It’s Okay, I Need The Deduction

It's that time of year again.

No, not Thanksgiving. Not Christmas shopping.

If you're a business owner, especially a farmer, you're staring into the face of one full month of "Year-End Tax Deduction" season, specifically my inanimate arch nemesis: Section 179.

Many well meaning sales people and tax advisors will suggest making purchases this December to take advantage of Section 179, calling it wise tax planning. It certainly can be useful under the right circumstances. But remember that even in a best case scenario, accelerated depreciation is only a tax deferral tool. It is never a tax avoidance mechanism.

To be clear, legal tax avoidance is a permanent difference allowing you to never pay tax on certain income--think municipal bonds that are exempt from income tax. Tax deferral is strictly a timing difference meaning you might not pay tax expense this year, but you will in subsequent years.

Let's compare two examples in an attempt to illustrate an extra year-end deduction:

• Earn $10, pay tax on $10 at 30% rate = $7 after tax net income. [Tax expense $3]

• Earn $10, extra expense of $1 for deduction, pay tax on $9 at 30% rate = $6.30 gain after tax. [Tax expense $2.70]

You might think to yourself, “self, that extra deduction just cost me 70 cents. But I'm not concerned, because the new machine will generate 70 cents of incremental revenue. I'll be just fine.” Unfortunately, that’s not enough income to overcome the after-tax difference, because you will have to pay tax on the 70 cents of income.

Your $1 expense needs to pay back at least $1 in future profits to generate after-tax parity versus not having that expense at all.

There are lots of reasons to invest in or upgrade capital assets, but never take on an expense for the sole purpose of reducing current year tax expense. Cash expenditures of this nature need to actually make your business more profitable. The dollars spent should increase your revenue or reduce your expenses at a minimum dollar for dollar ratio.

Anything less is winning the before tax battle, while losing the after tax war.

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