Manage Risk with Fixed Assets

Manage Risk with Fixed

Assets

Presented by: V. Lynn Lambert, CPA Lambert Lanoue & Smoker LLC

www.lambertcpas.com

Outline

•Analysis of Lease vs Purchase of Fixed Assets

•New IRS Repair Regulations

Capital Lease

•Capital Leases are considered a purchase of an asset and recognized as an asset with a corresponding liability on the balance sheet if any of the four criteria are met:

• Term exceeds 75% of the life of the asset • Transfer of ownership at the end of the lease

• Payments exceed 90% of the fair market value of the asset over the life of the lease • Bargain purchase is a condition at the end of the lease period

Operating Lease

•Asset and liability is not recorded on the balance sheet.

•Annual lease payments are deducted on the income statement.

•Asset is returned to the lessor at the end of the lease.

Qualitative Consideration of a Lease

•Expense annual lease payment for income tax purposes (operating lease)

•No down payment, security deposit or origination fees

•Generally lower fixed payments for the lease term

•Inflation

•Protection against obsolescence

•Impact on Balance Sheet

Qualitative - continued

•Economic value of the asset at the end of lease

•A lease is a long-term legal obligation and generally you cannot cancel the lease agreement.

Discounted Cash Flow Analysis

•To analyze the cost differences between a lease vs a direct purchase of an assets, one must perform a discounted cash flow analysis.

•This analysis compares the cost of each alternative by considering: the timing of the payments, tax benefits, the interest rate on the loan, the lease rate, and other financial arrangements.

•Need to make certain assumptions about the economic life of the equipment, salvage value and depreciation.

Net Cash Outlay & Present Value

•Net cash outlay IS NOT cash flow.

•Net cash outlay is annual lease payments less tax savings on the transaction.

•Each year’s net cash outlay must be discounted to take into consideration the time value of money to determine the present value of each payment.

•The sum of the present value computations will determine the best financial option for the use of the asset.

Fast Tools – Spreadsheet

Lease Data Input

LEASE:

Description of item

Cash downpayment/s ecurity deposit $1,500

Fixed cash lease payments per payment period $9,000

Length of lease contract (years ) 3

Payments per year 1

Purchase option at end of lease * $20,000

Terminal value at the end of planning horizon $0

Effect of downpayment on lease payments Return of downpayment/security deposit $0

Truck

Tax Deductible Yr.1 Prepaid

No effect

Purchase Data Input

PURCHASE:

Des cription of item

Purchas e price (cas h boot) $50,000

Term inal value at the end of planning horizon $0

Length to depreciate (years ) 5

Depreciation m ethod *

Section 179 election $0

Financing :

Downpaym ent (% of purchas e) 10%

Length of loan (years ) 5

Interes t rate on loan 3.000%

Paym ents per year 1

Truck

MACRS (150%, half year)

Additional Data Input

Planning horizon (years ) 5

Marginal incom e & SE tax rate 45%

Tax rate on capital s ale 30%

After-tax dis count rate 3.000%

ITEM TRADED:

Adjus ted bas is of traded or s old item $0

0

Num ber of additional item s s till being depreciated 0

Market value of traded item applied towards leas e $0

ITEM SOLD FOR CASH:

Cas h received for item s old (not traded) $0

Applies to:

Years rem aining depreciation on item traded

Purchase Lease

Lease Analysis

Lease Security Lease Lease Payment Cash LeaseAdjustment Terminal Expense After Tax Tax Discount Present Payment & Payments Adjustments Payments for Purchase Purchase Option Terminal Value Cash Flow s Factor Value

Refund Taxes & Trade Value

0 0 -1,500.00 0.00 0.00 0.00 0.00 -1,500.00 1 -1,500.00 1 1 0.00 -9,000.00 0.00 -9,000.00 4,050.00 0.00 0.00 0.00 -4,950.00 0.9709 -4,805.83 2 2 0.00 -9,000.00 0.00 -9,000.00 4,050.00 0.00 0.00 0.00 -4,950.00 0.9426 -4,665.85 3 3 0.00 -9,000.00 0.00 -9,000.00 4,050.00 20,000.00 0.00 0.00 -24,950.00 0.9151 -22,832.78 4 4 0.00 0.00 0.00 0.00 1,350.00 0.00 -3,000.00 0.00 1,350.00 0.8885 1,199.46 5 5 0.00 0.00 0.00 0.00 2,295.00 0.00 -5,100.00 3,570.00 5,865.00 0.8626 5,059.20 0 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.0000 0.00 Payment Period Year

Purchase Analysis

Credit Purchase End of Period Dow npayment Interest Depreciation After Tax Adjustment Net After Discount Present Loan and Loan Payment Expense Expense Terminal Value & for Tax Factor Value

Year Balance Loan Balance Taxes Cash Flow s

0 45,000.00 -5,000.00 -5,000.00 1 -5,000.00 1 36,524.04 -9,825.96 -1,350.00 -7,500.00 0.00 3,982.50 -5,843.46 0.9709 -5,673.26 2 27,793.81 -9,825.95 -1,095.72 -12,750.00 0.00 6,230.57 -3,595.38 0.9426 -3,388.99 3 18,801.66 -9,825.96 -833.81 -8,925.00 0.00 4,391.46 -5,434.50 0.9151 -4,973.33 4 9,539.76 -9,825.95 -564.05 -8,330.00 0.00 4,002.32 -5,823.63 0.8885 -5,174.22 5 0.00 -9,825.95 -286.19 -8,330.00 1,249.50 3,877.29 -4,699.16 0.8626 -4,053.54

Results

Cas h leas e payments that would equate NPV $9,461.22

Original purchas e price that would equate NPV $48,730.60 Under thes e term s,

the lease is preferred by an amount equal to: Pres ent Value Leas e Outflows Pres ent Value Purchas e Outlfows

Click to calculate item s below

New IRS Repair Regulations

•Effective January 1, 2014, IRS has issued complex tax regulations on the purchase and improvement of assets and property.

•To better understand the regulations, one must consider the initial proposition presented below:

•All tangible property that is not inventory, must be capitalized and depreciated unless there is an exception.

Five Main Areas

•The IRS Comprehensive Repair and Capitalization Final Regulations address changes to the following areas:

• Materials & Supplies • Repairs and Maintenance • Capital Expenditures

• Acquisition and Production of Tangible Property • Improvements of Tangible Property

Materials and Supplies

•Materials and supplies – items under $200 or has an economic useful life under 12 months, then the items can be expensed.

•Each business needs a capitalization policy.

Repairs & Maintenance

•Make the annual De Minimis election to expense materials and repairs of $500 or under.

•Implement your capitalization policy by reviewing your repairs and expense items and determine whether they are repairs or need to be capitalized.

•Each business needs a capitalization policy.

Repairs Considered Improvements

•Betterment to the unit of property

•Restoration of the unit of property

•Adaptation of the unit of property

•If a repair meets one of these requirements, then the item must be capitalized.

Betterments

A repair that is considered a betterment must be capitalized under the following three tests:

1. Improves a condition or defect that existed prior to the acquisition of the property or production of the property.

2. Results in a material addition to the unit of property (expansion)

3. Results in material increase in the capacity, productivity, efficiency, strength or quality of unit of property or its output.

Restorations

•Repairs that actually “restore” or “built like new” is considered a depreciable asset.

•Casualty losses are exempt under certain situations.

•Final regulations state that a generally comprehensive maintenance program conducted according to manufacturer’s original specifications, even if substantial in nature, does not return a unit of property to a “like-new” condition.

Adaptation

•Change the use of the unit of property in any form or nature will be considered a depreciable item and not a repair.

Unit of Property

• A unit of property consists of a group of functionally interdependent components. • Parts of a machine (engine, chassis, cab, etc.) are a unit of property for a truck. • Floors, roofs, walls are a unit of property for a building.

• Major systems of building such as HVAC, plumbing, and electrical are considered separate units of property for capitalization purposes but remain part of unit of property of a building.

Real Property - Buildings

•Safe Harbor rules for Small Taxpayer as defined with buildings unadjusted basis under $10 million and taxpayer’s average annual gross receipts under $10 million can treat repairs as follows:

• No need to capitalize repairs, maintenance, improvements and similar activities so long as the cost does not exceed $10,000 or 2% of the unadjusted basis of the building.

Partial Dispositions

•Under the new capitalization/repair regulations, an election can be made to take a loss on the disposal of a structural component. For example:

•When repairing a roof, a taxpayer can make an election to remove the original roof and take a loss on the remaining basis in the original cost of the roof.

•The issue is how to determine the cost of the original roof placed in service in 1998.

Form 3115

•Report Method of Accounting Change to update and get depreciation schedules in compliance with the new capitalization and repair regulations

•Penalties for understatement of tax liability is 20%.

•After 2014 tax year, the cost file Form 3115 is $7000.00.

•Preparer penalties for failure to properly apply these new regulations.

Questions

Thank You for Attending

•V. Lynn Lambert, CPA

•Lambert Lanoue & Smoker LLC

•219-324-0304 – La Porte Office

•574-583-5041 – Monticello Office