To Capitalize or Not to Capitalize

No, we're not talking about punctuation. The issue is whether or not you can write off that business expenditure this year or whether you will have to take your tax deduction over several years. Depreciation can be a pain in the neck for the small business person because it represents a disconnect between actual cash out of pocket and the resulting tax deduction.

Imagine your business is sitting on $50,000 of positive cash flow going into December. You have a great CPA who helps you estimate your tax bill before year end and she tells you that you're going to owe $17,500 in taxes unless you can generate some big tax deductions before year end. Not a problem...you need a new work truck, some additional equipment and new uniforms for employees. You get all of this done by year-end and deliver your records to the CPA with a big smile on your face, expecting not to owe Uncle Sam a dime.

A month later your CPA tells you the new truck earned you a deduction of $3,000, your equipment will get a deduction of $1,500 and all $1,200 for uniforms is deductible. The net result is your $50,000 spending spree earned you $5,700 in deductions lowering your tax bill by only $2,000. Needless to say you're not thrilled. Welcome to the world of depreciation.

Situations like the one above have conditioned small business owners to attempt to write off everything they possibly can and depreciate as little as possible. So what are the rules? Here's a quick summary.

IRS Publication 946 outlines four requirements for identifying property the must be depreciated.

1. It must be property you own.



2. It must be used in your business or income producing activity.



3. It must have a determinable useful life.



4. It must be expected to last more than one year.

The first two are fairly straightforward. To have a determinable useful life the property must be something "that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes." Land for instance is not depreciable because it doesn't get used up. Fine art and collectibles are other examples of things that do not wear out.

The fourth criteria is the one with the biggest gray area. For instance, a repair shop may depreciate a portable welder because they expect it to last 5 years. A contractor, however, may know the welder will get beat up enough on job sites that it will have to be replaced in twelve months. In the first situation the welder is depreciated, in the second it is written off in the year of purchase as an expense.

Dollar value also plays a part in deciding what gets depreciated. A useful tool for all Small businesses is a capitalization policy with a minimum dollar value for depreciable items. A professional practice may have a capitalization policy with a minimum value of $500 whereas a home builder may have a minimum of $5,000. When establishing such a policy you should base the minimum on a realistic assessment of the average value of equipment and other fixed assets you buy. Don't set the policy minimum so high that you don't depreciate anything (unless you want IRS help in revising your policy later).

If you do get stuck with a large tax bill in a year when you spent big money on fixed assets make sure you discuss a Section 179 election with your CPA. This yearly election allows you to write off fixed assets in the year of purchase up to a maximum dollar amount.

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