The Potential Cash Flow Impact of Bonus Depreciation

As CPAs are starting tax returns for their small business owner clients, the question arises, “Should we take the bonus depreciation?” Bonus depreciation is the tax law that allows you to take the full deduction for long-term equipment purchased in the year it was purchased, versus depreciating the cost of that purchase over the life of the equipment.

For example, if you buy a new piece of equipment to run your business, for $10,000, under the standard depreciation rules, you would only get to take a portion of that expense in the year you purchased the equipment. For simplicity, let’s say the equipment has a 5-year life, you would take a $2,000 deduction from your taxable income each year after you’ve purchased the equipment. It would take 5 years to take the full deduction. However, with bonus depreciation, you can take the deduction all in the year that you purchased the equipment.

Bonus depreciation can make a positive impact on your tax bill and can be really beneficial to lining up the deduction for the purchase with the cash used to make that purchase. But, bonus depreciation can also get you into a cash flow pinch if you choose to take bonus depreciation on equipment that you’ve financed.

Here’s how the math maths.

If you buy a $100,000 piece of equipment and finance that equipment for 5 years, you’ll pay approximately $20,000 per year on the loan (plus interest, but keeping the math simple). If you take the full $100,000 deduction from your taxes in year 1, that could give you a boost of $25,000 – $30,000 in cash flow that year. However, in year 2, through 5, you’re going to have $20,000 in cash payments leaving your business, but you won’t be able to deduct that from your income for tax purposes during that year. That $25,000 to $30,000 benefit in year 1, needs to be set aside and saved to cover the taxes that you’re going to owe in years 2 through 5.

I once worked with a client who financed a new piece of equipment at the end of every year. This was how their CPA was helping them to do tax planning. They would purchase a piece of equipment for anywhere between $50,000 and $150,000. They didn’t have the cash, so they would finance the purchase, typically with 5-year terms. The problem I highlighted above? Compounded. Every year they added a new piece of equipment, they added an average of about $20,000 in loan payments, but weren’t able to deduct those payments from their taxable income, because they’d already taken the deduction. At one point they had more than $100,000 in loan payments annually, with no deductibility for tax purposes. They got a huge tax bill that year and they couldn’t figure it out. On paper (the bank statement) they weren’t making any money. But, on the tax return they were.

Time value of money is real. And, it is helpful to get the tax benefit up front. But, if you’re not careful, you’ll have an unwelcome surprise come tax time in the years following the bonus depreciation if you’re not preparing yourself.