Friday, December 26, 2014

Shame on Ford (misleading mailing)

It's that time of year, again, when you get tax statements.  What better way to slip one under the radar than to send an advertisement as a tax statement?  Click to enlarge.

Ford should be ashamed of itself.  A recent mailing (above) is sent out in an envelope that is formatted to look like a year-end tax statement.  As a Ford Shareholder, I have gotten these in the past (1099-DIV).  So I open the envelope.

It ain't a tax statement.

Instead, it is an ad for Ford, suggesting that I buy a new Ford and then write-off the cost on this year's taxes.  For me, that would be sure aduit-bait of the first order.  Kind of sleazy, Ford giving tax advice to sell cars.  I wonder how many people will get in trouble over this.

The kicker is, if the vehicle has over 6,000 lbs gross vehicle weight, you can "expense" the cost over one year, as opposed to "depreciating" the expense over a number of years.   So instead of a string of little deductions for a few years, you get one big deduction for one year.   And this is why BMW designed the X6 with a 6,000 lbs gross vehicle weight rating.  The first car designed with the IRS code as its technical specification!

Now, as I noted before you cannot deduct your way to wealth.  Yes, you can buy  a car and deduct the purchase price (if it is used SOLELY for business) from your gross income - if you run a business, that is, and you need a vehicle for that business.   If you work at a "job" then no go.

And while this might reduce your tax burden, it is hardly like getting a free car.   Your taxes may be reduced by the amount of your marginal rate, times the price of the car.

Plebes at "jobs" like to toss around terms like "write-off" without knowing what it means.  For example, there would be some sort of waste at the company, and Johnny Lunchbucket (who caused the waste) would say, "Well, they can just write it off!" like the company somehow makes money form his idiotic mistakes.

It doesn't.  It merely doesn't have to pay taxes on them.

And the same is true for cars and trucks used in the business.  Yes, they are a deduction.  No, you don't make money on deductions - they are expenses.

Some folks think that since a vehicle is a deduction for their business, you should buy or lease a new one every two or three years.  After all, you'll get a deduction on your taxes!

But financially, that makes no sense.  Let's crank some numbers to find out why.

Joe runs a plumbing company (which is him and one assistant) and he has a van he paid $25,000 for, new.  Now regardless of whether he depreciates the vehicle over several years or writes-off the cost in one year, the net effect is that he gets a deduction in his taxes equal to the cost of the van.

So let's say in scenario #1 he keeps the van for three years and then buys (or leases) a new one.  The analysis for leasing is really the same as buying (as a lease really is a purchase) except that the costs are higher.  Let's assume his marginal tax rate (combined State & Federal Income) is 30%.  He saves $7500 on his taxes by deducting the cost of the van (it really isn't a "savings" though - it is just not being taxed on what is an expense).

Coincidentally, using the 50% depreciation for every 5 years rule, his van depreciates by $7500 after three years.  If he sells the van now, he'll get about $17,500 for it.   Now if we assume that the cost of a new van is the same, the total cost of depreciation over six years is $15,000.

Now, let's assume that he decides to keep the van for six years instead.  The tax deduction is the same, but now the van is worth maybe $11,000.   The cost of depreciation over six years is $14,000 - a savings of about $1,000.  Now at first glance, you might think, "Gee, he would come out ahead buying a new van every three years - with two $7500 deductions, that's $15,000 right there - and it cancels out the depreciation!"

And you'd be wrong.  You'd probably be confused by the "missing dollar puzzle" as well.  The solution to that problem is very simple.  The reason why it seems a puzzle is how they present the data.

And the same thing happens here.  By presenting a "deduction" as a profit or some sort of income, it makes it seem like, well, you can deduct your way to wealth.  But like I said, a deduction is merely not paying taxes on your expenses.  And increasing your expenses is not going to make you a profit.

Let's assume Joe make $100,000 a year, which is a nice round number, and his plumbing truck is his only expense.  And let's assume the flat-taxers have won, and Joe's 30% marginal rate applied to his whole tax burden - to make the math easier.

In Scenario #1, he buys two vans over six years, and deducts $50,000 (the cost of his vans) from his income, minus the resale value) or $25,000 (when you fully depreciate or deduct the cost of an asset, you have to add back in the resale value).   So his net taxable income over six years is as follows:

Income:   $600,000
Cost of Van #1:  -$25,000
Resale of Van #1: +$17,500
Cost of Van #2:  -$25,000
Resale of Van #2: +17,500
Net taxable income:  $585,000
Total Tax @30%:  175,500
Net income after taxes: $409,500

In Scenario #2, the situation would be as follows:

Income:   $600,000
Cost of Van #1:  -$25,000
Resale of Van #1: +$11,500
Net taxable income:  $586.500
Total Tax @30%:  175,950
Net income after taxes:  $410,550 

As you can see, when you look at the overall income, Joe comes out ahead by keeping the van longer, as his net after-tax income goes up even as his taxes go up as well.

Now, of course, this does not take into account a number of factors.  For example, after three years, Joe's van may need new tires or other repairs, which may wipe out the cost savings.

And then there is tax bracket.   I am assuming here that the deductions are not large enough to put Joe in a lower bracket.   That would affect the calculations as well.

And then there are more esoteric things like convenience.  Joe is "on call" 24 hours a day for plumbing emergencies.   If his van breaks down, or is in the shop, that is time away from his calls and lost income (as well as lost reputation).   He may decide, rationally, that it makes more sense for him to buy a new van every few years so that he is insured of reliability of the equipment - and he may decide, rationally, that this trade-off is worth the extra cost.

Of course, the resale numbers here are conjecture.  As a commercial van that is used heavily, it may not yield $17,500 in resale value - and the savings maybe far more than the $1050 shown above.  And more likely, a heavy-duty van would likely cost more than $25,000.  A larger truck might cost $50,000 or more, and this would put a real dent in Joe's income, which means less net take-home income for him, even if he gets to drive a shiny new truck all the time.

And of course, if we go to replacing the vehicles every two years the situation gets even worse.

And there are, of course, other games people play with automotive deductions - legally or illegally.   For example, if you are a Real Estate Agent, you may be tempted to deduct the cost of a car as a "business expense" as you need it to show houses (and it has to be a Mercedes or other luxury car, of course!).   But if you use the car for personal use, that may not be an allowable deduction (and you could be audited).

Rather than trade-in their used vehicle, some sell it to a friend or family member for a reduced price (again, more audit bait).

Others may choose to use their personal car, and then deduct a fixed amount for mileage, which for 2014 is 56 cents a mile.   If Joe drives 15,000 miles a year (the national average) he may be able to deduct $8400 per year for the use of the van.  Using this number, keeping the van longer makes more financial sense.

Over six years, at 15,000 miles, he could deduct $50,400 in automobile expenses.   This would, however, have to cover his gasoline, repairs, registration, and the like.  But the amount of deduction would not depend on the resale value of the van - or its purchase price.   He could buy a used van and deduct it by mileage and get the same number as for a new van.

Let's assume the van gets 20 mpg and gas is $4 a gallon - that yields $3000 a year in fuel costs.  Assume repairs,etc.  average $500 a year.     That means fuel and repairs come to $21,000 over six years.  That leaves a deduction of $29,400 which is more  than the purchase price of the van, new.

In this scenario, Joe could come out ahead, particularly if he took good care of his van.   The mileage deduction works better if you have fewer repairs and expenses, and use less gas.  It also works better when you have a cheaper vehicle.   Obviously, Joe would come out behind, if he was buying a $50,000 van instead.

Deducting based on mileage has one other advantage:  You can use a vehicle for both personal and business use.  And for a self-employed person, this often makes more sense.   Rather than try to keep track of oil change costs and how much gas you put into your car, you can just keep a log of how many miles you've driven for business, and then simply deduct this from your income instead.

For me, this is not an issue. I don't need a vehicle exclusively for my business, so I cannot legally deduct such a vehicle from my taxes.  However, I do take the 56 cents a mile deduction for trips to visit clients, or to visit the Patent Office, or even to buy office supplies or to visit the post office.   It is a lot easier and less hassle (and less audit bait) to do it this way.   But then again, I'm not a plumber, like Joe.