One of the principles underlying the tax rules for deductions is that your income for the year should only be offset by those expenses that contributed to earning that income. Expenses to acquire or improve a business asset that will last longer than a year are not deductible as business expenses.
A capital asset is an asset that benefits your business for more than one year. Most businesses will need capital assets such as equipment, a car, computer and office furniture. Some businesses require capital assets such as land, a building, patents, or franchise rights.
Items that are entirely used up within a year are generally business expenses. For example, a new pizza oven is a capital asset: Paper napkins and cardboard to-go boxes are not capital expenses. The cost of the napkins and boxes can be deducted fully in the year of purchase: The cost of the pizza oven must be recovered over time.
Deciding whether a particular item should properly be classified as a capital expenditure or as a currently deductible expense is not always easy as easy. This is especially true when it is debatable whether the expense represents a repair, or an improvement to a capital asset. However, over time, the IRS and the courts have classified, on a case-by-case basis, some categories of items commonly considered to be capital expenditures.
Warning
The IRS has adopted new rules designed to help classify whether an item is a "repair" which is generally deductible in the year it is made, or an "improvement" that must be added to the property's basis and deducted over a period of years. These rules are exceedingly complex! If you are making substantial repairs or improvements to your property, you will want to consult your accountant before you begin. Not only are the rules convoluted and intricate, the ramifications can be significant--triggering accounting method changes and amended returns. Getting advice before proceeding could save you accounting fees--and tax dollars--in the long-run.
The following list of items that the IRS or the courts have determined to be capital expenditures under certain circumstances may assist you with your deduct-or-capitalize analysis.
Remember that an item is a deductible expense for one taxpayer might be a capital expenditure to another. This is because the deduct-or-capitalize question does not just involve what was purchased, but also whether its benefits will be expected to last for more than one year. If two taxpayers use an identical item in different ways in their businesses, the item may represent a capital expenditure to one, but a currently deductible expense to the other.
Note that many of these must be reconsidered in light of the "repair regs" that are discussed below. It can not be stressed enough: Working with your accountant is critical.
- abstracts of title costs
- appraisal costs paid in obtaining possession of premises
- author's publishing costs
- boiler patching and welding costs
- burglar alarm installation charges
- business facility improvement costs (for example: waterproofing; replacing a roof; planning, designing, and constructing an addition; remodeling costs)
- cable replacement costs upon sudden failure
- copyright development costs
- credit card, membership fees
- display cases, remodeling costs
- drainage costs electric wiring, costs (new wiring, replacement, and rearrangement)
- electrical system replacement costs Federal Communications Commission (FCC) license preparation fees
- fire escapes, costs of cutting exits to, costs of new
- flood protection costs (such as costs of raising floors, or rearranging bins)
- insulation costs
- irrigation system costs
- merger negotiation costs
- mutual fund setup costs incurred by investment advisors
- ·office, cost of changing location and equipment
- package design costs
- performance bond premiums
- Security Exchange and Commission (SEC) statement preparation cost
- settlement costs for threatened lawsuit
- well (water) costs
- zoning change costs that increase the value of property beyond the tax year
Guidelines for classifying expenses
The classification of an expense as a repair or as an improvement will have a dramatically different impact on your tax liability. A repair or routine maintenance to a capital asset, such as an office building or equipment, may be a business expense that is fully deductible in the year that you incur the costs. In contrast, an improvement to that asset is considered a capital expenditure.
You can not deduct the entire cost of an improvement in the year it was made. Instead, you depreciate the property, deducting a portion of the cost over the life of the improvement. Capitalization is required for both direct and indirect costs, including removal costs involved. This true even if the indirect cost might otherwise be deductible as a repair cost.
Example
Daniel Driver is the owner-operator of a petroleum hauling truck. Driver replaces the tank on the trailer. The cost of the tank must be capitalized because it is a major component of the trailer. He also has his logo painted on the side of the new tank. Although painting a logo would normally be considered a deductible expense, this cost must also be capitalized because it is incurred as part of the tank replacement.
Improvements Come in Three Flavors: Betterments, Restorations and Adaptations. The basic rule is simple to state: If what you do betters, restores or adapts a unit of property to another use, then you have made an improvement. There are three categories of expenses that are considered to be improvements:
- Betterments. A betterment changes the existing condition of the unit of property for the better. An expenses is a betterment if it does one or more of the following:
- Cures a material condition or defect in the unit of property. (Installing a backflow prevention system would be a betterment. Installing new water taps would not.)
- Enlarges or expands the unit of property.
- Materially increases its capacity, productivity, output, efficiency, strength, or quality. (Replacing damaged panels in a drop-down acoustical ceiling in not a betterment. Replacing the girders to enable the floor above to support 50 percent more weight is a betterment.)
- Restorations. A restoration brings the condition of property back to what is once was. Specifically, a restoration:
- Replaces a major component or a substantial structural part of a unit of property. (A load-bearing wall is a substantial structural part of a building, but a drop-down acoustical ceiling is not.)
- Returns to its ordinary operating condition, property that is in despair and is no longer functional (Shoring up the wall of badly deteriorated building is returning it to its original condition.) Rebuilds a fully depreciated unit of property to a like-new condition.
- Replaces a component of the property if you had either sold the component or deducted a loss (other than a casualty loss) for that component.
- Adaptations. An adaptation converts an existing unit of property to a new or different use.
Whether an expense betters/improves, or simply repairs/maintains, the unit of property turns on all the facts and circumstances surrounding the expense. Factors taken into consideration include:
- The purpose of the expenditure;
- The physical nature of the work performed;
- The effect of the expenditure on the unit of property; and
- The treatment of the expenditure on the taxpayer's applicable financial statement.
What is a unit of property and why should you care?
IRS regulations require that you evaluate whether an expense is a repair or improvement with respect to a specific unit of property-which may not conform to the commonsense view of a unit of property. A unit of property is considered to be composed of all the functionally interdependent components necessary for the property to function. (Special rules, discussed below, apply to buildings, plant property and network assets.)
If you cannot place one component into service without placing the other components of the property into service, then those components are functionally interdependent. For example, a car is a unit of property because it is composed of functionally interdependent components, while a computer and a printer are two separate units of property.
Work Smart
Unless specific rules apply, which is the case with buildings, you will want to define the unit of property to be the largest unit possible. The larger a unit, the more likely your action will be considered to be a repair, rather than a betterment, restoration or adaptation of the property. Take the car mentioned above, if you defined the windshield as a unit of property, then replacing the windshield would be an improvement and the cost could not be deducted all at once. However, if the entire car is the unit of property, then replacing a windshield is much more likely to be a repair.
Beware: Buildings are actually multiple units of property
If you own a building, you already are aware that there are numerous systems within that building, such as the plumbing system and the heating system. For purposes of determining whether an expense or a repair, each of those systems is considered a unit of property. So, you have the building structure as one unit of property that contains the following distinct units of property:
- Heating, ventilation, and air conditioning (HVAC) systems. This includes all motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators.
- Plumbing systems. This means all pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment. It also includes any site utility equipment that is used to distribute water and waste to and from the property line and between buildings and other permanent structures.
- Electrical systems. Included are wiring, outlets, junction boxes, lighting fixtures and associated connectors. As with plumbing, this also includes any site utility equipment used to distribute electricity from property line to and between buildings and other permanent structures.
- Gas distribution systems. As with other utility systems, this includes the pipes and equipment used to distribute gas to and from property line and between buildings or permanent structures
- Elevators. All elevators in the same building are treated as a single building system or unit of property. In effect, each separate elevator is a component (part) of the elevator building system.
- Escalators. Just like elevators, all the escalators in a building are considered a unit of property.
- Fire protection and alarm systems. This includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers, hoses); and
- Security systems. Among the components included are window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit).
You need to test whether the costs you incurred bettered, restored or adapted the particular system, not the impact on the building as a whole.
When you purchase a building, the building structure and all of the various building systems are depreciated as a unified whole based upon the cost of a building. However, this scheme is radically altered when a building system is replaced or when improvements are made to it. In that case, the cost of the improvement is separately depreciated using the modified cost recovery system (MACRS) periods that applies to the building.
Warning
You will need to consult a tax professional if you previously deducted costs that are considered improvements to a building system under the regulations or if you have capitalized costs that are now considered to be repairs. In this case, you will need to file for an accounting method change so that you can capitalize the previously deducted repair costs.
There will be an adjustment (called a Section 481(a) adjustment) to take into account the difference between the amount you claimed as a repair expense deduction and the amount of depreciation that you would have been able to claim if the costs had been capitalized.
Manufacturers need to consider plant property rules
If you own a manufacturing plant, in addition to worrying about the units of property in your building and your building systems, you need to determine the units of property used in your production processes. If property is used in an industrial process, there is a caveat added to the standard definition of a unit of property. As noted earlier, a unit of property generally consists of all the functionally interdependent component parts of a piece of property. However, special rules apply if that property is used in an industrial process.
Examples of an industrial process most likely to concern small business owners include:
- manufacturing,
- warehousing,
- distribution, and
- automated materials handling in service industries.
If the property is used an industrial process, the unit of property is subdivided into those components that perform a discrete and major function or operation. This means that each assembly line is likely to have multiple of units of plant property. If the equipment is not used in an industrial process, then it does not have to be treated as multiple units of property based upon the major functions it performs.
Example
Example 1. Tortillas de Todo el Mundo is a tortilla manufacturing company. At the plant, there is a tortilla manufacturing line that transforms flour and water into tortillas, which are then packaged and transported to supermarkets. The line consists of machines that mix the dough, machines the extrude it and cut it into the correct portions, machines that flatten the dough, ovens that cook the dough, conveyor belts the transport the baked tortilla to the packaging equipment.
The initial unit of property is the entire line-from start to finish-because each component is interdependent. However, because this is an industrial process, the plant property rule is triggered. Each component performs a discrete and major function within the line. As a result Tortilla de Todo el Mundo must treat each stage in the process (mixing, segmenting, flattening, baking, etc.) as a separate unit of property.
Example 2.Tortillas de Wauconda is a retail restaurant that prides itself on the freshest and most authentic Mexican food in the area. Customers enjoy watching the restaurant prepare its own tortillas on a single piece of equipment that transforms a ball of dough into a flat and perfectly cooked tortilla before their eyes. All the components of the tortilla making machine are interdependent; therefore, the machine is considered a unit of property.
Because Tortillas de Wauconda is a restaurant and the machine performs a small-scale function within the restaurant, its use is not considered an industrial process. Therefore, Tortillas de Wauconda does not have to deal with the plant property rules that would require the equipment to be further divided into separate units of property.
As you can see, expenses to acquire or improve a business asset that will last longer than a year are not deductible as business expenses.
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