Business owners often think that if they pay money for anything that is business related it’s a business expense; while this is often true, sometimes it’s not. If the expenditure falls under a different IRS definition it could cause different deductability rules and limits to be applicable. Therefore, putting the business owner at risk of an audit do to over stating business expenses. This may result in unnecessary penalties and interest along with an increase in tax liability for the year in question.
Prevent that from happening to your business by understanding the difference of these expenditures.
IRS Definitions:
Expenses:
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.
It is important to separate business expenses from the following expenses:
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The expenses used to figure the cost of goods sold (COGS),
- See IRS explanations for more information on COGS.
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Capital Expenses (Assets), and
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Personal Expenses.
Capital Expenses:
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses. Capital expenses are considered assets in your business. In general, there are three types of costs you capitalize.
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Business start-up costs (See the note below)
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Business assets
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Improvements
Note: You can elect to deduct or amortize certain business start-up costs. Refer to chapters 7 and 8 of Publication 535, Business Expenses. Also, capital assets generally get depreciated over their useful life instead of deducting them in full in the year of purchase. Capital assets may qualify for preferential deductability if they qualify for Sec. 179 or Bonus depreciation.
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Review of Tax Reform Impact on Asset Depreciation:
- The Tax reform doubled Section 179 expensing limit to $1 Mill and increased the phaseout limit to $2.5 Mill.
- The bonus depreciation was also doubled to 100% and now includes used assets as qualified assets.
- Effective for assets purchased and placed in services after Sep. 27, 2017 through Jan. 1, 2023.
Does this affect Business record keeping and reporting?
YES, General business expenses and Assets are reported completely differently on the tax return. But, most importantly the way they are reported may yield a different deduction for the current years tax return. Further, it is also required to keep record of the assets the company has on its books, and later report to the IRS when those assets are sold or otherwise disposed of. There is none such requirement for expenses.
Are there any exceptions?
YES, like always: for every general rule, generally there is an exception. Capital expenditures may qualify for the De minimis safe harbor election to be treated as expenses instead of capital assets up to a certain dollar amount per asset or invoice, if qualifications are met.
For more information see:
The materials posted in this article are for informational purposes only and should not be regarded as accounting or tax advice provided by YR Tax Compliance LLC. These materials have been prepared by professionals, however they should not replace professional services, and the user should seek advice before acting on any information presented. Every situation is uniquely different, and could make a world of difference on implementation of specific regulations. YR TAX Compliance LLC assumes no obligation to provide notification of changes of tax laws, regulations or other factors that could affect the information posted.