Small businesses and self-employed individuals can use tax deductions to reduce the amount of tax they owe each year. One of the often-misunderstood tax provisions is how to recognize expenses related to tangible property due to the multi-faceted way these expenses are treated under the tax law.
Deductions and Taxes
Most business expenses are deductible on a company's tax return which can reduce the amount of tax owed by the company. Although most business expenses are deductible when purchased or incurred, tax law has long required you to determine whether expenditures, related to tangible property, are currently deductible (in the year of purchase) or if they are capital expenditures (deductible through various years).
According to Section 263(a) of the Internal Revenue Code (“IRC”), the Internal Revenue Service (“IRS”) requires you to capitalize the costs of acquiring, producing, and improving tangible property, regardless of the size or the cost incurred. There are two questions that come from this:
- What is tangible property?
- Are there any exceptions to capitalizing tangible property from Section 263(a)?
Understanding Tangible Property
Tangible property is the physical assets that a business purchases, such as furniture, office equipment, machinery, or buildings (it excludes Material and Supplies and Inventory which are accounted for differently). Any costs of acquiring, producing, and improving tangible property would be considered as a capital expenditure and therefore deducted over a certain number of years which is determined by IRS regulations.
Although the acquisition of tangible property is easier to determine (think of a Table or an Office Chair), the production or repairing of tangible property might be a little trickier which we have summarized below:
Repair vs Improvement of Tangible Property
What is considered a repair or an improvement to tangible property? A repair is an expense that is necessary to restore property to its original condition. If that expense does not increase the value of the property or substantially prolong its useful life, then it can be claimed as a deduction in the year incurred.
On the other hand, if the expense adds to the value of the property, greatly extends its useful life, restores a unit of property (like a replacement of a major component) or changes the property's nature, then it can be considered a capitalizable improvement.
Production of Tangible Property
We won’t go in depth, as this can be quite a lengthy topic, but there are various costs that can be associated to the production of tangible property. The easiest example to illustrate this would be the construction of a building. There are both direct costs, like purchasing and installing windows in a building, to indirect costs like the labor involved, or equipment used, in producing the tangible property.
As such, these direct and indirect costs are allocable as being capitalized as part of the tangible property.
Now that we have a clearer understanding of what tangible property is, and some of the intricacies related to it, what are the exceptions to capitalizing tangible property and deduct expenses in the current year?
Safe Harbor exceptions to Section 263(a)
There are three main exceptions from capitalizing tangible property and deducting them during the year that they were paid or incurred. These are the De Minimis Safe Harbor Exception, the Safe Harbor Election for Small Taxpayers, and the Safe Harbor for Routine Maintenance.
De Minimis Safe Harbor Exception
The safe harbor deduction for small businesses allows businesses to deduct, and not capitalize, the cost of acquiring, producing, or improving tangible property that would otherwise need to be capitalized (up to $2,500 for each item). This saves small businesses the trouble of tracking low-value items and complying with complicated depreciation rules.
If a taxpayer has an Applicable Financial Statement (AFS), then the amount increases to $5,000 for each item, however not many small businesses have one.
This safe harbor exception is a yearly election that has to be included in a statement on your tax return.
Safe Harbor Election for Small Taxpayers
Under this Safe Harbor Election, you are not required to capitalize as an improvement, and therefore may be permitted to deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements, or similar costs, that fall into the safe harbor election for small taxpayers.
To qualify for the safe harbor, the company would have to fit within the 3 criteria established by the IRS which are based on gross receipts, the unadjusted basis of owned or leased building and the limitation on total amount spent activities during the year (per applicable property).
They would then have to make a yearly election that has to be included in a statement on your tax return.
Safe Harbor for Routine Maintenance
Under this Safe Harbor, you are not required to capitalize as an improvement amounts that meet all 4 criteria established by the IRS which are based on whether the expense is based on recurring activities, resulted from the use of the property in your trade or business, is to keep the property in its ordinary efficient operating condition and reasonably expect, at the time the property is placed in service, to perform the activities in the future.
Generally, there is no requirement to make an election for this Safe Harbor, however there might be a requirement to file Form 3115 (Changes in Accounting Methods) depending on your situation.
For small businesses and self-employed individuals, it can be a challenge to navigate tax codes while frequently being swamped with responsibilities. The tangible property rules are quite detailed and can be daunting, especially when trying to figure out all of its intricacies, the criteria you have to fit within to qualify for the Safe Harbor Exceptions and the procedures to elect these exceptions.
We always advise speaking with a knowledgeable tax professional, such as our firm, to diminish the risk of being in non-compliance, avoid penalties and interest on unpaid taxes, and ensure that the correct procedures are being followed.