Situation:
Logan (45) owns a software development company and lives in California. He has gradually expanded his company over the last ten years. Logan has a large group of clients that need similar work from his company year after year.
Logan has created a roadmap of the current and upcoming projects for 2023 and knows there will be significant research and development costs. Research and development costs have been a manageable issue in past years because IRC Section 174 allowed companies to deduct the expenses in the year they incurred them. However, when the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted, research and development expenses must be capitalized and amortized over five years. This eliminated the option to deduct the full expense in the year incurred. This change went into effect in January 2021.
For the last two years, Logan has been dealing with the changes to the tax code, assuming he can do nothing to offset his tax obligation. During a meeting with his CPA, he was lamenting about the burden an artificially inflated taxable income had on his business. They examined how the TCJA changes have affected his after-tax cash flow over the last two years. His CPA discussed some exclusive tax mitigation strategies he had recently learned about and how this strategy could be beneficial to reducing Logan’s tax burden.
Solution:
Logan can project a taxable income of $1,500,000 in 2023. He will owe 48% in federal and state income tax, resulting in a tax obligation of $720,000 in 2023. Logan follows the advice of his CPA and participates in a tax mitigation strategy that combines a Section 179 expense and a Section 168(k) bonus depreciation deduction.
Logan will purchase six capital assets for a total of $300,000 equity from his company and a $1,200,000 loan provided by the strategy. He will split the capital assets between Section 179 and Section 168(k) to maximize his deductions. $1,000,000 will utilize the Section 179 expense, and $500,000 will be allocated to the 168k bonus depreciation allowance.
Result:
As a result of utilizing this approach, Logan’s business can deduct $957,600 from the Section 179 expense and $383,040 of bonus depreciation from Section 168(k). The Section 168(k) deduction will also have a $23,940 depreciation deduction he will use annually for the next four years.
Logan’s business can reduce its taxable income from $1,500,000 to $159,360 in 2023. This will reduce his company’s tax obligation to $47,808. This tax mitigation strategy will increase after-tax cash flow by $343,508 in 2023 (with additional savings of $45,900 in the following four years).