About eight months have passed since we visited Vernon in our last blog post. Right now, it's June, and Vernon is sitting at his desk, rubbing his forehead. He's just been reviewing his bank account. Even though he deducted $75,000 in vehicle and equipment purchases, his bank account was lower than he thought it would be.
"How is this possible?" He asks himself. "I made a ton of purchases over the last year, which lowered my tax bill. How is my bank account still lower than it was last year with the higher tax bill?"
A New Truck, a "Smart" Tax Move
We defined the concept of depreciation in our blog post "Most HVAC Owners are Planning Taxes Backwards", so I'll refer you to the blog post for a more in-depth explanation of the concept. I'll also briefly define it in the next section. But the idea of depreciation can be exciting for business owners, because it means they get to deduct more of the purchase from their tax bill.
However, a new truck feels like a smart tax move. Sometimes it is. Sometimes it isn't. If the truck, or any asset, is purchased with a loan, then the immediate tax benefits are oftentimes overshadowed by the ongoing cash drain. In reality, a $75,000 financed purchase may save more than $11,000 in taxes, but require an additional $1,500 a month in payments and interest. Those monthly payments mean that the tax savings will negatively impact the owners cash position by $18,000 for every year that the truck is owned. If purchasing the truck is part of the company's growth strategy, then securing the additional $11,000 in tax savings is a great strategic move. But if the truck was only purchased for the tax savings, then the long-term effects could put the business in a worse financial position.
Depreciation, Plainly: What the Deduction Actually Does
Depreciation is the lifespan given to a vehicle or piece of equipment. Tax law dictates the lifespan of various assets for income tax purposes, even if the asset is likely to last longer. Trucks are typically depreciated over 5 years for tax purposes. During said lifespan, the original cost is divided amongst each year of the lifespan so a business owner like Vernon can deduct a portion of the purchase from his taxes during that lifespan. Under Section 179 or bonus depreciation, however, Vernon can claim an entire vehicle purchase the first year as long as the vehicle is in use.
According to Chris in the video "Tax Terms You Need to Know - Deduction vs Credit", tax deductions lower the amount of income a business owner is taxed on. Business owners like Vernon can deduct expenses like equipment and vehicles from their income. In our last blog post we said that Vernon made $500,000 in profits. If Vernon deducts $15,000, then he's only taxed on the remaining $485,000. A deduction doesn't give Vernon free money; it simply lowers the amount of income he's taxed on.
When Tax Strategy Is Hiding a Bigger Problem
As we talked about in our blog post mentioned above, the timing of buying vehicles and other materials can be the differentiating factor of when and how your taxes are impacted. Vernon pulls out receipts for equipment purchases from the previous year, and reviews them along with his tax bill for that year. He realizes that all his purchases were made solely for tax reasons, not for job reasons.
He also realizes that he was using these tax deductions to mask his company's cashflow issues. If you're spending $50,000 on a vehicle to save on taxes, you're still ending up with less cash in your pocket than if you hadn't bought the truck at all. It's not "free" money, since the cost of the truck just lowers your taxable income, which is the number used to calculate your tax. The tax savings will always be less than the cost of the purchase. If there isn't a true need for a new vehicle right now, push the purchase out until the first quarter of next year, when things get slower. Then you'll actually be able to utilize the vehicle for the busy season.
Treating Taxes as Part of the System, Not an Afterthought
Vernon pulls out a pen to write down some questions to bring up to his accountant at their next meeting in October. He also schedules some time to go through all the vehicles and equipment currently in use to see if anything needs to be replaced or upgraded.
Call to Action
Pull the most recent equipment purchase. Was it made for tax reasons, job reasons, or both?
If you need additional assistance, book a complimentary consultation with Joseph.
Disclaimer: The information in this post is intended for general guidance purposes. For advice specific to your business finances or taxes, consult a licensed accountant or financial advisor.
