While capital and repair expenditures have been long recognized in both the accounting and tax area, deciding whether to capitalize or expense fixed asset-related expenditures still causes significant issues for the rest of us.
All companies utilize fixed asset to run businesses they make, therefore the decision whether to expense or capitalize fixed asset-related expenditure is critical and always happened in any companies—big and small—along the operation.
In the accounting area, the right decision is needed in the aim of pursuing the matching principle—expenses should well match revenues being generated for the period. For example: a small manufacturer, in 2011, spent $15K to upgrade a machine in its production line. Average annual expense for the manufacturer is only $30K to generate revenue of $40K, annually. If the manufacturer expensed all the 15K for the 2011, total expense would be $45 while the revenue stayed the same, $40K—which were unmatched.
While the accounting principle behaves rather flexible—small businesses (particularly private ones) may or may not follow the accounting principle, the tax law behave more strict—there has been a deduction limitation, by the tax law, that prohibits a taxpayer from deducting amounts paid for certain fixed asset-related expenditures. Current tax law, IRS’s Section 263(a) reads that it:
(1) provides that no deduction shall be allowed for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
(2) prohibits a deduction for amounts expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.
According the regulation, capitalization is the proper treatment for expenditures incurred in new construction. Capitalization is also generally required for additions to existing buildings or for installations of material components to buildings or equipment.
Treas. Reg. § 1.263(a)-1(b) clearly provides that:
Capital expenditures include amounts paid or incurred to (1) add to the value, or substantially prolong the useful life of property owned by the taxpayer, such as plant or equipment or (2) adapt property to a new or different use.
Section 162 provides a deduction for all ordinary and necessary business expenses paid or incurred during the taxable year in carrying on a trade or business.
Treas. Reg. § 1.162-4 provides that the cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted. However, this regulation also provides that repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the useful life of the property, shall either be capitalized and depreciated or charged against the depreciation reserve.
Quiet often, new additions are made to already existing property. These additions are not replacement components nor are they repairs to property, but are instead newly installed components. These additions are required to be capitalized (§ 1245 and § 1250 property.)
At other times, replacement parts or components are added. For example, a car’s engine is worn out and replaced. This replacement returns the car back to its condition prior to the deterioration of the part. It would be logical to consider this replacement as an increase to the car’s value resulting in capitalization. Conversely, it would also make sense to say that by returning the car back to its prior condition, it had been repaired. Under this theory, all repairs would be deductible under § 162(a), no matter how substantial they might be.
This interpretation would render meaningless any distinction between a deductible business expense and a capital expenditure. Thus, it is oftentimes insufficient to merely look at increased value as the determinative factor for the purpose of characterizing the replacement of a part or component. An increase in value is one of many factors that must be considered to determine deductibility or capitalization.
In general, you should capitalize a fixed asset-related expenditure that:
- Put property in a better operating condition
- Restores the property to a “like new” condition
- Addition of new or replacement components or material sub-components to property
- Addition of upgrades or modifications to property
- Enhances the value of the property in the nature of a betterment
- Extends the useful life of the property
- Improves the efficiency of the property
- Improves the quality of the property
- Increases the strength of the property
- Increases the capacity of the property
- Ameliorates a material condition or defect
- Adapts the property to a new use
Any fixed asset-related expenditures meets the above criterions is not deductible under the tax law. In addition, all direct costs of property produced, which includes an improvement and all indirect costs that directly benefit or are incurred by reason of the production (improvement) must be capitalized and are not deductible.
You expense fixed asset-related expenditures only if it:
- Keeps property in efficient operating condition
- Restores the property to its previous condition
- Protects the underlying property through routine maintenance
Any fixed asset-related expenditures meets the above is deductible. In addition, the costs of incidental repairs are typically deductible. The regulations state that the cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient condition, may be deducted as an expense.
Repairs in the nature of replacements however, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated or charged against the depreciation reserve if such an account is kept.
However, when we come into a tax audit, things can get even harder. The tax auditors weigh many factors—and may use decisive distinctions to conduct careful examination of the facts and circumstances in each case—when considering whether an expenditure is required to be capitalized or should be afforded treatment as a current deduction.