Industry Insights

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010. The act contains several tax-related provisions:  an increase of Internal Revenue Code (IRC) Section 179 expensing limiting for 2010 and 2011; a provision making qualifying real property eligible for Section 179 expensing; an extension of bonus first-year depreciation through 2010; and a provision amending the cost allocation rules for long-term contract accounting. This article will focus on the changes to bonus first-year depreciation and cost allocation rules for long-term contracts.

Bonus first-year depreciation as introduced in the Job Creation and Worker Assistance Act of 2002 was created as a means to encourage economic growth. It has been modified and extended several times in the last nine years. Under pre-act law, a taxpayer could elect to expense 50 percent of the cost of qualifying assets placed in service after December 31, 2007, and before January 1, 2010. Qualifying assets were generally new machinery and equipment, most computer software and certain leasehold improvements.

If a taxpayer was subject to the rules under IRC Section 460, the taxpayer was required to allocate the bonus first-year depreciation to the cost of the contract and adjust the percentage of completion—and thus adjust the profit recognized—on that contract. As a result of being required to allocate the bonus depreciation to job cost and adjusting the percentage of completion, bonus depreciation often resulted in an acceleration of income for the taxpayer.

The act extends first-year bonus depreciation again by allowing taxpayers to expense 50 percent of the adjusted basis of qualifying assets placed in service through December 31, 2010. Assets qualifying for bonus depreciation under the act are the same as assets that would have qualified under pre-act law, with the exception of the new in-service date requirements.

The act changes the contract cost allocation requirements by allowing taxpayers to exclude the bonus first-year depreciation taken on qualifying property from the percentage of completion method. For purposes of applying the exclusion, qualifying property is an asset that has a recovery period of no more than seven years and is placed in service after December 31, 2009, and before January 1, 2011. The percentage of completion method under the act assumes that bonus depreciation was not taken into account but instead allows taxpayers to calculate the percentage of completion as if regular Modified Accelerated Cost Recovery System (MACRS) depreciation was taken on the qualifying property. Since the percentage of completion method under the act is not adjusted for the additional first-year bonus depreciation, taxpayers no longer accelerate income recognition and are allowed to take full advantage of the extended bonus depreciation for 2010.

An Example of Bonus First-Year Depreciation

XYZ Construction has a tax year-end of December 31, 2010, and is required to use the percentage of completion method. The company purchases $800,000 of construction equipment on February 1, 2010.

The purchased property qualifies for both bonus depreciation and the revised percentage of completion method requirements set forth in the Small Business Jobs Act of 2010. The equipment is used on a $5 million contract the taxpayer expects to last two years, beginning in 2010. The total estimated cost of the contract is $4 million, excluding depreciation. In 2010, excluding depreciation for tax purposes, the taxpayer incurred $1.5 million of direct and indirect costs allocated to the contract.

*Revenue = $5 million expected revenue x [$1.66 million cost incurred to date / ($4 million total estimated cost + $416,000 estimated depreciation)]

Bonus depreciation can be a useful tool for managing taxable income since the decision to elect or not elect bonus depreciation can be made right up to the time of filing the return. With the possibility of higher individual income tax rates in 2011, taxpayers should carefully determine if electing bonus depreciation in 2010 is the right decision for them. Please contact your BKD advisor for assistance in making this decision.