However, there are some straightforward, low-risk ideas for certain businesses that can increase tax deductions thereby decreasing tax liabilities. Business owners may find an investment in a tax cost segregation study study to be valuable if they own or are about to acquire a building or other equipment.
A tax cost segregation study is a detailed examination of the actual itemized costs that make up an asset. These individual costs are then segregated into different categories, based on a large body of tax law and statutes, to create a list of assets.
This study examines the rules of capital recovery for both financial statements and federal income tax to be organized in a way that generates a larger tax depreciation deduction in the first few years of the asset’s life.
Learning the rules
The rules under the Generally Accepted Accounting Principles (GAAP) ordinarily provide that costs associated with the acquisition of capital assets should be recovered through a depreciation expense over the useful life of the asset.
In other words, if you acquire a building (or a piece of equipment), the business should have an annual depreciation expense relating to the cost of that building divided by the expected useful life of the building.
Let’s use an example of a small manufacturing building that is acquired for $1 million with an expected useful life of 50 years. In this example, the business would have an annual depreciation expense of $20,000 ($1 million divided by 50 years, using a straight-line method of accounting).
Congress has generated its own complicated rules on the ability of business owners to take similar depreciation deductions against their income for assets. These rules are parallel to GAAP rules, in that they do not affect one another.
Under the IRS’s rules, taxpayers are allowed a depreciation deduction under a statutory schedule that spells out the life of the asset. In addition, the IRS generally accepts a more accelerated method of accounting for equipment (as opposed to buildings) that front-loads the depreciation deductions in the earlier years. This is in recognition that most of an asset’s value depreciates in the earlier years of its life.
Again using our example above, a taxpayer would be entitled to a depreciation expense of $24,610 (using a 39-year life, straight-line method as explained in the Internal Revenue Code and appropriate regulations.)
The difference between GAAP and tax depreciation is then $4,610 in the first year ($24,610 minus $20,000). This is known as a temporary (or timing) book-tax difference and over the course of the asset will reverse out. In other words, at the end of the asset’s useful life the deductions for tax purposes will be the same as the expenses for GAAP purposes.
About the study
A cost segregation study is a detailed examination of the actual itemized costs that make up an asset. These individual costs are then segregated into different categories, based on a large body of tax law and statutes, to create a list of assets.
This is highly recommended for three reasons. First, most often when an asset, such as the above building example, is acquired it is treated as one asset for GAAP and tax purposes, when in closer examination it consists of several smaller assets working in concert.
Secondly, the tax code provides various incentives (such as accelerated depreciation, and for certain years, “bonus” depreciation) for equipment-type assets to be depreciated more quickly than under GAAP standards. This means higher depreciation deductions in the early years of an asset’s life and lower taxes in those years. (The later years of an asset’s life will of course have smaller deductions, but the time value of money theory clearly demonstrates that having lower tax liabilities upfront is worthwhile.)
The third reason is tax court cases have provided examples of costs that could be considered part of a building for GAAP purposes, but are actually treated as equipment for tax purposes. For example, parts of the electrical distribution network (or any other type of utility) in our manufacturing building example that are dedicated to specific pieces of equipment or manufacturing processes could be considered equipment. These costs would then be considered equipment for tax purposes and still part of the building for GAAP purposes.
The true value of a cost segregation study is realized in this final stated reason. With these types of segregated assets, the costs would be recovered through tax depreciation deductions more quickly as equipment than as part of a building. Also, it would not mean a higher depreciation expense on your internal GAAP income statement, since these assets would continue to be classified as part of the building.
This different treatment of assets for the two different types of financial books is permitted by the relevant authorities, but the rules surrounding what fits within each definition can be quite complex. Qualified professionals in areas such as accounting, engineering and tax law are often needed to conduct these studies.
The effort to find these professionals is well worth it. As in our example, it is common for 20 percent or more of the cost of that manufacturing building to be considered equipment for tax purposes. With those results, that would mean that the portion considered equipment for tax purposes would receive a $40,000 deduction compared to a $4,922 deduction. The bigger tax deduction in the first year of $35,078 would mean less tax liability and more money in the business owner’s pocket.