A Quarter of States are Failing Small Businesses

New report examines how states handle first-year expensing on capital investments

From The Tax Foundation

Washington, DC (Jan 28, 2015)—Many people think that when a corporation pays income taxes they take their revenue, subtract their costs, and are taxed on the remaining profits. In reality, when a business purchases a piece of capital (warehouse, equipment, etc.) they cannot deduct the full cost from their tax liability in the first year, but have to slowly deduct the cost over many years. Correcting this problem and allowing businesses to deduct the full cost in the first year is known as “full expensing”. The current system can be problematic for small businesses who could otherwise use the income saved from full expensing to invest in additional equipment, increase wages, or new workers.

A key provision that helps small businesses cope with the burdens of depreciation is Section 179 of the federal tax code. Under Section 179 and under state provisions linked to it, businesses may deduct up to $500,000 on $2 million of equipment purchases in the first year, with the deduction then phasing out before it is completely removed for businesses with more than $2.5 million in annual equipment expenditures.

However, because this provision is part of the last minute tax extenders bill each year, businesses in 2014 remained uncertain what their tax liability would be until nearly the end of the year.  This retroactive approach undermines the investment incentive Section 179 is supposed to provide.

States also provide expensing allowances, but do not always allow the same amount as the federal code, creating unnecessary complexity. According to the latest report from the nonpartisan Tax Foundation, 12 states are lagging being the rest of the country by offering lower than usual allowances. The study’s key findings

• Forty-five states and the District of Columbia allow first-year expensing of small business capital investment as permitted under Section 179 of the Internal Revenue Code.
• Twelve of those states and the District of Columbia are out of conformity with current federal expensing limits, putting small businesses in their state at a competitive disadvantage. [see map]
• These twelve states include: Arizona, Arkansas, California, Florida, Georgia, Hawaii, Indiana, Kentucky, Maryland, Minnesota, New Hampshire, New Jersey, and the District of Columbia.
• Now that the federal government has offered six-digit Section 179 allowances for more than a decade, holdout states are increasingly looking at raising state deduction limits or pegging them to federal allowances to remain competitive, less complicated, and growth-oriented.

“Raising the expensing limit is both sound tax policy and economically advantageous, enhancing the state’s competitiveness and curtailing a disincentive to economic growth currently embedded in the tax code,” says Tax Foundation Policy Analyst Jared Walczak. “By adopting the federal allowance, coupled with a floor at or above current state limits, states can provide greater certainty for small businesses and help set the stage for additional business expansion and job creation.”

Full report: Consistent and Predictable Business Deductions: State Conformity with Section 179 Deductions