When you opened your business, you probably thought about the challenges of being your own boss, the long hours you’d work, the pride of owning something of your own – a successful small business. The need to learn accounting terms like amortization and depreciation probably didn’t cross your mind.
But even if you have an accountant, or someone who prepares you taxes, you should know what these terms mean. That way, you understand what the money professionals are talking about, you can alert them to things that might reduce your taxes. And if you’re creating your own business plans and revenue statements, you obviously need to know some accounting terminology.
What’s the difference between amortization and depreciation?
Business assets are deductible business expenses. Amortization and depreciation are two methods of calculating value for business assets and enable you to reduce the tax liability for your business. The difference between amortization and depreciation is that they apply to different types of assets.
How to calculate amortization deductions
Amortization allows you to spread the cost of an intangible asset over the useful life of that asset. The thing to remember here is that word “intangible.” An intangible asset could include:
• Franchise agreements
• Licensing agreements
• Organizational costs
• Patents and trademarks
• Proprietary information (such as recipes, design processes, and algorithms)
• Research and development: To calculate amortization, you need to know the value of the asset and its anticipated useful life span - the time span that you anticipate the asset being of use to your business. Divide the life span by the value of the asset to find out how much you can claim in amortization expense each year.
We’d strongly advise you to let a financial professional calculate amortization expenses. Since you can claim the same amount over the useful life of the asset, its easier to simply have the calculation done so that you can expense it with confidence.
Also note that asset amortization is completely different than a loan amortization schedule. When referencing loans, an amortization schedule can be used to calculate loan payments consisting of principal and interest. Using this process, you pay off interest early in the loan’s lifetime, and subsequent payments increasingly are applied to the principal. The most common examples of this usage are mortgage or auto loan payments.
How to calculate depreciation deductions
Depreciation is similar to amortization; the big difference is that you are dealing with tangible assets. So, if you own an asset, you use it in your business, it will eventually wear out or need to be replaced, you can calculate its anticipated useful life, and you expect it to be useful for more than a year, you can probably depreciate (“write off”) part of the cost of those assets over a period of time.
Assets that can be depreciated would typically include:
• Computers and other digital devices • Furniture • Livestock • Office equipment • Property • Tools and equipment • Vehicles
The IRS allows you to depreciate specific items over a set period of years. Check the information in IRS Publication 946 for exhaustive details on what property can be depreciated and how to calculate the write off. In general, though, and with many exceptions:
• Three years: tractors, tools, and some livestock (specifically, race horses)
• Five Years: computers, office equipment, cars, light trucks, and construction equipment.
• Seven years: office furniture, appliances, vehicles, and assets that don’t fall into other categories (apart from real estate). You are allowed to write off real estate over a longer time period; 27.5 years (residential rental properties) and 39 years (commercial buildings).
Assuming you are not a financial whiz, you do need professional advice – or at least a tax preparation program that you really trust - to figure out how to best calculate depreciation. There are three different options:
Straight-Line Depreciation: Simple to figure out, but slowest deprecation write off.
Accelerated Depreciation: The method used by most small businesses, you get a larger write off in the beginning years, and the write off dwindles over the useful life of the asset.
Bonus Depreciation: talk to a tax preparer, as the rules for taking a bonus depreciation recently changed for assets acquired and put to use after September 27, 2017.
Or you can just take a Section 179 Expense Deduction, which (with some limitations) lets you deduct the entire cost of a tangible asset in the year you acquire and begin using it in your business. The current maximum Section 179 deduction is $1,000,000.
At the risk of boring you, we’ll repeat this again: general tax advice is useful only to a point. It is essential to talk to a financial professional to understand how to calculate and expense amortization and depreciation deductions.
If you are ready to invest in your business by adding new assets or replacing those that are nearing the end of their useful lifespan, you probably need working capital. Sadly, owners of smaller businesses often struggle to access working capital from bank loans – the application process is complex and demanding, and requirements are strict. You may not have the time, know-how, patience or credit history to qualify for the same financing options that were designed to meet the needs of big businesses.
One Park Financial works to help owners of small and mid-sized businesses access the working capital that they need. Our process is simple and straightforward, and we’ve helped many small businesses who have been turned down by banks to access funding. Visit oneparkfinancial.com to discover the options that make sense for you and your business.