Confused About Capitalization and Safe Harbor
Whenever you spend money on your business, the expense is either deducted on your federal tax return in the year it is incurred or depreciated over time. Here's how to tell what to do.
These are the day-to-day costs of operating your business, such as rent, insurance, maintenance and office supplies. The IRS lets you deduct all these "ordinary and necessary expenses" during the taxable year they are incurred.
Generally, these are payments you make to acquire or improve your building and equipment. These costs, such as upgrading an HVAC system, are considered business investments that add to the value of your asset. Capital costs are depreciated on tax returns over the course of their "useful life" as determined by the IRS. The useful life of a laptop, for instance, is five years, while the useful life of manufacturing equipment is seven years. Under some circumstances, intangible assets such as patents and trademarks are considered capital expenses.
It seems straightforward. But, in fact, determining whether a cost must be capitalized over its useful life isn't as easy as it looks. And, to make accounting even more complex, the IRS has a "de minimis safe harbor election" that lets you deduct costs that you otherwise would be capitalizing, if the expense meets certain criteria and falls under the applicable threshold.
Let's look at that.
The de minimis (Latin for "concerning the smallest things") safe harbor is a yearly tax return election that lets you deduct expenses for tangible property with costs below a certain threshold, if certain criteria are met. Essentially, it gives taxpayers an immediate but limited tax break on items that would otherwise take many years to depreciate.
The IRS has increased the capitalization threshold from $500 to $2,500 for businesses that don't have an audited financial statement. This means that if your small business bought, for example, a computer for $2,499, you might be able to deduct the entire amount on that year's tax return, rather than capitalize the costs and potentially depreciate it over its useful life.
For businesses that maintain “applicable financial statements” (generally, a certified audited financial statement), the threshold continues to be $5,000.
De minimis safe harbor is considered a good thing because taking immediate tax deductions simplifies record keeping and decrease the taxpayers tax burden. It is advisable to have a written policy and procedures in place, as they could help you make the case that you were entitled to make the safe harbor election.
How to make "de maximis" of your de minimis
- Make sure you expense all tangible property costs below your applicable threshold and that the amounts can be substantiated with an invoice.
- Since the de minimis safe harbor threshold can be applied to tangible property purchases below the applicable threshold, make sure your bookkeeping staff has procedures in place to apply the threshold consistently to each qualifying item because the same method of recording the costs must be consistent between the financial statements and the tax return.
- The tax preparer must include an annual election with the filing of the tax return.
Give us a call, and we'll help you set up systems that take advantage of this tax break.