by Trent Krassow
We get asked fairly often, “Can I deduct this if I spend the money this year?” And of course, the answer is always, “It depends!” If you haven’t noticed or haven’t had reason to notice, the US tax code is riddled with carve-outs, exceptions, and exceptions to the exceptions. So, if you are unsure of whether something should be deducted (expensed) or capitalized, it is best to ask your tax pro. I will attempt here to provide a basic outline of some of the different cases of when to expense vs. capitalize, but as always, this is general information and should not be seen as advice specific to your situation.
First, let’s clear up what is meant by “expense vs. capitalize.” In the tax world, “expensing” refers to deducting the whole cost of something this year, whereas “capitalizing” means spreading the expense over many years, depending on what you bought. Thus, when you expense, you get a bigger deduction this year (but nothing in future years), and when you capitalize, you get a partial deduction this year, and another partial deduction next year and the year after, and so on, depending on the “life” of the asset (how long you spread it out – for example, a 3-year asset that costs $30,000 might produce $10,000 of deduction in each of three years).
There are two general concepts we can apply in determining whether a business expenditure should be expensed in the current year or capitalized for the long term. Generally speaking, an expenditure should be capitalized if:
1. If the expenditure is part of creating an asset with benefit “substantially” beyond the current tax year,
OR
2. The immediate recognition of the full expenditure as a current year expense would create an unnatural distortion of financial results (including for tax purposes).
The objective is to match the expenditures to the revenue the asset in question is supposed to help generate. For example, buying a factory to make widgets may produce revenue this year, but usually the goal is for this factory to continue producing revenue for many more years, and a company usually does not “replace” its factory every year. Because the asset produces revenue over many years, the idea is that the expense of that asset should also be spread over many years – or capitalized (in this case, depreciated).
We also want to avoid timing distortions. Using the factory example above, suppose this company has the following revenue and expenses:
Revenue: $100 million
Expenses: $ 80 million
Net Income: $ 20 million
In this case, the purchase of a $90 million factory would greatly distort the financials in the year of purchase if we simply expensed that purchase. Rather, we would spread that expense over a number of years, since it will be used over a number of years, and not all at once. This, of course, is a very simplified example, and even here there are exceptions, nuances, etc. Some of this likely would be expensed in the current year, so there is, in reality, some level of distortion that we as a society have agreed to accept.
As we look at exceptions to the above concept, it is important to remember that there are exceptions for when to capitalize, and there are also “exceptions” to what most people would intuitively expense. There are also exceptions to the exceptions! Here some exceptions that allow expensing when you might otherwise think to capitalize:
1. The benefit goes beyond the current year, but not “substantially so”. For example, if your business makes an expenditure that will provide benefit for the current year plus a few months into the next year, there is likely a good case to expense this.
While the official guidance on this topic is somewhat scarce, the general thought amongst tax commentators and practitioners is that 12 months beyond the end of the current year is generally not considered “substantially” beyond the current year.
The example that comes to mind here is prepaid expenses. For example, a farmer might buy 12-13 months of feed in November because he was able to secure a good price, or a company may prepay a year of insurance premiums. In either case, these expenditures could likely be expensed in the current year if the taxpayer in question files on the cash basis.
Another example might be small assets that are “consumable” and under commercial use may only reasonably be expected to provide a useful life only slightly beyond a year – small tools might be an example.
2. The law also provides an exception to capitalization requirements if allocating costs to different assets over different periods would be administratively burdensome. In other words, if it is too much a pain in the neck to keep track, you might not have to capitalize!
But be careful, here! Just because you think something is a pain in the neck, doesn’t mean the IRS will agree. Here is where we have to use the “reasonable person” criteria: if this would be too much work for most companies, you can probably expense. If everybody else has a system and you’re the only business that can’t figure it out, probably not.
Here is a simple example: Suppose that as part of your company culture, your team members boisterously greet customers and visitors as they come through your door. The greeting generally creates a chuckle with visitors to your business, and in so doing, builds goodwill – an intangible, capitalizable asset. Consistently carried out, this probably creates benefits beyond the current year. There is certainly not an expectation that you will parse out the payroll expenses involved in this routine greeting and add those expenses to the asset called “Goodwill”, and amortize accordingly. Rather, you simply expense the payroll as a current operating expense – it would simply be too cumbersome for most businesses to figure out this allocation on a daily basis.
On the other hand, payroll expense that is clearly tied to the production of a specific asset should be allocated to that asset. For example, payroll costs for employees directly involved in constructing a new facility should generally be allocated to that specific asset and capitalized accordingly.
3. Recurring expenses would generally be expensed, even if those recurring expenses build an asset, such as goodwill. For example, our boisterous greeting, even if not already exempt due to the tediousness of breaking it out, would be exempt due to the recurring nature of that expense.
Another example, here, is advertising – advertising builds goodwill for both the current and likely, future years, but is considered an operating expense due to its recurring nature. Note that this exception is pretty narrow because most recurring expenses by very nature do not create an asset, so probably wouldn’t be capitalized anyway.
However, within certain industries, this might be more applicable than in most: drug companies advertising specific products over an extended period of time, book publishers continuously advertising titles available, the ongoing cost of expert contributors to reference materials, etc. (there is actually a court case for this involving Encyclopedia Britannica here)
4. And then, of course, there are the non-conceptual carve-outs provided directly by the tax code, namely Section 179 and bonus depreciation, which allow expenditures for certain types of assets to be fully expensed and deducted immediately (or quickly). Interestingly, Section 179 was actually added to the tax code specifically to simplify the compliance for smaller asset purchases and alleviate the administrative burden taxpayers faced in record-keeping for such assets.
After the 9/11 terrorist attacks on the United States, Congress expanded the provisions of Section 179 deductions to encourage investment and spending by small businesses on larger assets. Of course, after a few years of enjoying those benefits, taxpayers became pretty accustomed to the ability to deduct certain large purchases immediately, rather than capitalizing them, and once taxpayers get used to such a benefit, it becomes very difficult for Congress to take those benefits away, so Section 179 has remained a pretty big pool of benefits for smaller businesses throughout the country.
So what is Section 179? Without getting into the nitty-gritty on Section 179 (we’ll do that, just not here), the general idea is that business personal property can often be immediately expensed, even if that asset will provide benefit beyond the current year (not the personal property you use for your personal life, but rather the personal property you use for business purposes). Where does Section 179 apply? Pretty much any tangible personal property, such as equipment, vehicles, etc. that are specifically for business purposes. Where does it not apply? Intangible property (goodwill, copyrights, patents, trademarks, and other intangibles) and real property – that is, real estate.
That last category creates a lot of opportunity for both confusion and careful planning. Land can neither be expensed currently nor depreciated – it is like a “saved up” expense that is not recognized until that land is sold in the future. Making sure your allocation of the value of land compared to a building is correct and defensible is therefore very important - the dirt under a building used for business in California has a very different value than the dirt under an identical building in Oklahoma.
But what about the stuff on the land – buildings, other structures, and improvements to the property? These items are generally capitalizable, and therefore depreciated over time rather than expensed all at once. But is it “fair” to treat carpet that wears out in a few years the same as a structure that lasts decades? Wouldn’t some of the “stuff” in a building be personal property if isn’t nailed down?
All of these questions opened the door for cost segregation studies for real property, as taxpayers tried to untangle real estate from the stuff that comes with real estate, obviously seeking to accelerate that depreciation. Cost segregation is a technical matter beyond the scope of this article and will be addressed in future posts on this site.
For simplicity, however, we can generally state that the “normal” parts of a building are treated as real property. The guiding principle on subsequent expenditures for components of real estate (absent an appropriate cost segregation study) becomes repair vs. replace or improve. This again gets really complicated, but the way too simplistic way to look at it is that if you “improve” the property or extend the useful life of a major component of that property, this is a capital expense. If you merely “repair” that component, it is an expense in the current year. The line between these is sometimes fuzzy, so be sure to document your expenditures in this area very carefully and seek guidance where appropriate.
Some items which many people naturally would expense are surprisingly subject to capitalization. For example, the expense of acquiring a property is actually part of the property for tax purposes, as are the costs of disposing of an asset. For example, if you pay a fee to a broker to secure a long term asset, the fee paid to that broker becomes part of the asset – you capitalize that expenditure, rather than expensing in the current year. The exception here is again if you have a recurring fee arrangement with that broker and the fee is not allocable to specific assets – such a recurring, non-allocable fee would generally be expensible if the business is continuously acquiring new assets and no part of the fee is contingent upon acquisition of specific assets. Most businesses do not have such an arrangement, so this exception is rarely invoked.
Another expenditure commonly thought to be immediately deductible is that of start-up costs for a new business. Start-up costs are considered a capital expenditure, but once again, there is an exception: in most cases, a company can immediately expense up to $5,000 of start-up expenses if:
a) The total of such expenses do not exceed $50,000, and
b) The business holds itself out for business in the same tax year in which that $5,000 expense was incurred.
Once the cumulative start-up expense exceeds $50,000, the amount that can be currently deducted is reduced dollar for dollar. For example, if the total expenditure is $51,000, the amount currently deductible is reduced by $1,000. After $55,000 total, the whole thing becomes capitalizable.
Perfecting a title or right of claim to an asset after you own it is another area where people sometimes get surprised at tax time. Suppose you own business property, and a dispute arises due to somebody else laying claim to a portion of the property – encroachment. For example, suppose the business next door completes a fancy remodel, and constructs a patio eating area, part of which is actually on your property. You are forced to hire an attorney to push your neighbor back behind his own property line. Your costs associated with this action are not immediately deductible but instead are added to your basis in the property. You did not “buy” an asset – you were merely defending a previously acquired asset. Nonetheless, the IRS contends that this is not an operating expense.
A similar situation can arise with a company fending off a hostile takeover. The company is forced to hire legions of attorneys and specialists to keep the potential takeover at bay. Are these expenses deductible? The IRS and Supreme Court both say no. Again, even though there is no real asset, this is considered an abnormal expenditure, the deduction of which would distort the financial results (and tax liability.)
Cost of goods sold, while not technically a “capital asset”, follows similar logic. The idea is that this the “basis” in the items sold. Thus, purchases of inventory or the production cost of inventory is recognized when those products are sold, so there could still be a delay in your ability to deduct that expense, depending on how quickly you turn your inventory.
When to deduct an expense doesn’t always follow what might be common sense to many business owners. Furthermore, since there may also be some legal discretion as to when to actually incur or recognize certain expenses, this can have enormous tax implications.
For example, accelerating a planned purchase to a higher profit or higher tax year may make that deduction worth more than if the expense was incurred in a different tax period. Due to rules about expensing vs. capitalizing business start-up costs, some entrepreneurs may change their plans as to just how perfect those plans need to be prior to launch. Below are some links to IRS resources on this topic – you’ll want a cup of something strong for some of this! You can also feel free to contact us if you have questions about your business expenses, incurred or planned – we would love to help!
Publication 946 How to Depreciate Property
Publication 527 Residential Rental Property
Audit Technique Guide for Cost Segregation (in other words, what the IRS looks for when auditing a return that has utilized a cost segregation study to accelerate depreciation on certain types of property.)