Understanding Bonus Depreciation for Business Tax Benefits

Bonus depreciation allows businesses to deduct a significant portion of the cost of eligible assets in the year they are placed in service, enhancing cash flow and reducing taxable income.

Eligibility Criteria

To utilize bonus depreciation, businesses must ensure their assets meet specific criteria set by the Internal Revenue Code (IRC). Qualified property includes tangible personal property with a recovery period of 20 years or less, certain computer software, and water utility property. The asset must be new to the taxpayer, meaning it cannot be acquired from a related party or previously used by the taxpayer.

Assets must be acquired and placed in service after September 27, 2017, and before January 1, 2027, under the Tax Cuts and Jobs Act (TCJA). This legislation expanded bonus depreciation, allowing 100% immediate expensing of eligible assets. However, buildings and structural components are excluded. Businesses under specific accounting methods or subject to alternative minimum tax (AMT) considerations may face additional restrictions.

Qualified Property Types

Qualified property includes tangible personal properties such as machinery, equipment, and vehicles. For instance, a manufacturing company acquiring new production machinery can immediately expense a substantial portion of its cost. Certain computer software, including off-the-shelf software available for purchase, lease, or license to the general public, is also eligible.

Qualified improvement property (QIP) refers to improvements made to the interior of nonresidential buildings, such as electrical or plumbing enhancements. The CARES Act correction made QIP eligible for bonus depreciation, enabling accelerated cost recovery for building improvements.

Calculating Bonus Depreciation

To calculate bonus depreciation, businesses determine the cost basis of the asset, which includes the purchase price, sales tax, delivery charges, and installation fees. For example, if machinery is purchased for $100,000 with additional costs of $5,000, the cost basis is $105,000.

Under the TCJA, 100% bonus depreciation is allowed on eligible property, meaning businesses can deduct the full cost in the year it is placed in service. This provision phases down beginning in 2023, decreasing annually until fully phased out by 2027 unless legislative changes occur. Depreciation is based on when the asset is ready for use, not when it was purchased.

Impact on Taxable Income

Bonus depreciation can significantly reduce a business’s taxable income in the year of acquisition, lowering the tax bill and improving cash flow. For example, a company with a taxable income of $500,000 using $200,000 in bonus depreciation could reduce its taxable income to $300,000, resulting in substantial tax savings.

These deductions can also affect financial statements under accounting standards like GAAP. While tax savings appear as lower tax expenses on the income statement, they can impact deferred tax liabilities because accelerated depreciation for tax purposes may differ from book depreciation.

Interaction with Section 179

Bonus depreciation and Section 179 expensing offer flexibility in tax strategies. Section 179 allows businesses to deduct the cost of certain property as expenses, with a maximum deduction limit subject to annual inflation adjustments. Unlike bonus depreciation, Section 179 applies to both new and used property.

A strategic approach involves using Section 179 for assets exceeding bonus depreciation eligibility, such as those with longer useful lives. Section 179 deductions cannot create a net operating loss, so careful planning is needed to optimize both provisions without exceeding allowable limits. When the Section 179 cap is reached, bonus depreciation serves as a complementary mechanism to continue maximizing deductions. For instance, if a business invests $1 million in qualifying assets, using Section 179 up to its limit and applying bonus depreciation to the remainder can significantly reduce taxable income. Diligent record-keeping is necessary to track these deductions across various assets.

Record-Keeping Requirements

Accurate record-keeping is essential for businesses utilizing bonus depreciation to ensure compliance and facilitate audits. The IRS requires detailed records of transactions related to asset acquisitions, including invoices, contracts, and receipts, to substantiate the cost basis and verify eligibility.

Businesses should maintain a fixed asset register with information such as acquisition date, asset description, cost, depreciation method, and date placed in service. This record tracks depreciation over time and reconciles tax and financial reporting. Accounting software can enhance efficiency by automating tracking and reporting.

Proper documentation is also critical for subsequent improvements, modifications, or disposals. For Qualified Improvement Property (QIP), maintaining records of the nature and cost of enhancements ensures accurate application of depreciation methods and rates, maximizing tax benefits while minimizing non-compliance risk.