Amortization and Depreciation and Your Small Business
Posted on 04/20/2017 at 12:00 AM by Shannon Hoyle
Written by Dan Burden, AgMRC Program Specialist.
Are you sure that you are doing everything that you can do to maximize your profit margin, reflect your investment in your company and community infrastructure while still paying your fair share to the government? Amortization and depreciation are ways to do this.
This can be a complex area, especially as it pertains to complex businesses, for example, those that co-mingle various types of intangible intellectual property. This article is a simple guide to introduce you to the tax world as it pertains to small-business management. It is common sense that most taxpayers and all business owners should regularly consult with a well-recommended certified accountant or tax professional to determine their deduction eligibility, as well as how depreciation, amortization and similar issues impact your overall objectives and performance goals. This is another area of sound business planning where no one person has all of the answers. Talk to people, do your research and the time that you invest in this subject will benefit you.
All tax deductions are intended to lower an individual or business’s taxable income, thereby beneficially changing the amount paid in federal and state taxes. The government encourages citizens and business ventures to invest in themselves and their communities. To reflect that, deductions are available for all sorts of things in all sorts of areas.
Business purchases affect the company’s tax status and impact the asset wealth and profits of the business. As a general rule of thumb, if a one-time expense occurs within a particular tax year, it is taken as a direct deduction that particular tax year. If the expense crosses several tax years, it should be reflected over those tax years for greatest benefit. Amortizing capital expenses also reflects a more accurate view of the company's financial health and true cost of doing business, something that is quite important with bankers and investors; and spreading the expense over several years makes tax liability more consistent.
Since few assets last forever. An asset's cost can be proportionally “expensed” (prorated) based on the period over which the asset it is used. There are three primary types of incremental deduction. In business accounting these are referred to as depreciation, amortization and depletion. Depletion usually applies resources that cannot be replaced; for example a company owns a natural gas well, as the gas is recovered and sold, the value of the asset (the company) is gradually depleted.
In most of the world, and with most non-accountant-type folks, the terms amortization and depreciation are used interchangeably, not so with the IRS and tax professionals here in the United States. Yet the process of depreciation is “amortizing” some assets over the course of their lives. –Yes, it is can be confusing.
Amortization (prorating an intangible asset’s cost over its “usable” life span) pertains to “intangible assets.” These can include many start-up costs, intellectual property and brand recognition. Amortization and depreciation rates are figured using some period of time and the point at which the asset reaches its “salvage value” where the asset no longer justified and should be scrapped.
Depreciation is prorating a tangible asset’s cost over its life. Tangible assets are physical things like inventory, building and machinery, stocks, bonds and cash. In addition to an accounting convention, the term depreciation also refers to loss of market value. Real estate and currency investments are two examples of assets that can depreciate or lose value. Many regions and countries, for example Asia, Latin America, Greece, Spain, Ireland, Venezuela, Argentina, Russia, Mexico, Germany and others have had wild recent or historic currency devaluations, fluctuations, and extended slumps. During the housing crisis of 2008, homeowner home values plummeted by as much as 50% in the worst hit markets.
It can be confusing since the term amortization often comes to mind when paying off interest-bearing debt with scheduled repayment installments. For example, a home mortgage or car loan. For accounting and tax purposes, the amortization of a “tangible asset” for example a small work tractor would be called depreciation. For accounting purposes, depreciation expense does not represent any kind of cash transaction; it does however, directly reflect “used-up” asset value over time.
With respect to amortization, the IRS has “schedules” that break tangible and intangible assets into categories. These may have slightly different amortization or depreciation rates. Particular schedules will dictate the asset's cost percentage that can be amortized each year. The resulting deductions are reported on IRS reporting Form 4563, Part VI.
Small businesses, in-home offices, and start-ups need to itemized deductions in the manner most beneficial to business profitability. In researching your amortization needs, most modern financial calculators have easily programmable functions that will generate the data you need. Simple tables for a few years can easily be constructed on the back of a napkin with a ball-point pen. For your lap-top computer, tablet or smart phone, there are all sorts of free-ware and low-cost software applications available for either spreadsheet calculations and record keeping, as well as simple quick-reference tables.
References and Additional Resources
Mortization The Internal Revenue Service
A Brief Overview of Depreciation The Internal Revenue Service
Section 179: Using the Tax Code to Your Advantage National Federation of Independent Business
How to Calculate Tax Depreciation Houston Small-Business Chronicle
Tax Tips for Sole Proprietors from Intuit Turbotax
Little-Known Tax Tips For Small Business Owners from Intuit TurboTax
You’ve Been Selected for an IRS Audit. Now What? By Clare Curley
Top Tax Deductions for Your Small Business by Stephen Fishman , J.D.
5 overlooked small-business tax deductions by Steve Nicastro of Nerd Wallet
15 Small-Business Tax Deductions by Karen Price Mueller
The Big List of Business Deductions (excerpt) from Kabbage
Small Business & Self-Employed Tax Center: The Internal Revenue Service
Starting a Business: The Internal Revenue Service