If an equipment sale puts you in a taxable position, a replacement purchase may be just the ticket to get you out.
Another complicated tax bill comes our way, which should be used to stimulate equipment sales, as well as manage 2010-2011 tax positions. By the time you read this, the benefits related to 2010 may be restricted because of a lack of equipment availability. However, the 2011 benefits will be available for all of next year.
As mentioned in prior articles, many contractors have income tax risk to contend with that can be mitigated by the extension of the bonus depreciation or use of the Section 179 write-offs. This income tax risk results from the accelerated use of depreciation deductions or Section 179 write-offs prior to 2010, either to reduce taxable gains or to generate taxable losses that were carried back to recover taxes paid in prior years.
This process of deferring taxes can be carried on as long as depreciable assets are purchased annually. Slow down or stop making purchases and you soon wind up with tax gains larger than book gains. When that happens, you can guess the result -- a tax bill, even though in some cases your books show a loss.
TAX RISK EXPLAINED
Let's assume you purchased a $100,000 piece of new equipment that is considered a "business asset" which is depreciable. For book purposes, this asset will be depreciated over five to 10 years and sold at some point during that period. Following this example, the book depreciation may be $10,000 per year and, after three years, the book balance is $70,000.
For tax purposes, this unit could have a tax basis from $0 to $70,000. If the remaining tax basis is $0, this means you have depreciated the unit for book purposes for a total of $30,000, but have written off 100% of the $100,000 for tax purposes, leaving $0 available for future tax benefits. So what happens if you sell the unit?
Let's say you sell the unit for $80,000 at the end of three years. For book purposes, you generate a sale of $80,000 and a $10,000 gross profit on the sale. For tax purposes, you have a tax sales price of $80,000 and a tax gain (at ordinary rates). An $80,000 gain at ordinary rates, plus a bank loan payable somewhere in the range of $50,000 equates to a $10,000 book gain, a potential tax liability of $25,000 and a note balance due of $50,000 ($80,000 - $50,000 - $25,000 = $5,000 of cash flow).
Under normal circumstances, you could avoid these consequences by buying additional business assets to use the tax attributes of MACRS Depreciation, the bonus depreciation or Section 179 write-offs to offset the $80,000 gain referred to above. But this is not a normal year. It is a year where dealers and business owners are selling off equipment to generate cash flow and have zero plans to purchase replacement units. It is also a year where units are being sold with zero tax bases, making the total sales price taxable. So selling off the fleet without replacements results in an unexpected tax bill and an estimated tax bill falling in the next 12 months.
NEW TAX BILL OFFERS OPTIONS
The new tax bill reinstates MACRS, along with the higher limits of $500,000 for Section 179. This gives you the option of replacing a unit to offset taxable gains where the gains create taxable income even if the books show a loss for the year. Thus, it's worth reviewing your choice to pay taxes or replace a unit for the same amount of money.
My belief is that many contractors have a tax risk to deal with and probably don't know it, and don't have the cash to pay the bill. So it's very important to prepare tax projections for 2010 and 2011 to assess what your risk may be, and then assess if a purchase of depreciable assets makes sense.
All indications are that rental will become the major purchase alternative for contractors in the near future and could, in some way, aggravate the tax risk discussed above. On the other hand, additions to equipment fleets in the remainder of 2010 could reduce the bulk of any unexpected taxes related to the 2010 year-end.
Contractors should use this approach to assess their own situation to determine if they have a tax liability for 2010. If you do have such risk, a replacement purchase before the end of the year may be just what the doctor ordered. The new Section 179 limits offer a similar result for 2011.
While these opportunities offer up seemingly simple solutions, they are not as simple as they seem. Consequently, you should check with your tax professional before making any commitments.
Garry Bartecki is the managing member of GB Financial Services LLP and VP Finance for the Associated Equipment Distributors. He can be reached at (708) 347-9109 or firstname.lastname@example.org.