Month: February 2010

Depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors.

Although depreciation recognizes the decline in an asset’s value, the cost allocation process used in accounting for depreciation bears little or no relationship to the actual market value or resale value of the asset.

It is simply an acknowledgment that a portion of the asset’s value has been used up in the process of generating revenue for your business.

Depreciating a business asset allows you to spread its purchase cost over the span of several years. It is a noncash expense that does not directly affect cash flow.

You can depreciate business assets that meet these criteria:

• The item must be used in your business or to produce income
• It must have a useful life of greater than one year
• That useful life must be finite.

Assets begin depreciating on the date they are placed in service for the business.

You can deduct only the portion of the item that you use for business.

At some point, depreciated items are expected to wear out, break down, deplete or become obsolete.

But if you spend money to extend the item’s useful life, you can deduct that as well.

Examples would be installing more memory or a bigger hard drive in your PC, or repairing, maintaining or upgrading business machinery. The Internal Revenue Service (IRS) provides several different depreciation methods.

The simplest is the straight-line depreciation method. Using the straight-line method, you simply deduct a percentage of the asset’s cost during each year of its useful life.

The IRS considers the useful life of most information technology assets, such as computers, peripheral equipment, fax machines and copiers, to be five years.

Office furnishings are considered seven-year properties.

Other depreciation techniques include:

• Declining Balance Method: Allows higher depreciation in the first year. with gradually decreasing amounts over time
• Activity Depreciation: Depreciation based on the asset’s level of activity, not time
• Units of Production Method: Useful life of the asset expressed as the number of units it is expected to produce
• Units of Time Depreciation: Applied in cases where usage of the asset is not linear from year to year
• Group Method: Groups similar assets with similar service lives and uses the straight-line depreciation method
• Composite Method: Applied to a collection of dissimilar assets that have different service lives

Whichever method of depreciation you use, you must continue using it for the life of the asset. You cannot switch to a different method of depreciation.

From the perspective of the Internal Revenue Service (IRS), a sole proprietorship isn’t a taxable entity. Assets and liabilities of the business are treated as belonging to the owner. As a sole proprietor, you report the profits or losses of your business on your personal income tax return, Form 1040. Your earnings are subject to income tax and self-employment tax, and you’re required to pay tax on income the year you earn it. At tax time, income and expenses generated by your business are reported on either Schedule C (Profit or Loss from Business) or Schedule C-EZ (Net Profit from Business) and submitted to the IRS along with Form 1040. You must pay tax on all profits whether or not you actually withdraw money from the business. There are no tax effects for transferring money into or out of a sole proprietorship.

Business Expenses: You can deduct some of the money you spend to generate income, including operating expenses, travel expenses, advertising, and a percentage of business-related meals and entertainment. You are also allowed to write off the cost of business equipment and other business assets as well as certain start-up expenses.

Self-Employment Taxes: Sole proprietors contribute to the Social Security and medicare systems through so-called self-employment taxes. Self-employment taxes are reported on Schedule SE (Self-Employment Tax) and submitted together with Form 1040 and Schedule C-EZ (Net Profit from Business).

Estimated Tax Payments: The IRS requires you to estimate how much tax you will owe each year and make quarterly estimated tax payments. Some states require this as well.