI excluded there are attribute reduction ordering rules that apply. In the case of partnerships, attribute reduction applies at the partner level based on the amount of excluded CODI and based on the partner’s tax attributes.

As mentioned above, to the extent there is CODI excluded there are attribute reduction ordering rules that apply. In the case of partnerships, attribute reduction applies at the partner level based on the amount of excluded CODI and based on the partner’s tax attributes.

S corporations

While S corporations are similar to partnerships in their flow-through nature, for purposes of CODI, the insolvency and bankruptcy exclusions are applied at the corporate level as opposed to the shareholder level. ¹⁷ Just as a partner in a partnership is entitled to deduct their share of the partnership’s losses, so too is the shareholder of an S corporation entitled to deduct their share of the corporate losses.¹⁸ In the S corporation context, losses are taken into account by the shareholder, but are generally limited to the shareholder’s basis in the stock or debt of the corporation. As such, a shareholder may have losses allocated in excess of basis which are suspended.¹⁹

Shareholders must carry forward their suspended losses, and since there is no carryover at the S corporation level, a special rule treats these suspended losses of the shareholder as deemed NOLs of the corporation for that tax year.²⁰ As a result, the suspended losses are subject to reduction when CODI is excluded from income under the insolvency or bankruptcy exclusions.²¹

CODI that is taxable to the S corporation, increases the shareholders tax basis ²², and also increases the S corporation’s accumulated adjustments account (“AAA”)²³. However, to the extent that CODI is excluded from the S corporation’s income because of its bankruptcy status or insolvency, the shareholders do not increase their basis for the excluded CODI.²⁴

C corporations

C corporations recognize CODI at the corporate level, and is included in gross income, subject to specific exceptions. As mentioned above, Section 108(a) outlines circumstances under which CODI is excluded from a C corporation’s gross income and generally include discharge in a Title 11 bankruptcy and discharge when the corporation is insolvent.²⁵ Again, while Section 108 allows for the exclusion of CODI, it generally comes at a cost by way of tax attribute reduction.²⁶

The ordering rules generally provide reduction in the following order:

1. Net Operating Losses (“NOL”)
2. General Business Credits
3. Minimum Tax Credits
4. Capital Loss Carryovers
5. Basis Reduction
6. Passive Activity Loss and Credit Carryovers
7. Foreign Tax Credit Carryovers

To the extent that any CODI remains after the attribute reduction is applied, it is essentially erased, something that practitioners have come to refer as “Black-hole Cancellation of Debt (COD) ”. By reducing tax attributes, to the extent they exist, the debtor is provided with a fresh start, but also facilitates an equitable tax deferral, rather than a permanent tax difference.

Additionally, the attribute reduction, described above, occurs after determination of the debtor’s tax liability for the year of the debt discharge.²⁷ This ordering rule can significantly impact a debtor corporation’s tax liability, particularly in instances of liquidating bankruptcies. When it is clear that a corporation will not become profitable even after its outstanding debt is reduced, the purpose of the bankruptcy process is then to ensure the orderly liquidation and distribution of the debtor’s assets to its creditors.²⁸ A liquidating bankruptcy process often involve taxable sales of debtor assets under section 363 of the Bankruptcy Code, and also potential CODI.

Here Debtor Corp. will recognize a $10x gain on the sale of the assets, and likely recognizes $90x of CODI. The CODI would likely be excluded under section 108(a) and will reduce the $10x NOLs after the determination of the tax for the year of the discharge.²⁹ As such the ordering rule will allow Debtor Corp. to use its NOLs to offset the gain on the sale, prior to the attribute reduction. Thus, when the attribute reduction is made, there are no attributes left to reduce and the entire $90x of CODI is Black-hole COD.

Consolidated Group Setting³⁰

If a debtor corporation, that is a member of a consolidated group, recognizes CODI and excludes it from income under section 108(a), there are special rules regarding attribute reduction.³¹ The consolidated group’s tax attributes are generally subject to reduction, after reduction of the debtor’s own tax attributes, following a mechanical ordering rule. Additionally, in the consolidated context, there is a “tier-down” attribute reduction mechanism that applies to reduce the tax attributes of a lower-tier member in certain circumstances.³²

For U.S. federal tax purposes, the exclusion of CODI under section 108(a) (i.e., bankruptcy, insolvency, etc.) does not apply to cancellation transactions between members of a consolidated group involving intercompany debt.³³

The ultimate impact of debt workouts for a consolidated group are complex, and often can have odd results depending upon which a consolidated group member is the true debtor. Careful consultation and modeling from knowledgeable tax advisors is always recommended in these contexts.

Conclusion

The tax consequences of CODI are highly dependent on the entity’s classification, solvency, and bankruptcy status. Successfully navigating the complexities of CODI requires a thorough understanding of the tax implications specific to each entity type and the equity owners. Consulting with experienced tax advisors and legal professionals is critical in handling CODI and related tax matters effectively.

[1] Kirby Lumber v. United States, 284 U.S. 1 (1931).

[2] All section references are to the Internal Revenue Code of 1986 (the “Code”), as amended, or to underlying regulations.

[3] Section 108(a)(1)(B).

[4] Section 108(a)(3).

[5] Section 108(a)(1)(A).

[6] Title 11 U.S.C.

[7] Section 108(d)(2).

[8] For example, if during the bankruptcy proceedings, the debtor and creditor independently agree to a modification of the debt, or the debtor buys back its debt for stock at a discount, all without the court’s approval.

[9] Note that a Chapter 7 (liquidating) or Chapter 11 (reorganizing bankruptcy) are two examples of title 11 bankruptcies.

[10] The mechanics of the attribute reduction resulting from excluded CODI is beyond the scope of this article.

[11] Section 108(e)(4);. Reg. section 1.108-2.

[12] Timing of the acquisition of the debt when compared to the timing of becoming related is also relevant, for example:  Reg. section 1.108-2(c)(3) “a holder of indebtedness is treated as having acquired the indebtedness in anticipation of becoming related to the debtor if the holder acquired the indebtedness less than 6 months before the date the holder becomes related to the debtor.”

[13] Section 108(d)(6).

[14] Reg. section. 1.108-9(b); Note: There are Tax Court cases wherein a partner was permitted to exclude CODI, where the partnership was in bankruptcy, but the partner was not in their individual capacity, however the IRS has come out against these decisions in nonacquiescence in A.O.D. 2015-001. See e.g., Estate of Martinez v. Commissioner, T.C. Memo. 2004-150; Gracia v. Commissioner, T.C. Memo. 2004-147; Mirarchi v. Commissioner, T.C. Memo. 2004-148; and Price v. Commissioner, T.C. Memo. 2004-149 (essentially identical opinions for three partners in the partnership).

[15] Section 705.

[16] See Sections 752(b) and 733. Note however, that depending on the nature of the debt discharged, the basis decrease may differ from the increase pursuant to Section 705.

[17] Section 108(d)(7)(A).

[18] Section 1366(a)(1).

[19] Section 1366(d)(1); (d)(2).

[20] Section 108(d)(7)(B).

[21] Reg. section 1.108-7(d).

[22] Section 1367(a)(1)(A).

[23] Section 1368(e).

[24] Section 108(d)(7)(A).

[25] Note: also includes discharge of qualified farm indebtedness

[26] Section 108(b).

[27] Section 108(b)(4)(A).

[28] This process has various tax consequences, but for purposes of this article the discussion is limited to CODI.

[29] Section 108(b)(4)(A).

[30] A detailed discussion of the consolidated return rules regarding CODI is beyond the scope of this limited discussion.

[31] Reg. section. 1.1502-28.

[32] Reg. section. 1.1502-28(b).

[33] Reg. section. 1.1502-13(g)(4)(i)(C).