According to the IRS, business expenses are the costs of carrying on a trade or business. And business expenses are generally deductible in the period in which they are incurred. However, there are some expenses that a business incurs that are not immediately deductible. They are typically expenses for items that have a useful life of more than one year or take more than one year to use up or consume. These items are referred to as assets (also called fixed assets or capital assets). And the accounting procedure used to handle these transactions is called capitalizing.
What is Capitalizing?
To capitalize, or capitalizing, is an accounting method used to delay the recognition of an expense by recording it as an asset in the company’s books. In general, capitalizing expenses is good for a company that is spending large amounts of money to purchase new assets with long-term lifespans because the costs can be spread out over a longer period of time thus lessening the immediate negative impact on net income.
Both Generally Accepted Accounting Principles and IRS regulations require a business to capitalize rather than expense or deduct the cost of an asset when it is purchased. Your business then expenses or deducts the amount that was spent on the asset by taking a depreciation expense each year over the life time of the asset.
What is Depreciation?
Depreciation is the method by which the cost of an asset is expensed over time. Depreciation reduces the value of the asset and reduces taxable income for a business. It is considered a non-cash expense because it is only an accounting entry; the cash was already spent when the asset was purchased.
Depreciation is calculated based on the original cost of the item, including the cost of acquiring the asset, transporting it, and setting it up, less any anticipated scrap or salvage value. This amount is then divided over the number of years of useful life of the item. The most common method is straight line depreciation where the same amount is expensed each year. Other methods include double-declining balance and sum-of-the-years’-digits.
What Should I Capitalize and When?
For accounting purposes, it is the company that decides which items will be expensed and which will be capitalized. This decision can be based on the type of item, its cost relative to the overall expenses of the company, how it will be used and, it’s anticipated useful life. Once the decision is made to capitalize an item, it is then management who decides the method and rate of depreciation that will be used, the useful life of the asset and any salvage or scrap value it may have at the end of its useful life.
For tax purposes, the IRS has established specific guidelines for determining what assets can and cannot be capitalized and the method of depreciation that is used. Thus, the amount of depreciation that is calculated for accounting purposes is most often very different from the amount that appears on the company’s tax return.
However, the IRS’s guidelines say nothing about the dollar value of an asset that must be capitalized. While many larger firms establish a policy of expensing assets under a certain value, IRS guidelines have no such capitalization threshold. So, technically, any asset purchased must be capitalized. And all assets capitalized are done so in the period in which they are acquired.
IRS Guidelines
Therefore, as a small business owner, I would suggest that you defer to a tax basis for capitalizing assets and use the IRS’s guidelines. In general, there are three types of costs that are capitalized:
- Business start-up costs
- Business assets
- Improvements
Business start-up costs are those costs that you incur before you actually begin your business. They can include expenses for advertising, travel, licenses or wages for training employees. Business assets, as mentioned above, are those items that have a useful life of more than one year. They include buildings, vehicles, machinery and equipment, computers and, office furniture and fixtures. A business asset must also:
- Be property that you own
- Be used in your business or income-producing activity, and
- Have a determinable useful life
Improvements are generally major expenditures that add to the value of the asset. The improvements lengthen the time an asset can be used, like a new roof or new electric wiring in a building, or adapt it to a different use, such as converting a manufacturing building to an office building. Also, the costs of reconditioning, improving, or altering a property to make it suitable for your business (known as leasehold improvements) are also capital expenditures. The costs of repairs that keep the asset in a normal efficient operating condition, however, are deductible expenses.
One caveat to the capitalization rule involves tools. Amounts spent for tools that are used in your business can be deducted as a business expense in the period in which they are acquired if they have a life expectancy of less than one year or their cost is minor (e.g. less than $300).
If your business is profitable at the end of the year, you may be able to take an accelerated or special deprecation deduction that will allow you to expense some or all of the assets that you purchased and just capitalized. Be sure to check with your tax accountant.
Setting a Capitalizing Policy
Many larger companies establish a general policy of expensing all assets under a certain dollar value such as $500 or $1000. They do this because they purchase a lot of assets every year and because the likelihood of their qualifying for an accelerated depreciation deduction is very high. But because the IRS does not have a stated capitalization threshold, a company should be diligent in officially establishing a policy if they decide to. Make sure that your capitalizing policy makes sense and is not arbitrary. That it is in writing, has been approved via a meeting of the board of directors or all owners or members, and that the approval has been documented with a corporate resolution.
Improperly expensing assets that should be capitalized can wind up being a very costly mistake. When in doubt, consult your tax advisor.