With year-end approaching, we will soon be turning our attention to holiday celebrations and festivities; Thanksgiving, Christmas, the New Year, and Section 179 Deductions!
Suppose you are a small business owner, especially a dentist. In that case, you will be visited by equipment sales professionals, especially at year-end, who tout the incredible tax savings one can accrue by using Section 179. With those two words, “tax deduction,” dentists become easy prey for the dental equipment sales rep and many times make large capital purchases for their tax benefits alone.
Section 179 is a part of the Internal Revenue Tax Code, which allows small businesses to take an accelerated tax write-off in the year of purchase for equipment that would otherwise be depreciated or expensed over time. Most of the equipment in a dental practice qualifies. Under the right conditions, it can be a great tool to reduce your tax liability while improving and upgrading the technology in your practice. Pundits are preaching the benefits of Section 179 as an incentive for Doctors to save on their taxes. Admittedly, there is a time and a place where we would agree; however, there are some Section 179 pitfalls practice owners need to be aware of and consider when making that determination.
Let’s take some time to go down the “rabbit hole” and learn some rules to be aware of when considering Section 179.
Rule 1: Only your Tax Professional knows best.
Section 179 has so many nuances that you need to consult with your Tax Professional before pulling the trigger on this. Projections and planning for your current year as well as future years are critical. Many times it is in the future years where the potential problems with Section 179 become apparent. Only your Accountant knows for sure if electing the Section 179 Deduction is beneficial to you.
Rule 2: Your sales rep is NOT your Tax Professional.
In all the excitement of the year-end sales frenzy, your equipment sales rep will most likely illustrate the maximum one-year “tax savings” for you with a quick spreadsheet calculation. I wish this were that easy, but it’s not. As my Accountant likes to tell me repeatedly, “It depends, David!”
“It depends, David.”
Maurice, my Accountant
Buyer beware; this calculation is an estimate only and should have the disclaimer, “for illustrative purposes only!”
Without a comprehensive understanding of the doctor’s financial situation and tax bracket, an equipment sales rep does not have sufficient information to determine the amount of money a doctor will save. You, as the doctor, must consult with your tax advisor before making a large purchase.
“Knowing the name of something doesn’t mean you understand it.”
Rule 3: Knowing the name of something doesn’t mean you understand it.
It seems at year-end, everyone is talking about “Section 179 Write-Off” or “Section 179 Deduction” or even “accelerated depreciation.” So, just because someone espouses this term does not mean they know or understand it! At this time of year, this is a common question to ask, “Can I use the 179 Write Off?” or “How much more equipment can I buy to save taxes?” So which is it? An expense? A deduction? A Write-off? A depreciation?
How exactly does Section 179 reduce your taxes?
If you don’t know, keep reading.
To understand how Section 179 reduces your taxes, we must appreciate, in basic terms, how your financial statements work and how they are interrelated; the Balance Sheet, the Income Statement or P&L, and the Statement of Cash Flows.
First, Capital Equipment purchases are classified as Assets and appear on your Balance Sheet, avoiding your Income Statement altogether. The Income Statement shows your revenue and all expenses incurred to generate that revenue, not your assets.
Capital Equipment is Expensed in the Income Statement through the process of Depreciation. Depreciation is a complex topic best delegated to your Accountant. As the business owner, you should understand that the Depreciation expense accounts for the loss in economic value, over time, of an asset. This loss is the result of wear and tear, consumption, the effects of time, as well as obsolescence. This Depreciation expense is a NON-Cash expense, as no cash is exchanged here, i.e., no check is written. Think of it as an accounting entry or “adjustment.” Be aware there are several methods Accountants can use to depreciate assets. As a result, it is acceptable to calculate Depreciation for taxes differently from how Depreciation is recorded for accounting purposes.
So, say you purchased that new Cone Beam Scanner for $100,000, and your Accountant recommended a 5-year depreciation schedule to match your 5-year bank loan. Assuming the equipment will be fully depreciated to a book value of zero, your Depreciation would be $20,000 per year. This $20,000 shows up on your Income Statement as a Depreciation Expense, thus reducing your Net Income by $20,000.
Remember, your Net Income is linked to your Balance Sheet through the Retained Earnings section. The Retained Earnings account enables a cash basis corporation to track the balances of all undistributed Net Income. The essential point is that Income is distributed to shareholders (the dentist) from the Retained Earnings account.
Since most dental Corporations are Pass-Through Entities and not subject to taxation, your $100,000 Cone Beam Scanner, depreciated at $20,000 per year, has effectively reduced your Net Income and, ultimately, your Retained Earnings by the same amount. This $20,000 depreciation expense effectively lowers your Retained Earnings by the same $20,000. With a smaller Retained Earnings account balance, Income distributed to the shareholders would be less too. With less Income, taxes would also be less.
There you have it, your Section 179 Deduction works through your financial statements, ultimately potentially lowering your Income and with it your taxes.
Remember, and the critical point here is your mileage may vary, as may your tax savings. Only your Accountant knows for sure if Section 179 is beneficial to you.
Rule 4: You should never be in a hurry to buy equipment!
Section 179 is available to you year-round, not just on the closing days of the year. It is not a time-limited offer valid in December only!
There is no special Tax Magic for Section 179 at year-end. The rush and panic are created because to qualify for the Section 179 Deduction; the equipment must be purchased and put into service by December 31! Ideally, it would be best to carefully plan your major capital expenditures throughout the year, not rushing at the last closing moments of the year to get the equipment installed.
So, please feel free to purchase your needed equipment throughout the year, not just in December, and still take advantage of Section 179 Depreciation while enjoying using your new technology.
Rule 5: You get the maximum deduction with or without Section 179.
It is essential to realize that your Accountant will fully depreciate all Capital Equipment. Section 179 does not allow for any additional depreciation. Section 179 takes all the Depreciation in one year, no more, no less: no special magic or secret sauce.
Rule 6: You Still Have to Pay for the Equipment!
Write off, deduction, expensing all sound wonderful, but none of these verbs reduce the cost of your equipment. You must still pay for it.
After celebrating your massive Section 179 year-end deduction that just saved you taxes, you are left with the reality of paying on your banknote for the next five years or so.
You have now completely lost the depreciation expense and deduction on your income statement in future years since you took all of your Depreciation in the year of purchase by electing Section 179. In future years you now have less cash because you are now paying on your debt service. You now have a higher taxable income and the corresponding tax bill that further reduces your cash without deductions! Many call this Section 179 “tax trap.”
Rule 7: If you fail to plan, you plan to fail.
With all the year-end excitement and frenzy is sounds like a great idea to write everything off, but doing so may not result in all the tax savings claimed. In deciding whether to elect Section 179 or Bonus Depreciation, doctors need to consider expected future earnings. One might want to save some deductions for the future when earnings and taxes could be higher.
As with any tax decision, you cannot look at the current year with blinders on. Before deciding to take the Section179 deduction, it’s vital that you and your Accountant discuss this year’s tax implications and the impact it will have on future years. Ask your Accountant if the refund I get this year is at the expense of next year. Don’t fall for the Section 179 Tax Trap!
Rule 8: Never buy a tax deduction.
Maximizing and growing your Income is the key to growing your wealth and becoming financially independent. Minimizing taxes at all costs is not a wealth creation strategy. Spending your cash to buy a business tax deduction is not a financially sound plan. Your deduction reduces your taxable Income by the amount of your expense, just like if you were buying something on sale. If your marginal tax rate is 35%, you get everything the practice buys at 35% off. The kicker is, and many forget, you still have to pay for the 65%.
Said another way, would you spend $1000 to save $350? Understand that simple question along with the answer, and you are well on your way to creating wealth.
Remember, Section 179 only accelerates Depreciation; it does not allow any additional write-offs, deductions, or Depreciation.
And finally, never buy a tax deduction. If you need the equipment to provide better care to your patients, then, by all means, purchase it, but buying it solely for its tax deduction is a wealth-destroying strategy.
David Darab DDS MBA