Businesses are always in constant search of novel ways to increase tax savings and maximize their overall profit. Hence, it is important for companies to understand the tax amortization benefit, its principle, and how to utilize it to bring about a total turnaround in their cash flow.
Tax amortization involves spreading the cost of an intangible asset over a period of time, and the savings that come from it are known as amortization benefits. However, you can only amortize intangible assets like copyrights, patents, goodwill, trademarks, etc. and spread their cost within their estimated useful lifespan. Although amortized assets have several advantages, there are also lots of limitations that must be taken into consideration before amortizing an asset.
What is the Tax Amortization Benefit?
The tax amortization benefit, or TAB, is a tax advantage that arises from spreading the cost of a non-physical asset over a certain period of time. It is the process of spreading the cost of an intangible asset over its useful lifespan.
Unlike immediate expenses, where the full cost of an asset is deducted in the year it was acquired, amortization of certain expenditures allows businesses to spread the cost of such assets over time, thereby maximizing their profit within the useful lifespan of such assets.
The intangible asset that can be amortized include copyrights, patents, goodwill, trademarks, etc.
Major Components of Tax Amortization Benefit
There are three major components of the tax amortization benefit, they are:
1. Intangible Assets
One of the major components of TAB is intangible assets. Intangible assets are non-physical assets that have a useful lifespan without a finite life. Examples of intangible assets that can be amortized include:
- Patents
- Copyrights
- Trademarks
- Goodwill
These assets have long-term benefits, but they do not have a physical presence. What happens is that the cost of acquiring this intangible asset is spread over the useful lifespan of such an asset.
2. Amortization Period
Another component of the tax amortization benefit is the amortization period. It is the duration within which the cost of an intangible asset is spread. This period is determined based on the estimated useful life of the asset, which is an assessment of the duration for which the said asset is expected to provide economic benefits.
The Internal Revenue Service (IRS) provides comprehensive guidelines and rules regulating the allowable amortization duration for different kinds of intangible assets. So, if you want to know the amortization period of your intangible asset, you can check the IRS website.
3.Tax Deductions
The last component of TAB is a tax deduction. Tax amortization benefits result in tax deductions for the intended business. What happens is that the amortized amount is deducted from the said business’s taxable income annually during the asset’s amortization period.
When these taxable incomes are deducted, it reduces the overall tax that the business is supposed to pay, thereby leading to a reduced income tax. The savings made from the tax deduction will now contribute to the overall profit that the business will make.
Importance of Tax Amortization Benefit
From our discussion so far, you can agree with me that tax amortization has numerous benefits, whose importance is outlined below:
1. Cash Flow Management
One of the major advantages of the tax amortization benefit is that it impacts cash flow positively. When businesses spread the cost of their intangible assets over time, it will definitely lessen the financial burden associated with large capital expenditures, thereby leading to seamless cash flow in the business. This, in turn, allows businesses to manage their finances with ease.
2. Encouraging more Investment in Intangibles
Since intangibles are an essential part of any business, tax amortization serves as an inducement for businesses to invest more in their intangible assets. So, by allowing businesses to spread the cost of such assets over time, businesses will see it as an incentive to acquire more of them. Once a business invests more in intangibles, it is going to lead to innovation, research and development, and, above all, the acquisition of intellectual property.
3. Financial Statement Presentation
Another important aspect of tax amortization can be seen during the presentation of the financial statement. Although to ordinary businessmen, this may sound less important, from an accounting perspective, amortization expense is recorded as a non-cash charge on the income statement, hence reducing the overall reported earnings.
On this basis, the overall accumulated amortization can reflect on the balance sheet, hence providing shareholder/stakeholders in the business with insights into the remaining worth of the non-physical asset.
Drawbacks, Limitations and Considerations of Tax Amortization Benefit
While tax amortization offers lots of advantages, when amortizing your intangible assets, it is important to take into consideration the drawbacks and limitations that may come with such an action. Some of the considerations to look out for when amortizing your asset include:
1. Asset Recoverability
One of the considerations that businesses should look out for when amortizing their intangible assets is assessing their recoverability. This is vital because if the value of an asset diminishes, there is every need for such a company to adjust their amortization schedule to reflect the present reality.
If the company fails to adjust their amortization schedule when their intangible asset reduces, it may lead to overestimating the asset’s worth, which would invariably lead to overstating the tax benefits associated with such amortization.
2. Changing Tax Regulations
Since tax laws and regulations are liable to change over time, it is important for businesses to stay updated during their asset amortization period to make necessary adjustments when needed. If there are alterations in the tax regulations, it is going to definitely affect the tax amortization benefit. So, it is vital for companies to stay informed about any modifications in tax codes that may affect their amortized assets to enable them to adjust accordingly.
It is important for companies to adapt to any changes in the tax code to maximize the tax benefit that comes with amortization.
3. Legal and Compliance Considerations
Another consideration that should be considered when amortizing an asset is legal compliance.
So, when amortizing your intangible asset, it is important to look into the legal and regulatory requirements of such amortization to ensure that they comply strictly with the established rules and regulations that guide intangible asset amortization.
If a company fails to comply with asset amortization rules, they may be charged fees for defaulting, and it may also attract other legal consequences. Hence, it is best for companies to ensure that their amortization practices align with applicable laws and regulations.
Real-World Examples of Tax Amortization Benefit
For the sake of clarity, we are going to illustrate the typical example of where tax amortization benefits are applied in real business life.
Let’s assume a technology company acquires a patent for invention purposes. And the cost of the patent is $1 million, while its estimated useful life is 10 years. Instead of deducting the $1 million in that particular year of acquisition, the company can decide to amortize the cost for over ten years, which will lead to a yearly tax deduction of $100, 000.
Now, if the company’s corporate tax rate is 25%, the company would be able to save $25,000 from tax annually due to the tax amortization benefit. So, if you multiply the $25,000 by ten years, the company would have saved $250,000 from the amortized asset taxable income.
The illustration above shows how tax amortization can have a positive impact on the company’s overall finances within a specified period of time.
