DEPRECIATION HELPS CASH FLOW

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What do you think of when you see the word ``depreciation''?

Some business owners may recognize that depreciation is a tax deduction received on their tax returns for owning equipment and buildings. Most leave the depreciation calculations in the hands of the company accountant, who may not be familiar with some special technical and hidden rules that can increase depreciation deductions.

The most common mistake is the classification of an asset as a ``building'' improvement rather than an ``equipment'' item. The tax laws provide, in general, that a building improvement must be depreciated over 39 years on the straight-line method. If you classify this asset as equipment, the tax laws generally allow you to depreciate over a seven-year period using an accelerated rate.

Say you buy eight injection molding machines. In addition to the cost of the machines, you spend money to get the building ready to accommodate them. In this example, we are converting part of a warehouse to accommodate the new injection molding machines. Your costs might be as follows:

1. Eight injection molding machines, $1,000,000.

2. A materials-handling system to support all eight machines, $50,000.

3. Electrical connections to hook up the machines, including a new electrical transformer and fuse boxes, $150,000.

4. Coolant tower to control the temperature of the water supplied to the machines, $40,000.

5. Pipe and plumbing system to supply each machine, $60,000.

The total costs come to $1.3 million. How would you depreciate these new assets?

Obviously, the injection molding machines are considered equipment, and are then depreciated over the seven-year period. Most people think items two through five are considered building improvements, and would be depreciated over the 39-year life of a building. Wrong answer.

According to case laws and rulings, all of these items are directly related to the operation of the injection molding machines and all should be considered equipment.Switching items two through five, which represent $300,000 of assets, from building to equipment results in substantial tax savings. If you calculate depreciation deductions and tax savings for each year, apply a constant tax rate and a present value factor to each year, you would save about 17 percent for every dollar you reclassify from a building asset to equipment.

Your investment for a depreciation study will be well worth the thousands of tax dollars saved.

Morgan is a certified public accountant and business consultant with Chicago-based FERS Plastics Group.