Many businesses are uncertain how to account for costs to acquire, produce or improve property, plant and equipment. So, in 2013 the IRS issued regulations on capitalizing versus deducting the costs of tangible personal property. In 2014, the IRS added rules covering dispositions of tangible property.
On November 24, the IRS announced an increase in the de minimis safe harbor for some small businesses (see right-hand box) that will make it easier to deduct items like tablets and smartphones. As a result, taxpayers will be able to immediately deduct many purchases that would otherwise need to be spread over a period of years through annual depreciation deductions. Here’s more on this potential tax savings opportunity for small businesses.
Two Options for Reporting Fixed Assets
When deciding how to handle tangible property costs, businesses generally have two options:
Deduct now. Internal Revenue Code Section 162 allows you to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including the costs of certain supplies, repairs and maintenance.
In addition, businesses can deduct materials and supplies that cost $200 or less to acquire or produce under Section 162, as well as incidental repairs and routine building maintenance, including costs to inspect, clean, test and replace parts.
Capitalize and depreciate later. Section 263 requires you to capitalize amounts paid to acquire, produce or improve tangible property. Capitalized costs are generally not deducted in the current tax year; they’re depreciated over their economic useful lives.
Under Section 263, however, you must generally capitalize improvements that:
- Add to the value, or substantially prolong the useful life, of your property, or
- Adapt the property to a new or different use.
The decision to expense or capitalize an item is just a matter of timing. You will pay the same taxes over the life of the asset, regardless of how you classify the costs, as long as tax rates and laws remain consistent. If you expect higher tax rates or more restrictive tax laws in the future, you might prefer to capitalize costs to reduce taxable income in future periods.
Some items are easily classified as a deductible business expense (such as a box of staples) or a capital expenditure (such as a new forklift). Others fall in the gray area between Sections 162 and 263. The final repairs refine and clarify those gray areas, as well as provide various de minimis “safe harbors.”
Safe Harbor for Companies with Audited Financial Statements
As an alternative to the general capitalization rule, the final regs permit businesses to elect to expense their outlays for “de minimis” business expenses. The IRS permits certain taxpayers to deduct tangible property they acquire or produce, if the total cost per item (or invoice) is $5,000 or less. To qualify for this safe harbor, you must:
- Prepare an “applicable financial statement.” That is, a certified audited financial statement or a financial statement filed with a state or local government.
- Possess a written accounting procedure at the beginning of the tax year for expensing property under a specified dollar amount.
- Expense the cost on your applicable financial statement, not just your tax return.
The de minimis safe harbor also applies to property with an economic useful life of 12 months or less as long as the item doesn’t cost more than $5,000 per item (or per invoice).
Updated Safe Harbor for “Small” Taxpayers
However, small business taxpayers without applicable (audited) financial statements will be subject to a new $2,500 capitalization threshold (up from $500). Tangible property costs below this amount are generally considered to be ordinary and necessary business expenses and, therefore, not treated as capital expenditures under the final repair regs.
“We received many thoughtful comments from taxpayers, their representatives and the professional tax community. This important step simplifies taxes for small businesses, easing the recordkeeping and paperwork burden on small business owners and their tax preparers,” said IRS Commissioner John Koskinen.
Since February, the IRS received more than 150 letters from businesses and their representatives requesting an increase in the threshold. Many of those commenting noted that the cost of many commonly expensed items — such as tablet-style personal computers, smart phones, and machinery and equipment parts — surpass the $500 threshold.
As before, businesses can still claim otherwise deductible repair and maintenance costs, even if they exceed the $2,500 threshold. In addition, the existence of the de minimis safe harbor doesn’t mean that a taxpayer cannot establish a de minimis deduction threshold in excess of the safe harbor amount, provided the taxpayer can demonstrate that a higher threshold clearly reflects the taxpayer’s income.
The new $2,500 threshold takes effect starting with tax year 2016. In addition, the IRS will provide audit protection to eligible businesses by not challenging use of the new $2,500 threshold in tax years prior to 2016.
Updating Your Company’s Capitalization Policies
In light of IRS Notice 2015-82, it’s easier than ever before for a qualifying small business to deduct tangible personal property costs under the de minimis safe harbor. Before filing your 2015 federal tax review, update your company’s tangible property capitalization policies for the increased safe harbor threshold. Doing so could result in potential tax savings opportunities.
This brief article merely scratches the surface of this complex topic. Contact your tax adviser for more information. He or she can help evaluate the decision to deduct or capitalize tangible property costs and ensure compliance with the latest IRS regulations and procedures.
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