Q:

Hi Kerry,

 

First of all I would like to thank you for the website!  It's very informative and a great read.  But there is something that recently came up that is driving me crazy.  I hope it's ok for me asking.

 

I run a dedicated server business which basically means I purchase rackmount servers and then you can say I rent them out to individuals and companies for a monthly fee.  Now the question is regardiing the Section 179 and the actual server purchase.  What the CPA has done is utilized the maximum Section 179 and then depreciated the rest.  Now this provides a huge problem is many ways.  First of all assuming I purchase the server for $1,000 in will take many months to recoup just the initial cost of the server not including the cost to maintain the server, power cost, etc.  Now what is being proposed is that the excess of the maximum in the Section 179 is now considered "income" - taxable "income".  So now this $1,000 server has become a $1,000 + tax rate server and will take even longer to break even.  What is worse is let's assume the excess is $200,000, now I just spent that $200,000 to acquire the server to which the customer will go on.  How in the world is it expected of me to have the taxable rate for this $200,000?

 

So in essence we have my payroll / dividend which gets passed down to me as a normal s-corp would.  Let's assume it's $100,000 so roughly with state and federal would be $40,000 tax liability.  But now if you pass on the above server purchase above the Section 179 limit then I am supposed to magically find another $80,000 in tax fee??  Taking the above $200,000 which is now "income" at 40% is $80,000.  So we now take the $80K and original $40K income tax which would equal $120K.  Which in the end would mean I have a net of negative $20k!  What in the world is going on here?  I know I am missing something and hoping you can give some insight before I discuss further with CPA.

 

Hope the above makes sense...  Shouldn't the "servers" which I need just like I need the power / space to house them in be considered a "operating expense" and then none of this non-sense would happen?

 

Thanks for your time!

A:

I'm not sure if I'm completely clear on your question.  It seems to be that you are upset at not being able to fully deduct the cost of all of your new equipment in the very first year. 

From a purely cash basis of running a business, that is a valid concern, especially if you pay cash for all of the new items rather than finance them with loans.  That is simply a reality of running a business and something that you are going to have to learn how to deal with.

From the perspective of GAAP (generally accepted accounting principles) as well as tax law, unlimited first year expensing is not how new equipment has ever been treated on the books of businesses.  There is obviously a big difference between the treatment and deductibility of operating supplies that are used up in less than one year, and items that last for several years.  It has always been standard accounting practice to amortize or depreciate the cost of assets that provide service to the business over multiple years over those years as a better matching of expenses with the related revenues.  This has always been the case for all kinds of businesses that buy equipment.  Trucking companies and machine shops have the exact same situation that you have.

If your servers are used over more than one year, you will have to deal with this as a depreciation issue.  If you have a track record of having to replace each of your servers in less than one year, you could possibly justify deducting their purchases as annual operating supplies.  If you try this approach, you need to be very prepared to document the fact that none of your servers last over a year because the large numbers involved will most definitely attract IRS scrutiny.  An experienced tax pro will know how to include the proper documentation with your tax return to prevent an IRS audit on this issue.

In order to encourage business owners to stick their necks out and acquire more equipment, there have been various tax incentives passed by our rulers in DC over the year.  The most lucrative have been the Investment Tax Credit, which gave a rebate of 10% of the purchase price right against the taxes (repealed in the 1986 tax law) and the Section 179 expensing election, which has been raised from its earlier limit of $5,000 per year to the $128,000 we will have for 2008.  The tax savings from the Section 179 deduction are designed to offset the kind of cash flow problem you alluded to in your email.

What you need to do is to work more closely with your professional tax advisor to ensure that you don't put yourself into a cash flow problem.  This may entail financing some of the equipment purchases with loans in order to be able to retain some cash for other expenses, including taxes.  Another strategy may be to stagger your equipment purchases so that you can maximize the annual Section 179 allowance.  Buying too much in one single tax year can very easily cost you much more in taxes than you would have if you spread those purchases out over multiple years.

I hope I addressed your concerns.  If I missed the point, please let me know.

Kerry Kerstetter

Follow-Up:

Kerry,

 

Thank you for the detailed explanation and you hit it on the money.  I simply was not aware that the equipment expense will be considered income when it reaches over a certain amount.  Everything was paid cash so now I have to pay taxes on it, which IMO is extremely unfair.  Simply I have to make purchases smarter and try to get into leases and longer term notes than paying cash.

 

Will be certain to get this in order for 2008 so we don't encounter this problem ;-).  Know that we are utilizing the section 179 to the max.  Will look into the tax credit as you noted.

 

Thanks again!

My Reply:

I'm glad I was able to help.

The Investment Tax Credit for new equipment purchases is no longer available.  It was repealed in 1986.  I was just explaining the history of tax incentives for new equipment purchases.  The Section 179 expensing election was designed as a replacement for the ITC with the same qualifying rules.

Your personal tax advisor can give you much more details for your unique circumstances.

Good luck.

Kerry

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 9/23/2007 11:35:00 AM Send this post: