Deciding whether to expense or capitalize fixed assets is one of the most difficult concepts for owners to grasp when tax planning for business.
For purchases that are clearly fixed assets, such as a company vehicle or new computer, the answer is simple - but what if you need a printer to go with that computer? Should that be expensed or capitalized? It’s easy to see how the rules get complicated quickly.
Accounting standards used by professional accounting and tax services further muddy the waters. They tell us how to capitalize a fixed asset but fail to provide much guidance regarding which exact purchases qualify to be capitalized and how to depreciate these assets properly when you do.
Don’t worry. As a business accounting firm that deals with this question all the time, the experts at BGW CPA PLLC are here to help.
In this post, we’ll explain exactly what capitalization is, why companies do it, and how to develop a capitalization strategy for your business that leads to positive outcomes when it comes time for business tax prep.
Understanding Capitalization for Business Tax Planning
To capitalize an asset is to put it on your balance sheet instead of “expensing" it. The idea is to spread the expense out over time instead of recording the full cost against the current income statement.
Here’s how it works:
Say you spend $1,000 on a piece of equipment. If you expense the equipment today, the full $1,000 is reported immediately against your current income. However, if you list the equipment on your balance sheet as an asset worth $1,000, then you can amortize (depreciate) the asset over its useful life, taking a depreciation expense each year. This reduces the balance-sheet value of the asset each year by the amount of the expense.
This relates to business tax planning and preparation because it allows your company to spread out the cost of the asset and avoid drastic impacts to the income statement during the period when the asset was purchased.
But for a purchase to qualify for this treatment, it must be a fixed asset.
Fixed Assets as Defined by Business Audit Firms
Fixed assets are those that are used by a company for business operations and cannot include inventory for resale or repair or spare parts inventory. Fixed assets are typically expensive and a good rule of thumb is to remember that an item can never be capitalized unless its useful life exceeds the minimum of one year. Additionally, fixed assets are generally thought to be items that are new or replacement in nature, rather than for the repair of an item.
Examples of fixed assets include:
- Purchase price of the item and related taxes
- Construction cost of the item, which can include labor and employee benefits
- Import duties
- Inbound freight and handling
- Interest costs incurred during the period required to bring an asset to the condition and location necessary for
- its intended use
- Site preparation
- Installation and assembly
- Asset startup testing
- Professional fees
- The cost of major periodic replacements (e.g., a new roof)
Writing Your Capitalization Policy following Business CPA Services Guidance
It's a smart idea for your business to adopt its own customized fixed asset capitalization policy to serve as a guide for determining the level at which expenditures should be capitalized. Such a policy is also helpful in the construction of a capital asset budget for future periods by identifying which items should be capitalized. Most importantly, a written capitalization policy helps to maintain consistency and provides a defense to be presented by an auditing service firm in the event of a financial audit.
Issues to consider include:
- Size of your business
- Use of your customary capital items
- Level of revenues and expenses
- Compliance needs for tax depreciation report and property tax (if applicable)
Most professional accounting services suggest that organizations set minimum purchase thresholds for an item to be considered a fixed asset. The purpose of the capitalization threshold is to prevent the business from placing immaterial expenses on the balance sheet instead of recognizing them as an expense in the period incurred.
Determining the right capitalization threshold for your business can be tricky, as there is no set or commonly agreed-upon value. While the Internal Revenue Service indicates that most items with a useful life of more than one year should be capitalized, this doesn’t necessarily mean that the printer mentioned above should be capitalized and depreciated over the next five years.
To determine when to expense and when to capitalize, consider both the de minimus rule and the useful economic life.
- The de minimis rule allows you to expense any item that may potentially be capitalized so long as said expense (or the sum of related expenses) does not significantly distort your bottom line. In other words, these expenses cannot make up a large percentage of your total expenses, subsequently providing you with an extraordinarily low income. A strong metric to follow is that the sum of the expenses should be less than 0.1% of your gross receipts for the year, and/or 2% of your total depreciation and amortization expense for the year.
- Any item that will retain no value after 12 months may be expensed. Do note that the IRS may frown upon deductions that appear to take advantage of end-of-year timing. If you incur an expense in December and then consume the item in January, you may need to argue that the deduction did not distort your bottom line in order to take it.
Ask BGW CPA for Clarification
While setting a capitalization threshold and following the de minimus rule and useful economic life guidelines are helpful, deciding whether to expense or capitalize certain expenses can be tricky. As a full-service accounting firm, we can both advise you on when it is appropriate to capitalize and show you how the decision to do so will affect your financial position. Contact us today to get help writing your company’s unique capitalization policy.
