Worker and Construction Equipment

If your construction business is equipment intensive and you’re seeing taxable income spiking, you are not alone. The favorable depreciation rules of the past few years are now turning around with some surprisingly unfriendly results.

Is the Onus of Bonus Falling on You?

  • 3/7/2013

by Perry McGowan

If your construction business is equipment intensive and you’re seeing taxable income spiking, you are not alone. The fact is, the favorable depreciation rules of the past few years — the very ones that made tax planning easier in the downturn — are now turning around with some surprisingly unfriendly results.

The biggest culprit of the turnaround is bonus depreciation. Most recently, the tax depreciation rules have allowed 50 percent to 100 percent bonus depreciation since 2008. This peaked with 100 percent bonus in 2010 and 2011. Beginning with capital assets placed in service January 1, 2012 (and extending until at least December 31, 2013), bonus depreciation has fallen back to 50 percent.

Recent Calendar Years Bonus Rate Allowed
2007 0%
2008 50%
2009 50%
2010 (pre-9/9) 50%
2010 (post 9/8) 100%
2011 100%
2012 50%
2013 50%
Source: Congressional Research Service 

That means that a $100 investment in most new equipment in 2011 provided a $100 deduction, but the same investment in 2012 would earn $50 of bonus depreciation plus an amortization of the balance. Under modified accelerated cost recovery system (MACRS) tax depreciation, a taxpayer receives a 20 percent write-off ($10) in the first year for assets with a five-year life, or about 14 percent ($7) for assets with a seven-year life.

Industry Common MACRS Lives
Agriculture 7 years
Asphalt Production 7 years
Concrete Plants 7 years
Construction 5 years
Manufacturing 7 years
Mines/Pits/Quarries 7 years
Wholesale 5 years
Source: IRS Revenue Procedure 87-56

These sizable deductions are useful in controlling taxable income except for one detail: no one knew we would have any bonus depreciation in 2012 until the fiscal cliff legislation passed Congress in the early hours of 2013. While the extended bonus is something of a windfall, it may not be enough, and here is why.

Imagine a business earning $2 million every year that always pays tax at 40 percent. Then imagine the business acquires five-year capital equipment of $3 million annually. A quick look at their GAAP financial statements would show book income of $2 million and tax of $800,000. You can see this as the flat lines on the graph. But reported taxable income is much different. Because the mechanics of bonus and MACRS depreciation dropped a lot of tax depreciation from 2007 – 2009 investments into 2010 and 2011, and because 100 percent bonus depreciation in 2010 – 2011 amplified those deductions, reported taxable income has now been lower than books for several years.

Now that deduction magic is turning around. The graph shows how, with identical continuing capital equipment purchases every year, taxable income will spike in 2012 and is likely to remain higher than book income for several years.

Bonus Depreciation CHART

If bonus depreciation rules do expire as scheduled, there will be another income spike in 2014. If they extend the benefit yet again, they delay that day of reckoning. We don’t yet know the endgame, but we do know that bonus has taken a bite in 2012 and is likely to do so in 2013 as well. Mike Utz, a construction partner and colleague reminded me that with taxable income exceeding book income, tax payments may need to be half or more of book income over the next few years. Contractors, banks, bonding agents and investors should all cautiously watch this sizable cash flow need, since taxes will be a higher percent of book income than you have come to expect.

Taxpayers may be able to time equipment investments in 2013 to bring current tax down somewhat. For example, with 50 percent bonus, the above taxpayer could bring taxable income down into the same ballpark as book income, but this would require more than $1 million in added 2013 capital equipment purchases. That may or may not make sense in the business, but the alternative of paying half of current book income in tax is also hard to swallow.

Business strategies, capital equipment planning, and budgets all need to anticipate this bonus depreciation effect in 2013. Further, taxpayers should anticipate how they can prepare for the time that the bonus fades away in 2014 or later years.

Perry McGowan, Construction Tax Director or 612-376-4632