Businesses operating in multiple states or across international borders should be aware of common issues associated with tracking fixed assets and related depreciation. If these differences are not acknowledged these common issues can result in unexpected tax liabilities.
Section 179 & Bonus Depreciation
The starting point for calculating a company’s state tax liability begins with its federal taxable income. This is then adjusted for a variety of modifications such as state tax expense or depreciation. Depreciation expense is the most common modification encountered when calculating a state’s taxable base by virtually every company doing business on a multi-state basis. These adjustments are specifically caused by the expensing election under Internal Revenue Code Section 179 and bonus depreciation. The adjustment exists because many states do not conform to these federal depreciation laws.
For federal purposes, Section 179 allows for the immediate dollar-for-dollar expensing of qualified property up to $510,000 (2017) subject to a dollar-for-dollar phase out in excess of the limit. The expensing is granted once purchases exceed $2,030,000. This expensing election, which has varied over time, was made permanent through the enactment of the Protect Americans from Tax Hike (PATH) Act in December 2015. Although permanent for federal calculations, several states do not conform to the enacted federal amount. For example, California allows a maximum Section 179 deduction of $25,000. As a result, when computing California taxable income, any amount expensed under Section 179 in excess of $25,000 must be adjusted (added back) in the year the asset is placed in service. The amount also must be depreciated (subtracted out) in future years in order to arrive at the California taxable base.
Similarly, bonus depreciation, which allows for the immediate first year deduction of 50% on eligible property placed in service during a year for federal purposes, is treated differently by some states. As a result, adjustments must be made for states that do not conform to the federal bonus depreciation rules under Section 168(k).
Impacts on Gain/Loss at Disposal – Gain & Recapture
As a result of the adjustments between federal and state tax laws, complications also arise when eligible property is disposed of and, as a result of such modifications, the net tax value of the underlying property differs for state purposes. This difference in net tax value will result in the capital gain (loss) as well as depreciation recapture. For those unfamiliar with the concept of depreciation recapture, it results from the sale of business property at a gain that has been previously depreciated. Since the taxpayer has previously benefited from an ordinary deduction through depreciation, a portion or possibly the entire gain, must be recognized as ordinary income as opposed to capital gain.
Difference in Depreciation of Asset Used Domestically and Internationally
Lastly, it is important to note that property located outside the US must use a different method of cost recovery than property located within the US. Property being used internationally is required to be recovered using the Alternative Depreciation System (ADS). This depreciation method is calculated using the straight-line method while disregarding salvage value, resulting in a slower recovery of the assets cost. This method differs from the how companies depreciate assets within the US, which uses an accelerated recovery method under the General Deprecation System (GDS) and takes less time than the ADS.
Knowledge of the differences in depreciation rules across jurisdictions, both international and multi-state, is the first step to ensuring taxpayers are achieving their maximum tax benefit. If one of the above mentioned adjustments applies to your company, Clayton & McKervey can ensure companies are meeting compliance requirements while simultaneously maximizing tax opportunities.