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Child Support & the Self Employed – The Depreciation Deduction

what is acrs depreciation

Buried in DRL 240(1-b) and FCA 413(b)(5) is this often missed clause:

iv) at the discretion of the court, the court may attribute or impute income from, such other resources as may be available to the parent, including, but not limited to: … (A) any depreciation deduction greater than depreciation calculated on a straight-line basis for the purpose of determining business income or investment credits, …

I’ve seen this clause confuse judges and litigants, giving child support orders that are either too high or too low. So what exactly does this mean? In short, it means that some legitimate business deductions permitted by the IRS will not be allowed for determining income for child support.

Let’s take it one step at a time.

Straight Line Depreciation

First, what exactly is depreciation and what is meant by a straight line basis? I’m going to make up some numbers to make it easier to follow. For this example, all expenses are legitimate; there is no hidden income or artificially inflated expenses.

Let’s assume someone is self employed, and has gross revenue of $500,000 per year. Obviously, there are certain expenses associated with running a business, and those expenses should be deducted off the gross income. For example, rent, the cost of goods sold, salaries paid and utilities are all deducted off the gross income to determine profit. For this example, let’s say there are $275,000 in legitimate business expenses and all are valid deductions by the IRS. Other than depreciation, there are no other expenses. That leaves $225,000 in profit so far.

Now let’s assume the business owner purchases a new piece of equipment for $100,000. Since $100,000 was spent as a legitimate business expense, you’d think that it would be acceptable to deduct this expense from the gross income, giving a profit of $125,000.

Nope says the IRS. Even though you paid for this piece of equipment in full, you have to spread out its cost over its useful lifetime. And, the IRS being what it is, has charts saying what the useful lifetime is for every conceivable item. For this example, let’s say the IRS says the lifetime is 10 years.

So, to determine the business deduction, you divide the cost of the equipment ($100,000) by its useful lifetime (10 years) giving you a permitted deduction of $10,000 per year for 10 years. This type of depreciation gives an equal amount for each year, and if you draw a line on a chart for the annual depreciation, you get a straight line. Somebody decided to call this “straight line depreciation” So far so good. So for out example, the $225,000 in profit would be reduced by $10,000, reflecting one year’s worth of straight line depreciation.

Accelerated Depreciation

Now here’s where it starts to get complicated. In 1981, Congress said it would be a good thing to allow business owners a tax break if they bought new equipment. To accomplish this goal, accelerated depreciation was invented, otherwise known as the Accelerated Cost Recovery System, known as ACRS for short. Using hypothetical numbers, ACRS would allow our business owner to obtain

more depreciation early on at the expense of less depreciation down the road. For example, ACRS might allow 60% of the cost to be deducted the first four years, 20% of the cost spread out over the next two years, and the remaining 20% spread out equally over the remaining four years. Thus, under ACRS, the depreciation might be 15%-15%-15%-15%-10%-10%-5%-5%-5%-5%.

In 1986, Congress said that ACRS needed to be changed, and modified the depreciation schedule, giving us the Modified Accelerated Cost Recovery System, otherwise known as MACRS. Using hypothetical numbers, the depreciation schedule for our machine was changed to 20% the first year, 20% the second year, 15% for the third, 15% for the fourth year, and 5% for each of the remaining years. Thus under MACRS, the depreciation would be 20%-20%-15%-15%-5%-5%-5%-5%-5%-5%.

Separate from ACRS and MACRS, there is also the Section 179 expenses, which in simple terms, allows a business to deduct 100% of the expenses associated with certain qualified property in the year in which it was purchased. And for those who have made it this far, a Section 179 expense deduction is an exception to the depreciation rule. Remember, our tax code consists of rules, exceptions to the rules, and exceptions to the exceptions.

So turning back to the example, let’s say we are using MACRS, and the equipment is in the second year of service, giving a 20% depreciation deduction. Thus, for tax purposes, the net income is $125,000 less 20% of the cost (20% of $100,000 being $20,000), for a bottom line of $105,000.

But for child support, DRL 240 (1-b)(b) (vi)(A), and its twin companion, FCA 413 (b)(5) (vi)(A) require that any depreciation over the straight line be added back in. The straight line depreciation gives 10% of the total cost, or $10,000. The business properly deducted $20,000 under MACRS. Thus, any amount of depreciation over $10,000 is added back in. As $20,000 – $10,000 = $10,000, the income for child support is properly determined to be $105,000 plus $10,000, or $115,000.

In reality, the IRS has numerous classification of property, ranging from three to twenty years for personal property, and 27.5 & 30 years for buildings.

Now for two real examples. In one case, I represented the custodial parent, and got the credit for the increased depreciation added back in when the non custodial parent’s income was determined. In another case, I represented the non custodial parent. The judge was about to disallow all depreciation expenses, since they were only “paper losses.” I showed the judge this section of the statute, and preserved the deduction, thereby lowering the child support obligation.

For both cases, I anticipated that the court may not properly apply this section of the statute, and had several hard copies of the section ready to show the court. As a practice tip to any attorney dealing with the self employed, I’d recommend doing the same, highlighting the section helps greatly too.

One final point that’s worth repeating – this section of the child support statute simply disallows a legitimate deduction. There is no artificial manipulation of income or expenses going on.

Category: Bank

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