American Taxpayer Relief Act Averts the Fiscal Cliff, Extends Significant Benefits to Horse Businesses
As Tad Davis said in his article in this publication in early January (Tax Bulletin No. 360), “Like a shot heard around the world, Congress passed a bill in the final hours of the 112th Congress which averted the so-called ‘Fiscal Cliff.’” Continuing, but mixing the metaphor, those in the horse business, upon review of the American Taxpayer Relief Bill (the “Bill”) will quickly realize they dodged the proverbial bullet headed their way had Congress failed to act. The Bill maintains valuable incentives for the horse industry as it greatly enhances the opportunities for expensing (deducting) the purchase of assets placed in service in 2012 (retroactively) well beyond previously established limits and extends the unlimited 50% bonus depreciation through 2013 for new assets purchased and placed in service.
Although, effective January 1, 2013, taxpayers will be forced to cope with one brand new tax and significantly higher income, estate and gift tax rates (Mr. Davis provided an excellent summary of those changes in the previously referenced publication above, but see the chart at the end of this article for a quick reference guide), small businesses and particularly those in the horse business fared very well when the Bill was passed and the “Fiscal Cliff” was averted.
The purpose of this article is to 1) summarize the two significantly favorable changes to the tax code resulting from the passage of the Bill and, 2) alert horse business participants to a few tax planning strategies that may be of some utility in 2013. As always, it is essential that the taxpayer consult with his/her financial advisor and accountant as each taxpayer’s situation is unique.
Some Popular Deductions Have Been Extended for 2013 and Retroactively Enhanced for 2012
Section 179 Expensing Deduction. The IRC Section 179 expense deduction for new or used property purchased for use in a trade or business (including equipment and horses) effective for tax year 2012 (before the Bill was passed) was limited to $125,000 (down from $500,000 in 2010 and 2011). It also was phased out on a dollar for dollar basis for the total of 2012 purchases of depreciable property exceeding $500,000 (down from $2,000,000 in 2010 and 2011). The pre-Bill expensing deduction which had been scheduled to take effect in 2013 was a paltry $25,000 with the dollar for dollar reduction set to take effect at the $200,000 threshold.
The Bill, however, reverted to the more generous 2010 and 2011 limits allowing up to $500,000 in expensing (deduction) of qualifying property acquired in 2013, reduced dollar for dollar only when the total of such property acquired exceeds $2,000,000. This change was also retroactively applied to 2012 purchases of depreciable property resulting in a significant, albeit unanticipated, windfall to those who invested in their businesses beyond the limitations on deductions previously established by the Internal Revenue Code for 2012. N.B. The expensing election, as always, can only be used to offset net income, not to reduce net income below zero.
Bonus Depreciation. Bonus depreciation was to have been completely eliminated in 2013. This would have represented a significant loss of incentive to taxpayers to buy depreciable property to be used in a trade or business. With the passage of the Bill, however, bonus depreciation of 50% of the purchase price of new property placed in service in 2013 will still be available. The bonus depreciation and expensing deductions can be used together to maximize the benefit to the taxpayer.
While the option to purchase property to be used in the trade or business may be particularly attractive to taxpayers experiencing a windfall or with significant profits in 2013, it also may make sense to others less fortunate to take advantage of interest rates at historical lows to borrow to make depreciable property purchases. This strategy to acquire assets with cash on hand or through the use of leverage, if implemented in 2013, will take advantage of the opportunity to utilize higher tax deductions in 2013. If the taxpayer puts off such purchases into 2014 or beyond expecting increased profits or cash flow due in future years, the deductions may again be limited or eliminated.
Again, it must be emphasized that, unlike the expensing deduction which is available to the taxpayer for purchases of new and used property, bonus depreciation is only available to the taxpayer for those qualified purchases of depreciable new property placed in service in 2013. Accordingly, the choice of which property to expense and which to apply the 50% bonus depreciation deduction can be a critical decision in maximizing the total amount of available deductions. Taxpayers should consult with their tax experts to assist in making appropriate allocations between the assets purchased and placed in service in 2012 and 2013. (The election for 2012 can still be made at any time prior to filing the tax return or in a timely amendment thereto.)
An example of how generous these two changes (expensing and bonus depreciation) are to those in the horse business is as follows:
Jane and John Doe own a small racing stable made up of horses purchased privately and at public auction. They also own and operate a breeding farm. These two activities are operated as a single entity and thus are considered as one for tax purposes. In 2013 they purchase four yearlings for their racing stable for a total of $800,000 and four broodmare prospects for a total of $1,200,000.
Under the generous provisions of the Bill, the Does: 1) will be able to expense (immediately deduct) the first $500,000 of the purchase price of the four broodmare prospects (presumably used for racing before being offered for sale, thus making them ineligible for bonus depreciation which is only available for new property purchased for use in the trade or business by the taxpayer); 2) will be eligible for 50% bonus depreciation on the total of their 2013 yearling purchases ($400,000); and, 3) will be able to take regular depreciation deductions on the balance of their basis ($1,100,000) (the original basis of $2,000,000 purchase price of the eight horses is reduced by the amount of the expensing deduction [-$500,000] and bonus depreciation deduction [-$400,000] = $1,100,000 basis).
Assuming an effective maximum federal tax rate of 39.6 % (and income in excess of $500,000, because the expensing deduction cannot be used to reduce net income below zero) the Bill reduces the Does tax liability by $495,000, not including the regular depreciation. 1
Had the Bill not been passed, the expensing deduction would have been limited to $25,000 in 2013 and would have been wiped out entirely by the dollar for dollar phase out/reduction of the expensing benefit for total purchases placed in service in 2013 above $200,000. The Does would have received zero reduction in their tax liability for 2013 from either the expensing allowance or the bonus depreciation deduction. They would have been limited to the normal cost recovery (depreciation) deductions for 2013.
Had the same Jane and John Doe scenario occurred in 2012, the expectation for a reduction in tax liability resulting from the investment/purchase of assets would also have yielded no tax benefit, other than normal depreciation. As should be abundantly clear from the above example, the benefits of the Bill, anticipated or not, are substantial and will afford those with small businesses (making expenditures for depreciable property to be used in a trade or business) to take advantage of significant tax savings. It is Congress’ hope that these extended tax benefits will encourage further investment in the economy and continue the recovery rather than risk it being stalled by a pullback in tax incentives.
Although Congress may still tinker with the Bill, it is unlikely that any material changes will be made either to the Section 179 expensing or the bonus depreciation provisions. With the passage of the Bill, not only can taxpayers plan for 2013 knowing of the tax incentives available to them, those who invested despite the 2012 limited benefits were rewarded handsomely with an unexpected windfall due to the Bill’s having a retroactive effect on the generous Section 179 expensing provisions.
Other Strategies for 2013 Tax Planning
Because ordinary income rates have significantly increased for many in the equine business in 2013, a taxpayer may be wise to maximize deductions in 2013 to the extent possible. The now known deductions may no longer be available in 2014, and thereafter. Accordingly, if the taxpayer is considering the purchase of property to be used in the trade or business in the next couple of years, strong consideration should be given to acquiring such equine property in 2013, including yearend purchases of supplies and office equipment, to lock in the more generous 2013 deductions.
Someone famous once said (paraphrasing), “the only two things certain in life are death and taxes.” At least for now, the tax code for 2013 is certain. Although many in the horse business consider the nature of “the game” a gamble, to the extent a taxpayer can take advantage of the known 2013 tax benefits outlined above, instead of taking a shot (a long shot) that 2014 will benefit the taxpayer any more than the extensions afforded by the Bill in 2013, he/she may not be able to dodge the proverbial bullet again in 2014. Maximizing the benefits of the Bill in 2013 is taking advantage of one of the two certainties in life - the payment of a certain amount of taxes in 2013 (which may be far less than the amount we may all have to pay in the uncertain future). As for the second of life’s certainties - we will leave that to the estate planners among us.
Thanks to Jeff Dible (email@example.com) and Scott W. Dolson (firstname.lastname@example.org), also of Frost Brown Todd LLC, for their contributions to this article. For more information regarding the American Horse Council, please visit www.horsecouncil.org.
1 The Regular depreciation of the balance of the basis in the property acquired by the Does in 2013 would depend upon the age of the assets and the use to which they are put.