7 Depreciation Methods to Use for Startup Companies
Startup companies have a variety of depreciation methods that they can use when deducting expenses associated with the use of long-term assets. These methods can be used to greatly diminish the startup’s taxable income in the year the asset was purchased or depreciate the expenses and assets over an extended period of time.
7 Types of Depreciation Methods
There are 7 depreciation methods that startups are likely to use when filing their taxes. These depreciation methods are applied to assets that have a useful life that exceeds 12 months. It focuses on long-term assets because assets with a useful life that is equal to or less than 12 months are deducted as a business expense in the year in which the expense was incurred. However, there is more flexibility when depreciating long-term assets and the method used should be selected based on the company’s long-term tax strategy.
Some useful terms that you need to know before reviewing the 5 depreciation methods are book value, useful life, and salvage value. The definitions of these terms are:
The value of an asset on the company’s books. The value may be the same as the industry’s valuation of the asset or different. Regardless of the industry’s valuation of the asset, the company must justify its book value of the asset.
The amount of time that the asset can be used before it is no longer beneficial to the company and has lost its value (to the company).
The value of the asset at the end of its useful life.
Straight Line Depreciation
Straight line depreciation is the deduction of the value of an asset over time. Its total value is divided by the number of years that it is useful, and deducting the same value every year.
For example, if you have a computer system worth US$6,000, that is good for 4 years, you would divide the book value of the system by its useful life. In this case, it’s US$6,000 divided by 4 years, assuming the salvage value of the computer system is US$0. This means the annual depreciation for the computer system is US$1,500.
Double Declining Depreciation
Double declining depreciation is depreciation of an asset at twice the straight line rate. So, if you consider the example used in straight line depreciation, the computer system’s value would decline at an accelerated rate if the double declining depreciation rate was used by the company.
In this instance, the rate of depreciation for the computer system is 25%. For the double declining depreciation method, the rate of depreciation would increase to 50%. So, using this method, the US$3,000 worth of the computer system’s value will be expensed by the company. In 2 years, the entire value of the computer system will have been deducted as a business expense.
Sum of the Years Depreciation
The sum of the years depreciation method extends the time over which an asset can be depreciated, and decreases the amount of money deducted as an expense each year.
Using the US$6,000 computer system with a salvage value of US$0 and a useful life of 4 years, divide the value of the computer system by the sum of its yeas of useful life.
Sum of years = 1 + 2 + 3 + 4 = 10
Depreciation value = US$6,000 /10 = US$600
Units of Production Depreciation
This depreciation method is used for companies that own machinery. When the machinery is expected to produce a specific number of products over its useful life, then the value that is consumed within a year can be calculated based on the number of units produced by the machine during the fiscal year.
To illustrate this method, let’s assume that a company buys a machine for US$20,000 that can produce 200,000 units and has a salvage value of US$0. If the machine produces 20,000 units during the fiscal year. The percentage of total possible units produced during the year will be used to determine the value of the machine lost to production.
% of total possible production = 20,000 units / 200,000 units x 100 = 10%
Depreciation value = US$20,000 x 10% = US$2,000
Qualified Business Income (QBI)
The qualified business income (QBI) deduction allows you to deduct 20% of your qualified business income on your taxes during the fiscal year. If the deduction results in a net business loss, the loss can be carried over for several years. The carried over loss can be used to reduce future taxable business income.
QBI is the total value of a business’ income and gain and loss from trade or business activities during the fiscal year (i.e., business’ net profit). It excludes capital gains and losses, dividends, interest income, income earned outside the USA, and certain kinds of wages and guaranteed payments.
Use of this deduction is limited by the tax filer’s income. For 2022, the maximum income is US$170,050 for single tax filers and US$340,100 for joint tax filers. In 2023, the maximum income will be raised to US$182,100 for single tax filers and 364,200 for joint tax filers. If your income exceeds the maximum for the tax year, review the QBI guidelines to determine if you qualify for an income exception.
Bonus depreciation is available to businesses that have purchased assets, used or new, that have been put into service for the business in the year that they were acquired. This depreciation method allows for 100% depreciation of assets that can have their value deducted over future tax years. Bonus depreciation can be used to reduce a company’s income to less than US$0. The net loss can be carried over to future tax years and used to reduce future taxable income. The price paid for this accelerated depreciation is the sacrifice of potential asset depreciation deductions that could be used to reduce your future taxable income.
There is no limitation on the total value of the deductions. However, all assets within the chosen asset class must be included in the deduction.
Section 179 of the U.S. Internal Revenue Code
Section 179 of the U.S. Internal Revenue Code (IRC) can be used to accelerate depreciation of specific kinds of assets (e.g., vehicles, office equipment, business
machinery, computers). The assets must be used for business purposes. Minimum requirement, at least 50% of the item’s usage must be for the business. Section 179 lets you pick and choose which depreciable assets you want to include in the deduction. The amount of the deduction cannot exceed taxable business income for the fiscal year.
It can be used with assets purchased with cash or financing. The assets can be new or used. Each item’s full purchase price can be deducted using this depreciation method. If the asset is not used for the business 100% of the time it’s in use, then you must multiply its percentage of usage by the allowable depreciation and that is the amount eligible for deduction under Section 179. The maximum deduction is US$1,080,000 and the asset can have a maximum value of US$2,700,000 for 2022.
The depreciation method chosen by the startup should be done from a long-term perspective. It can be very difficult to change depreciation methods during the useful life of an asset, especially if the startup business used accelerated depreciation.
The key things to consider are whether you are willing to sacrifice potential tax deductions for accelerated deductions, and how it will affect your ability to reduce taxable income in future tax years. In addition, accelerated depreciation will decrease the book value of your assets. The lower book value of your assets can significantly affect your debt-equity ratios and the financial health of your business, based on your financial filings.
For example, accelerated deductions may make your business look less profitable and have less value than is true. This lower valuation may decrease the likelihood of the business getting a bank loan, being considered for a business partnership or acquisition, and other business-related opportunities. Finally, businesses that use accelerated depreciation methods may be taxed on any gains made from the disposal of assets that have been fully or partially depreciated.
For assistance with choosing the best depreciation methods for your business’ assets, contact the Free Cash Flow (FCF) Agency.