Tax Shields and Depreciation: Is the New Deduction Worth It?

Is Accelerated Depreciation Really a Tax Break? What Business Owners and Buyers Should Know

Governments love giving tax programs exciting names.

Canada's Productivity Mega Deduction and the United States' bonus depreciation rules can make accelerated depreciation sound like free money for business owners.

But there's an important distinction:

Accelerating depreciation generally changes when you receive a tax deduction. It doesn't necessarily create an entirely new deduction.

That timing can still be valuable. But using as much depreciation as possible immediately isn't automatically the smartest decision—especially if you've financed equipment, expect strong future profits, plan to sell your business, or are buying a business through an asset purchase.

Understanding the difference can help you have a much better conversation with your accountant.

 

What Does a Business Tax Write-Off Actually Mean?

Let's start with one of the most common misunderstandings.

A $500,000 write-off does not mean the government gives you $500,000.

You still had to spend the money.

When a business buys a long-lived asset such as a large piece of machinery, the entire purchase price traditionally isn't treated as an expense in the year of purchase.

The equipment is expected to provide value for several years.

Depreciation recognizes the cost of that asset over time as it wears out or is consumed by the business.

Different assets can also have different depreciation rules. Some may use straight-line depreciation, while others may use a declining-balance method or another treatment depending on the applicable tax rules.

How Does Depreciation Create a Tax Shield?

Consider a simplified example.

Suppose a business earns $200,000 and is subject to a 25% tax rate.

Without depreciation, the tax would be $50,000.

Now suppose the company has $50,000 of allowable depreciation.

Taxable income falls from $200,000 to $150,000.

At a 25% tax rate, the tax becomes $37,500.

The $50,000 depreciation deduction therefore reduced the tax bill by $12,500.

That's the tax shield created by depreciation.

Accelerated depreciation changes when you can use that shield.

Is Accelerated Depreciation Really Giving You More Tax Savings?

This is where the distinction becomes important.

Under ordinary depreciation, a $100,000 machine might produce deductions over several years.

Accelerated depreciation may allow the business to recognize much more—or potentially all—of the eligible depreciation earlier.

That can create substantial tax savings in the first year.

But you're also consuming depreciation that otherwise might have been available in future years.

“The tax shield gets consumed early.”
—David C. Barnett

You're changing the timing of the deduction.

That's very different from assuming the government has simply handed the business free money.

Why Might You NOT Want to Accelerate All Your Depreciation?

Getting the tax benefit sooner can certainly be attractive because a dollar today is generally more valuable than a dollar received years from now.

But consider what happens when the asset was financed.

Suppose you purchase a $100,000 machine using $10,000 of your own money and $90,000 of financing.

You accelerate the depreciation and receive a large tax benefit immediately.

Next year, however, you're still making payments on the loan.

The principal portion of those loan payments doesn't generally reduce taxable income. Interest may be deductible, but repaying borrowed principal is different.

Now you could find yourself simultaneously facing:

a tax bill + a loan payment.

“These things need to be planned for. Don't just always take the knee-jerk reaction of trying to pay the least amount all the time.”
—David C. Barnett

The lowest possible tax bill this year isn't necessarily the same thing as the best long-term financial decision.

Think About Future Profitability Too

Depreciation can be valuable in future periods if the business remains profitable.

Suppose you expect earnings to increase significantly.

Preserving depreciation for future years could potentially provide a useful tax shield when the business is producing greater income.

Future tax rates could also change.

Nobody knows with certainty what tax policy will look like years from now.

That's another reason depreciation decisions should be made as part of a broader financial plan rather than automatically choosing whatever creates the lowest tax bill today.

Your accountant can provide much better advice when they understand where you're trying to take the business.

What Does Depreciation Mean When Buying a Business?

Depreciation becomes especially interesting when you're buying a business through an asset sale.

Imagine you're acquiring a business for $1 million.

The transaction consists of:

• $400,000 of equipment

• $500,000 of goodwill

• $100,000 of inventory

You're not simply purchasing one thing called “the business.”

You're purchasing different classes of assets that receive different accounting and tax treatment.

Your opening balance sheet might therefore show the inventory, equipment, goodwill, and any additional operating cash or working capital you contribute.

This matters because accelerated depreciation rules don't necessarily apply equally to every asset category.

Inventory, Equipment and Goodwill Are Different

Inventory is eventually sold and becomes part of the cost of goods sold. It isn't treated the same way as equipment for purposes of the accelerated depreciation concept being discussed.

Equipment is where accelerated depreciation can become particularly relevant.

The buyer may have an opportunity to recognize eligible depreciation earlier rather than spreading it across future periods.

Goodwill is different again.

The transcript explains that accelerated depreciation doesn't apply to goodwill in the same manner as eligible equipment. It also highlights different treatment between the United States and Canada.

This is exactly why buyers shouldn't treat the purchase price as a single number.

Purchase Price Allocation Can Be as Important as Purchase Price

Suppose you agree to pay $1 million for a business.

The next question should be:

What exactly am I paying $1 million for?

How much is being allocated to inventory?

How much to equipment?

How much to goodwill?

Other assets may also be involved.

Those allocations can create different tax consequences for the buyer and seller.

“The allocation of the purchase price in an asset transaction is just as important as the price.”
—David C. Barnett

That's why allocation shouldn't necessarily be left until the end of the transaction.

David's approach is to discuss allocation as part of the offer process, even if an initial allocation needs to remain subject to due diligence.

The allocation also needs to have a reasonable connection to the actual value of the assets.

You can't simply assign arbitrary values to equipment because one allocation produces a more attractive tax result.

Why Buyers and Sellers May Want Different Allocations

The buyer and seller can have competing tax interests.

Consider a seller who previously purchased a $100,000 machine and used accelerated depreciation to reduce its tax basis significantly.

Years later, the machine still has economic value and is being sold as part of the business.

That sale can create tax consequences for the seller related to depreciation previously claimed.

From the buyer's perspective, allocating value to eligible depreciable assets may provide future tax benefits.

That creates another negotiation inside the larger business acquisition.

The purchase price matters.

The composition of that purchase price matters too.

Accelerated Depreciation Can Also Affect Your Future Business Sale

The same issue applies to today's business owner who expects to sell eventually.

Taking the maximum depreciation available today might reduce current taxes.

But if you're planning an eventual asset sale, you should understand what could happen when depreciated equipment is later sold for value.

That doesn't mean accelerated depreciation is inherently a bad strategy.

It means you should understand the entire lifecycle of the decision rather than focusing exclusively on this year's tax return.

Asset Purchases and Share Purchases Are Different

There's one final distinction business buyers need to understand.

This discussion primarily relates to asset purchases.

When you purchase shares or stock of an existing corporation, you're buying the entity that already owns the assets and already has its existing balance sheet.

If that corporation previously claimed depreciation on its equipment, buying its shares doesn't automatically create a fresh depreciation basis for those assets.

That can make the tax consequences of an asset purchase substantially different from those of a share purchase.

It's another reason transaction structure needs to be discussed with qualified accounting and tax advisors before the deal is finalized.

Don't Let the Tax Deduction Make the Business Decision for You

Accelerated depreciation can be useful.

But the headline tax savings shouldn't drive the entire decision.

Ask:

How was the asset financed?

What will loan payments look like in future years?

How profitable do you expect the business to be?

Could preserving deductions provide value later?

Are you planning to sell the business?

If you're acquiring a business, how is the purchase price being allocated?

And most importantly, have you modeled what these decisions could do to future cash flow?

“You need to be informed of these topics so that you can actually have intelligent conversations with your advisors and make a plan.”
—David C. Barnett

The objective isn't simply to minimize this year's tax bill.

It's to make decisions that make sense for the business over time.

Model the Future Cash Flow Before Making the Decision

If you want to better understand how depreciation, taxes, financing, profitability, and other business decisions can affect future cash flow, David's Cash Flow Forecasting and Business Plan Writing Program teaches entrepreneurs how to build a financial forecast from the ground up.

The program is designed for people starting or buying a business or planning a major expansion, with the goal of helping you understand whether the business or deal actually makes financial sense.

Learn more and enroll:
https://bizplanschool.com/

Buying a Business? How to Handle Financing and Due Diligence After Your Offer Is Accepted

 You've found a profitable business, negotiated with the seller, and had your offer accepted.

Now the real work begins.

You need to assemble the money required to complete the acquisition while investigating whether the business is actually what the seller represented it to be.

These two processes—financing and due diligence—can determine whether you close the transaction, renegotiate it, or discover that walking away is the smarter decision.

The important thing is to approach both systematically rather than becoming so excited about owning the business that you stop asking whether the deal still makes sense.

How Is a Small Business Acquisition Usually Financed?

A traditional small-business acquisition can involve three sources of money:

• Your own equity

• Bank financing

• Seller financing

The percentages can vary dramatically depending on the business, its assets and cash flow, the buyer's resources, the lender, and the structure of the transaction.

But buyers sometimes begin their search believing they can avoid putting much of their own money into the transaction by raising capital from outside investors.

That can happen.

It shouldn't automatically be your financing plan.

Can You Use Investors to Fund Your Business Acquisition?

The traditional search fund model involves an entrepreneur raising money from investors to finance the search for a business and eventually fund an acquisition.

You'll also hear the term self-funded search.

Don't let the terminology make this more complicated than necessary.

A self-funded searcher is essentially somebody looking to buy a business without having investors fund the search itself.

The important lesson for individual buyers is that outside capital isn't necessarily as readily available as online discussions can make it appear.

The 2023 Self-Funded Search Study referenced in the source found that 78% of the surveyed deals involved equity from the entrepreneur's personal savings, assets, or net worth. Other deals involved sources including friends and family, high-net-worth individuals, family offices, and private equity or institutional investors.

For most prospective buyers, that reinforces a basic lesson:

If you want to buy a business, building your own financial resources matters.

Build Investor Relationships Before You Need Their Money

If outside equity will be necessary, don't wait until you've signed an LOI to start meeting potential investors.

Start building relationships earlier.

Friends, family, business owners, professionals, and other people within your extended network may eventually become sources of capital—or introduce you to someone who could.

But somebody considering writing a significant check isn't only evaluating the business.

They're evaluating you.

Do they trust you?

Do they believe you understand the industry?

Do they think you're capable of operating the company?

As the saying goes, people do business with people they know, like, and trust.

Those relationships take time to build.

Talk to Lenders Before You Have a Deal

You probably won't receive a final financing commitment without an actual acquisition for the bank to evaluate.

That doesn't mean you should wait until your offer is accepted to meet bankers.

Identify lenders that regularly work with the type and size of business you hope to acquire.

Ask what they finance.

Do they provide acquisition loans? SBA loans in the United States? Equipment financing? Inventory financing? Working-capital lines?

More importantly, build a relationship with the banker.

“The way to approach it is to look at the banker for what they are. Someone trying to make a loan.” David C Barnett

A knowledgeable banker can sometimes identify financing problems before you submit an offer.

They may even suggest small changes to your proposed deal structure that make the acquisition more financeable without significantly changing the economics for you or the seller.

Treat the banker as part of your acquisition team—not an obstacle you're trying to outsmart.

Where Does Seller Financing Fit?

Seller financing can fill part of the gap between your equity and available bank financing.

But don't make your first conversation with the seller about how much money they're willing to lend you.

First investigate the business.

Determine whether you actually want it.

Then structure your offer.

You can even present alternative offers with different amounts of seller financing.

If you're asking the seller to finance a larger portion of the transaction, consider giving them something in return. Perhaps that version of the offer carries a higher overall purchase price or another economic benefit.

Financing terms have value.

Negotiating a business acquisition means recognizing that value on both sides.

What Are the Three Types of Due Diligence When Buying a Business?

Once your offer is accepted, due diligence can be divided into three broad areas:

Financial due diligence, business due diligence, and legal due diligence.

Each answers a different question.

You shouldn't focus exclusively on confirming the financial statements while ignoring how the company actually operates or what legal obligations you're inheriting.

1. Financial Due Diligence: Are the Numbers Real?

Financial due diligence investigates whether the financial information used to make your offer is accurate.

Buyers sometimes hear about getting a Quality of Earnings (QoE) report.

That can be appropriate for larger transactions, but it can also be a significant expense. A buyer purchasing a relatively small Main Street business needs to consider whether the level of financial investigation is proportionate to the transaction.

You may not always need an elaborate report.

You do need competent financial investigation.

An experienced CPA familiar with small-business acquisitions can help you understand what needs to be tested and identify bookkeeping practices that deserve closer examination.

For some businesses, confirming revenue may involve comparing invoices, bank deposits, accounting records, tax returns, and individual jobs.

“It's not hard. It's just work.”

When discrepancies appear, investigate them.

Sometimes there's a perfectly reasonable explanation.

Other times, the discovery gives you grounds to renegotiate—or a reason to walk away.

2. Business Due Diligence: How Does the Company Actually Work?

Financial statements tell you what happened financially.

They don't necessarily explain why it happened.

Business due diligence is about understanding the actual mechanics of the company.

Where do customers come from?

Which relationships matter?

Who generates the sales?

Which employees are critical?

How does work move through the company?

What happens if the owner leaves?

Consider a paint store.

Someone unfamiliar with the industry might see a straightforward retail business serving homeowners. But perhaps 75% of its sales come from professional contractors buying supplies early in the morning.

Suddenly, contractor relationships become an important part of what you're actually buying.

If those relationships are personally connected to the seller, you need to understand what happens when ownership changes.

3. Legal Due Diligence: What Legal Risks Come With the Business?

Legal due diligence is different from having an attorney draft the final purchase agreement.

Your lawyer should also investigate legal matters that could affect the business after acquisition.

That can include:

• Customer and supplier contracts

• Employment matters

• Existing agreements

• Licensing and regulatory requirements

• Litigation or potential disputes

• Privacy documentation

• Assignability of contracts

• Change-of-control provisions

Contract assignability can be particularly important.

Imagine acquiring a janitorial company with a valuable government contract.

If the contract says an asset sale gives the government the right to put the work back out to tender, buying the assets could jeopardize the recurring revenue you're trying to acquire.

A share purchase might produce a different result because the operating entity remains intact.

That's exactly the type of issue legal due diligence should uncover before closing.

Don't Spend All Your Due Diligence Money at Once

The order in which you perform due diligence matters.

If you're going to discover a fatal problem with the business two weeks into your investigation, you'd rather discover it before spending heavily on final legal agreements and other professional work.

Think about the acquisition using the concept of a critical path.

Several workstreams may happen simultaneously, but certain steps depend on others being completed successfully.

Arrange the process so major deal killers can be investigated before unnecessarily expensive closing work begins.

Due diligence isn't simply about discovering information.

It's also about controlling the cost of discovering it.

Keep Asking Whether Buying Still Makes Sense

There is another question buyers should keep in mind throughout due diligence:

Would I be better off starting this business instead?

Maybe the answer is clearly no.

An existing company may have valuable customers, employees, contracts, systems, equipment, reputation, and cash flow that would be difficult or expensive to recreate.

But don't stop asking the question merely because your offer has been accepted.

You may discover outdated processes, expensive legacy systems, weak customer relationships, or other issues that reduce the advantages of acquisition.

Be careful about buyer fever.

Don't become so emotionally attached to completing the deal that you stop objectively evaluating it.

“Does it make sense for me to do this deal?”

That question should remain in the back of your mind until closing.

Having your money safely in the bank while working a job you don't particularly enjoy can still be better than overpaying for a risky business that turns out to be very different from what you expected.

Learn How to Buy a Business the Right Way

If you're serious about buying an existing business, Business Buyer Advantage provides online training, group coaching, and buyer-side analysis services designed to help you understand the acquisition process.

The training includes dedicated due diligence material, while David and the ALP team also offer Buyer Insight Analysis services to help examine specific businesses and formulate potential offers.

Learn more about Business Buyer Advantage:
https://businessbuyeradvantage.com/

Should You Buy a Business with a Partner? (Don't Do It Until You Watch This)

 

Buying a Business With a Partner: The Questions You Need to Answer First

Buying a business with a partner can give you more capital, complementary skills, additional experience and someone to share the workload. But it also adds an entirely new layer of risk and complexity to the acquisition process.

Before you commit money to a deal, you and your prospective partner should be able to answer five important questions:

• Should this person even be your business partner?

• Should ownership really be split 50/50?

• What happens when the business needs more money and only one partner can provide it?

• How will you divide responsibilities, authority and compensation?

• What happens if the partnership eventually stops working?

These questions should be answered before you buy the business—not after problems arise.

1. Should This Person Even Be Your Partner?

Buying a business with another person actually involves three projects at once. You are creating a partnership, searching for and acquiring a business, and designing the future operating relationship between the partners.

As David C. Barnett explains, “A business partnership can be even more involved and laborious than a marriage.”

That means you should first question why you want a partner at all.

Perhaps you need additional money. Could you borrow it instead? Could an investor provide capital without becoming an operating partner?

Maybe you want another person because they possess expertise you lack. Could you hire an employee, consultant or coach instead?

There are legitimate reasons to have a partner. Someone may bring valuable relationships, reputation, specialized skills or experience. But loneliness, fear of responsibility or simply wanting someone else to share the burden are weak foundations for a partnership.

Once you decide a partnership makes sense, look carefully at trust, respect and alignment. Do you both want the same outcome from the business?

One partner may want to rapidly grow and sell the company within three years while the other wants to operate a stable, profitable business for 15 years. Neither objective is necessarily wrong, but combining them in one partnership can create predictable conflict.

2. Should You Really Split the Business 50/50?

Two partners do not automatically mean two equal ownership positions.

As Barnett puts it, “Fifty-fifty does not necessarily equate to a fair deal.”

Consider everything each partner is contributing: cash, labour, expertise, relationships, personal guarantees and financial risk.

Suppose one person provides most of the acquisition capital while the other brings 15 years of industry experience and agrees to manage the company for $50,000 per year instead of the $75,000 market salary. That $25,000 annual wage concession represents a real economic contribution.

Risk matters too.

If both partners personally guarantee a business loan, the guarantee may be joint and several. That doesn't necessarily mean each partner is economically exposed to only half the debt. A partner with significant personal assets may have considerably more at risk if the business fails.

Ownership, compensation, shareholder loans and other financial arrangements can be structured to recognize these differences rather than automatically dividing everything equally.

3. What Happens When the Business Needs More Money?

Sooner or later, many businesses need additional capital.

Before entering a partnership, decide what happens when that moment arrives.

Imagine two partners each own 50%. The company suddenly needs another $100,000, but only one partner can provide the money.

Is the additional $100,000 a shareholder loan? Does that partner receive additional shares? If new shares are issued, does the original 50/50 ownership structure disappear?

These decisions become much harder when the business is already experiencing financial stress.

Barnett recommends what he calls “planning for the next dollar.” Partners should establish the rules governing future capital requirements before the money is actually required.

4. Who Is Actually in Charge?

Ownership and employment are different things.

One partner might own half the company but work only five hours per week. Another might spend 50 hours running daily operations. Compensation for that work should not necessarily correspond to ownership percentages.

Responsibilities and decision-making authority should also be clearly divided.

Otherwise, every decision can become a committee meeting.

“If you have to wait, talk to your partner… you actually become less efficient,” Barnett explains.

One person might control operations while another handles marketing or finance. Each needs enough authority to make decisions within their area without seeking permission for every routine matter.

Even in a 50/50 partnership, someone will normally need to function as president or general manager. At the ownership or board level, both partners can establish strategic direction. Operationally, however, an organization cannot effectively have two people simultaneously acting as the ultimate boss.

5. What Happens When Something Goes Wrong?

Partners naturally concentrate on what happens if everything succeeds.

Good partnership planning also asks what happens when things fail.

What if your partner stops working but still owns their shares?

What happens if one partner becomes incapable of performing their assigned management role?

What happens if one partner dies, becomes disabled or wants to retire ten years before the other?

And what happens when the partners simply can't agree?

These issues become even more complicated when the business partners are married. As Barnett says, “A marriage certificate is not an operational guide for a business.”

Partners should discuss dispute resolution, departures, buyouts, valuation methods, death, disability and eventual exit while everyone is still friendly.

Those decisions should then be documented properly with legal and accounting professionals. A generic boilerplate shareholders agreement may not reflect the economics or realities of your particular business.

The objective is not to predict every future problem. It is to establish enough clarity that problems can be handled without destroying the company.

Ultimately, buying a business with a partner can work extremely well. But the relationship needs to be designed just as carefully as the acquisition itself.

Before committing your money, test the partner, design the economics, define the work, establish the rules and understand how each person eventually gets out.

Those conversations may feel uncomfortable before the deal.

They will be considerably more uncomfortable after it.

Learn more by signing up to our Business Buyer Advantage: Online Training, including the new bonus module at www.BusinessBuyerAdvantage.com