Comment by crimsonpowder 7 days ago
I don't understand the reasoning behind this, however. Why depreciate anything over multiple years vs just deducting it in the current year? Does it not all come out to the same amount to the IRS in the end?
> In other words, the IRS receives more upfront but less total in the end.
Assuming positive inflation, the IRS receives more total, because the taxes they get paid now are worth more than the same amount of dollars they give back in later years. And if the company goes out of business, the IRS never has to give those taxes back.
The tax code strives to minimize distortions (except insofar as they are deliberately introduced). That is, it seeks to minimize how much the existence of the income tax changes people’s economic conduct.
To minimize distortion, the income tax must accurately compute “income”—the actual increase in wealth. Depreciation is part of that. To compute income, the net increase in wealth, you need to subtract costs from revenue. When you buy an asset, your wealth doesn’t immediately increase or decrease—it simply changes form (from cash to an asset). The actual cost is the depreciation on the asset, which occurs over time.
Say you buy a delivery vehicle for $50,000. In the first year, you make $100,000 in revenue and have $20,000 in operating expenses. What’s your income after one year—the actual change in wealth? You have $80,000 in cash after operating expenses, plus a vehicle that you can sell for maybe $40,000. So you have $100,000+$40,000 in cash and assets in minus $20,000+$50,000 in cash and assets out, for a $70,000 increase in wealth.
Calculated another way, you have $100,000 in revenue-$20,000 in operating expenses-$10,000 in depreciation = $70,000 in income. Now, over say 5 years, you’ll depreciate the full $50,000 cost, and the total dollar amount the IRS gets will be the same. But it will get more taxes in the first year, which due to the time value of money is worth more than getting the money in subsequent years.
For clear, fixed assets this is a quite reasonable approach, although in some categories the depreciation rate isn't an accurate model of reality.
The problem is those of us who deal with code only rarely are actually just building a vehicle. It's an ongoing activity that more resembles maintenance than the outright purchase of an asset.
Look at how much software is going to a subscription model. That only makes sense if there is ongoing improvement to the software.
The usual thinking is that a business wants an asset’s upfront expense spread over the years that asset earns income to reduce taxable profit in future years. In other words, the IRS receives more upfront but less total in the end.
The problem is that R&D and software development behave more like recurring annual expenses, not upfront investments in something like a building or industrial equipment. Small VC-funded startups may not exist long enough to reap the long-term benefits of depreciation.