The changes to the Internal Revenue Code of 1986 under the Tax Cuts and Jobs Act (TCJA) have immediate implications for equipment companies and their customers. These changes run the gamut from companies having the ability to claim 100 percent depreciation on new and used equipment to reduced corporate and individual tax rates. Here’s a quick guide to inform readers on the major changes affecting equipment purchasing (and renting) under the new tax structure.
Reduction to Corporate Tax Rate Expected to Power Spending
The most profound change resulting from the TCJA is the reduction of the corporate tax rate from 35 to 21 percent. Individual rates were also reduced from 39 to 37 percent which will affect businesses operating under sole proprietorships/s-corps/partnerships.
Another change which affects small and midsize businesses which do not, generally, pay corporate taxes, is a new 20 percent deduction for taxable income that passes through and is taxed as personal income. These new rules allow businesses to keep more of their earnings and are expected to power spending and investments among businesses.
The healthy economy, combined with the recent changes approved to corporate taxes, means that investments in various types of equipment are expected to grow, according to an article published by Equipment Finance Advisor.
Jon Brown, Vice President of Finance at Hugg & Hall Equipment Company (Hugg & Hall), recently spoke on how the new tax structure is affecting the construction and industrial equipment industry.
“Many businesses are taking advantage of these rules and buying equipment from us,” said Brown. “The tax cuts are helping businesses generate activity which also results in higher rentals for us. There are also some new lease accounting rules going into effect next year that could push more companies to purchase outright, or might drive them to rent more. Either way, we win.”
100% Bonus Depreciation
One of the most significant, if not the most significant, change affecting the equipment industry, is the new bonus depreciation rules. Depreciation allows businesses to spread the cost of long-term assets throughout the life of the asset. Companies can now expense up to 100 percent of the cost immediately. This means that companies which previously spread out the expense of equipment across a series of years may now take the full expense, and lower their tax obligation, in the first year.
“The biggest, perhaps, change was the reintroduction of 100 percent bonus depreciation for purchases of equipment,” said Brown. “This means businesses can purchase equipment and for tax return purposes expense 100 percent of that purchase in the current tax year. It was at 50 percent prior to this change and was going to start sun-setting prior to this new law. Now this will be at 100 percent through 2022 and then slowly drops to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025, 20 percent in 2026 and then to 0 percent. For us this is huge because we have been able to significantly invest in growing our rental fleet.”
If a business is profitable, the upfront hit can be very beneficial as the depreciation expense lowers taxable income, allowing companies to pay less tax and retain more funds, according to Dynamic Funding, Inc. The write-off limit for equipment has also doubled from $500,000 to $1 million.
The new bonus depreciation law is one among many reasons that spending in the equipment industry is expected to steadily rise. Investments in equipment and software are expected to increase 9.1 percent in 2018, nearly double that of 2017, according to the Equipment Leasing & Finance Association.
Used Equipment Included on New Bonus Depreciation Rules
Another change to the bonus depreciation rules is the inclusion of used purchases. Bonus depreciation may now be applied to purchases that are “first use” by the business which purchases it, according to the TCJA.
“Previously bonus was only allowed on purchases of new equipment,” said Brown. “This will probably help used sales, I would guess, because they can get a decent discount from purchasing a new unit plus still take advantage of the bonus depreciation tax savings.”
New Limitations on Interest Deductions
The TCJA incorporates new limitations on the deduction of interest relating to business activity, according to Baker Donelson. Interest deductions may now not exceed 30 percent of taxable income determined without regard to depreciation. This limitation applies to businesses with average annual gross receipts in excess of $25 million.
“This could affect businesses that are financed purely by debt and are startups that do not have much profit in the early years but not likely to impact us a great deal,” said Brown, referring to how the new limitations will explicitly affect Hugg & Hall.
This limitation may impact leasing companies engaged in leveraged leasing, according to Baker Donelson. However, from the lessee’s perspective it may enhance the advantage of leasing under a true lease, and claiming a full deduction for the rental payments, over a leveraged purchase of the same equipment if the interest is not fully deductible.
Renting vs Purchasing
The new tax structure may elicit an increase both in the purchasing of new equipment and in the rental market.
“Some companies, especially publicly traded companies have very strict capital budgets and will sometimes pay more to rent and lease to avoid having assets on the balance sheet,” said Brown. “Other businesses may decide that it is better to take the balance sheet hit so they can take advantage of the 100 percent tax bonus depreciation. What percentage moves to purchase versus rent is a good question that really depends on each specific company and their financial covenants and goals.”
So, while the new bonus depreciation structure will likely motivate many companies to buy new and used equipment, many companies will choose to rent and lease (because of various factors) and equipment renting is also on the rise.
“Those in seasonal type businesses will many times opt to rent purely because they can turn it off when not needed and avoid the cost even though they pay a little more to rent while using,” Brown said. “For entities that know it will be fully utilized year-round I would guess are more likely to purchase unless they have restrictive bank covenants limiting what they spend on capital purchases.”
“In the future, leases will be required to be disclosed as a ‘right-to-use’ asset and also an offsetting liability related to the lease obligation on their balance sheet,” Brown said. “Certain companies with very specific criteria for not wanting assets or debt on the balance sheet will move to rent, the rest will likely buy.”
So, the new tax structure paired with a healthy economy is projected to yield good results for both equipment sales and equipment rental markets. The American Rental Association forecasts equipment rental revenue in the United States to finish 2018 7.6 percent above 2017, with upper-five percent growth rates in 2019 and 2020, according to an article published by For Construction Pros. While there are potential disruptions in the future, the September Report on Business by the Institute of Supply Management showed “strong growth in manufacturing for the 25th consecutive month.”
Likewise, the machinery manufacturing sector, which includes construction equipment, was among the sectors reporting growth in new orders, production and employment, according to an article published by Equipment World.
The entire scope of how the new tax structure will affect the industry is unknown. Most agree that purchasing is expected to increase, as is intended. One cautionary advisement is to especially understand that the bonus depreciation rules are designed to be ephemeral and companies should plan for its eventual expiration.
“So businesses have been operating in an environment for quite some time with some level of bonus depreciation and it will be very difficult when it eventually goes away and they begin paying a lot more in taxes,” said Brown. “Bonus depreciation is essentially a short term loan from the government because eventually it will be recovered.”
However, the outlook is primarily positive and companies are generally forecasted to take advantage of the new bonus depreciation rules and use their tax cuts to invest in operations.
“I do believe it will continue to have an impact on equipment purchases as long as it is in place,” said Brown.