Depreciation

Definitions: Depreciation is a noncash expense that reduces an asset’s value as a result of wear and tear, age, or obsolescence. Most assets lose their value over time (in other words, they "depreciate") and must be replaced once the end of their useful life is reached. There are several accounting methods that are used to write off an asset's depreciable cost over its useful life. Because depreciation is a non-cash expense, it lowers the self-employed person’s reported earnings while increasing free cash flow.

A non-cash expense is one that reduces current income on paper (tax returns, financial statements, etc.) but does not necessarily represent actual cash flow.

Example: If a father is a professional photographer who buys a large piece of equipment for developing photographs costing $20,000, it is a "capital asset" with a useful life or more than one year. Therefore, instead of reducing his income from self-employment by $20,000 in the year that the equipment is purchased, the photographer must depreciate the asset, deducting only a portion of the cost each year the equipment will be in use. Perhaps the photographer will deduct $4,000 each year for five years.

The depreciation deduction is the same amount, regardless how the equipment purchase was financed. If the photographer used $20,000 of his $120,000 net income from the current year to buy the equipment outright, or, if he financed the equipment with a loan paid over 15 years, the depreciation deduction is the same.

In summary, for this year, the photographer’s business otherwise netted $120,000 and, although he spent $20,000 of those profits on the new business equipment, his tax return and financial statements will reflect net income of $116,000 computed as follow:

How the Court Views Depreciation: When the photographer computes his income for guideline child support computations, there are several ways the Court can treat his depreciation:

• No Allowance for Deprecation — The most common method is to compute the photographer's income irrespective of capital asset purchases. No allowance is made for the capital asset purchase or depreciation, and guideline support is computed on $120,000 of annual income.

• Depreciation as a Reduction to Income — The least common method is to utilize depreciation as computed under the Internal Revenue Code and GAAP to determine the amount of a parent’s income for computing guideline support.

Arguments in support and in opposition to each method:

• No Allowance for Deprecation — Ignoring depreciation in computing support makes sense when the deduction truly is a noncash expense. An example is the depreciation of real estate improvements. Central Coast real estate values have not declined for some years, even though, for tax purposes and under GAAP, depreciation expense is not only allowable, but a mandated deduction under most circumstances.

However, in a business, such as the photographer’s, the equipment purchases represent real dollars actually spent on business assets that will enhance income production. If the equipment will be substantially valueless at the end of five years, (due to wear and tear or rapidly changing technology) the photographer would be given no deduction for the purchase price. He would not be allowed to deduct the cost when he paid for the equipment; he would not be allowed to deduct the cost over the equipment’s estimated useful life; and he would not be allowed to deduct the cost when he replaces the now useless equipment with new, state-of-the-art equipment.

Using this method forces the photographer to pay support on income that he does not actually receive, because his actual income is decreased by the cost to buy or finance the photography equipment.

• Actual Cash Flow — Looking only to cash flow allows the photographer to deduct the money he actually spends. This seems fair and may be easy to compute, depending on the photographer's financing arrangements.

If the photographer buys the equipment for cash, his $20,000 deduction is straight forward. However, he may, instead, finance the equipment. Then, each year, the actual cash pay down could be deducted from his net income. On the other hand, he may choose to finance other items at the same time he acquires the equipment, or consolidate business loans midway through the financing period. Under these circumstances, the actual cash pay down on the equipment would be much more difficult to compute.

Another problem with a strict cash flow analysis is that the photographer can "skew" his income. In the year child support is being computed, he can choose to deplete his working cash to buy equipment. This acquisition reduces his income and his child support obligation, and it will give the photographer a bonus in later years due to prepayment of expenses.

• Depreciation as a Reduction to Income — Using actual depreciation gives the photographer credit for the actual expense paid without giving him the power to depress income for the computation of support. This is a simple answer that may not be so simple in practice.

There are several depreciation methods sanctioned by the IRS that may or may not also be acceptable under GAAP. The IRS allows "accelerated depreciation" under some circumstances, allowing the equipment’s entire cost to be deducted in the year of acquisition. If this option is selected, the Court will need to examine the purchase and depreciation method’s unique impact on the photographer’s net income when computing guideline support.

Summary: Determining a self-employed parent’s income for support computations is always a challenge. The Court, the self-employed parent's lawyer, and the other parent's lawyer, must carefully review self-employment records and tax returns to confirm that gross income is properly included and that expenses are truly business related. In addition, each must consider the impact of capital asset acquisitions, and the resulting change to net income to be used to compute guideline support.