Is Electing Bonus Depreciation in a year with a Net Operating Loss a Good Idea?

When purchasing fixed assets like a machine or tractor for a business utilizing IRC Section 168(k) Bonus Depreciation is a great way to reduce taxable income. One problem with taking advantage of this deduction is that not all states conform with federal tax laws. For example, Delaware accepts bonus depreciation while Pennsylvania does not.  In addition, several other states like Ohio and North Carolina have complex laws requiring add-backs that some widely used software packages may not track accurately.  In these cases spreadsheets are used with supporting PDF attachments made to the respective state returns to prevent unwelcome future notices.

Ohio specifically has some special rules that out-of-state preparers/professionals/taxpayers need to be aware of.  While the 5/6 rule, where Ohio requires a business to deduct bonus depreciation over 6 years, is well known there is also a 3 year rule that gets little attention. This rule rewards businesses who increase their Ohio employer payroll withholding by at least 10% from the previous year by allowing them to use a 3 year recovery period instead of 6.

While the 6 year rule and the 3 year rule are great, a problem arises when the business has a Net Operating Loss on page 1 of the federal tax return (including an NOL created by electing Section 168(k) on the current year federal return), NOL carryback or NOL carryforward.  In this case, Ohio DOES NOT ALLOW a deduction for bonus depreciation in that tax year.  Ohio not only requires the entire bonus depreciation amount to be added-back and carried-forward to the next year but prior year 1/6 & 1/3 allocations are also DISALLOWED and must be carried forward to the next year.  If the business has three consecutive years of NOLs, then the disallowed bonus depreciation will be carried forward unused until the federal return has taxable income.  The good news is that Ohio allows a business to deduct all unused disallowed bonus depreciation in the year federal taxable income occurs.   

For example, XYZ Company who did not qualify for the 3 year rule had the following activity:

XYZ Company elected to take Bonus depreciation under Section 168(k) as follows:

As a result of the Net Operating Loss on the federal return, XYZ must add-back the entire bonus depreciation amount of $6,000 and $12,000 in years 20x1 & 20x2. In addition, in year 20x2, the expected bonus depreciation allocation is also disallowed even though it normally would be deducted in the that year.  

In year 20x3, the company had federal taxable income thus allowing it to utilize disallowed Ohio depreciation from the two previous years.  In this case, XYZ would deduct 3/6 or $3,000 of Year 20x1 Depreciation, 2/6 or $4,000 of Year 20x2 depreciation and the normal 1/6 ($500) of now current year 3’s bonus depreciation. The permitted $7,500 bonus deduction should be supported with an attachment to the Ohio tax return to avoid a potential notice.

Is it worth taking advantage of Section 168(k) Bonus Depreciation in a year of an NOL?  Depending on how big the potential deduction is, electing out of Section 168(k) could reduce the size of the NOL in the current year while allowing for additional deductions in future years. The bonus addback for “non-conforming” states would also not be necessary in that tax year. Finally, in a tax year where the bonus deduction causes an NOL, electing out of all or part of it to create federal taxable income would prevent prior year bonus deduction allocations (as stated above) from being disallowed in the current year.  

In the end, in a tax year where there is a Net Operating Loss at the federal level it is important to consider the big picture when considering whether or not to elect Section 168(k).  Every taxpayer’s situation is different.  It is important to consider how this matter effects the state returns being filed to gain the greatest tax savings while avoiding future surprise notices and potential penalties.