Amortization vs. depreciation: what's the difference?

If you run a small business or startup, you know you're responsible for more than most people realize.

Managing payroll, dealing with vendors, and keeping customers satisfied can leave little time to thoroughly review the tax code. However, it's crucial to understand some foundational concepts, especially ones that could save you money and protect you from expensive errors. Recognizing the difference between amortization and depreciation is vital for any business owner.

These two concepts are similar and serve related purposes, but they apply to different aspects of your business. Calculating them incorrectly could lead to issues with the IRS.

Understanding the importance of amortization and depreciation

Amortization and depreciation both help you account for the cost of assets over time. Instead of writing off a $25,000 purchase all at once, you spread that deduction out over several years. This provides a more accurate picture of your business's true performance.

It also ensures compliance with tax regulations. The IRS generally doesn't allow expensing large capital purchases in one year unless specific criteria are met or special rules like Bonus Depreciation or Section 179 apply. The concepts of depreciation and amortization can be confusing, so let's explore each in more detail.

What is depreciation?

Depreciation applies to physical items your business owns, referred to as "assets". These are tangible things like vehicles, equipment, buildings, and even office furniture.

Consider a scenario where you purchase a delivery van for your company. You won't deduct the full cost in the first year. Instead, you'll write off a portion each year over its useful life. Most small businesses use the Modified Accelerated Cost Recovery System (MACRS), which allows you to deduct more in the early years, benefiting cash flow.

Options like Section 179 and bonus depreciation can accelerate this process even further. However, selecting the best approach requires a solid understanding of your business goals and financial situation.

What is amortization?

Amortization is for intangible assets. These are items your business owns that have value but no physical form, such as patents, trademarks, customer lists, or goodwill paid when acquiring another company.

You may also amortize legal and organizational costs, like the expenses incurred when setting up your business. The IRS typically requires these to be written off evenly over fifteen years, with no shortcuts or accelerated deductions. Business owners often look to accelerate amortized assets, but current tax law doesn't allow it.

While depreciation often front-loads the write-offs, amortization follows a straight-line method, meaning the same deduction every year until the value is fully accounted for.

The common mistakes

This is where many business owners encounter issues. They attempt to depreciate something that should be amortized or expense an item that should be capitalized and written off over time.

A typical mistake is someone buying a business and trying to deduct the goodwill immediately, which is not allowed. Goodwill is an intangible asset that must be amortized over fifteen years.

Another common issue is not properly tracking and classifying startup costs. These might seem like small amounts initially, but they add up over time. If you don't record them correctly, you could miss out on valuable deductions.

Why strategy matters with amortization and depreciation

Amortization and depreciation aren't just accounting rules; they're tax strategy and planning tools. Used correctly, they can reduce your tax bill and improve cash flow. Used incorrectly, they can cause financial issues and even attract IRS attention.

If you plan to buy equipment, your accountant or tax strategist can help determine if it makes sense to use Section 179 or spread the deduction out. If you're acquiring another company, they can help you evaluate the impact of amortizing intangible assets on your long-term profits.

Factors like timing, asset type, and your growth plans all influence the best approach, as these decisions are unique to each business.

What you should do right now

Start by reviewing your current asset list to ensure tangible and intangible items are properly categorized. If anything is missing, contact your accountant to correct it. If tax returns have been filed incorrectly, the IRS has a streamlined process to catch up or fix missed amortization or depreciation.

Next, look at your upcoming purchases. If you plan to buy new equipment, vehicles, or software, discuss the best way to handle the deductions with your tax advisor or accountant.

Finally, review your startup and legal costs. If you invested money to get your business started, you may still be able to capture some of those expenses through amortization if you haven't already.

Final thoughts

The difference between amortization and depreciation may seem like a technical detail, but it's a detail that matters for small business owners. It impacts your taxes, cash flow, and long-term financial strategy.

The decision to accelerate certain depreciation deductions is often nuanced, while amortization will always be a straight-line deduction.

Regardless of your situation, as a business owner, you should work with your accountants year-round to ensure you're maximizing these cost recovery benefits.