While business expenses that are “ordinary and necessary” are generally deductible in the year they are incurred, some expenses are required to be “capitalized” and are subject to the cost recovery rules we know as “depreciation” / “amortization.” These expenses are described in Section 263 of the Internal Revenue Code (IRC) – Capital Expenditures.
Typically, these expenses represent the purchase of tangible property that has a useful life exceeding one year, such as equipment, machinery and buildings. There’s no delineation between big-ticket items, like buildings, and smaller items, like some office furniture. They all have a normal useful life of longer than one year and are subject to capitalization.
What about the small items that don’t cost that much but you expect could have lives longer than a year? Examples include small tools like hammers and drills, or small items like calculators or office chairs. Until recently, the IRC was silent regarding these “de minimis” items; the Internal Revenue Service (IRS) provided no guidelines. In practice, businesses would establish an expensing policy that would set an amount below which tools or equipment purchased would be expensed as opposed to being capitalized and depreciated. The tax court approved this practice in Cincinnati, New Orleans & Texas Pacific Railway Co. v. US, CtCls, 70-1 USTC ¶9344, 424 F2d 563. The court ruled:
The taxpayer’s method of accounting for items costing less than $500 by charging them to operating expenses rather than to a capital account in accordance with the Interstate Commerce Commission (ICC) minimum rule was in accordance with generally-accepted accounting principles and did not inhibit the ability of the taxpayer’s financial statements to clearly reflect its income for tax purposes. The fact that the items accounted for by the minimum rule admittedly had a useful life in excess of one year did not make them permanent improvements or betterments that had to be capitalized.
In this ruling, the court rejected the IRS’s claim that the only determining factor in classifying an asset as a capital item or a current expense is whether its useful life is more than a year, saying it was inflexible. The court concluded that so long as the application of the “minimum rule” didn’t distort income for tax purposes it was permissible.
The IRS wasn’t fond of this result, so the agency has standardized the process for determining what would be allowed as a current expense. On January 1, 2012, Temporary Regulation §1.263(a)-2T(g) went into effect. This regulation establishes the circumstances in which tangible business property can be currently expensed as de minimis. The regulation states that taxpayers with an “applicable financial statement,” such as a certified audited financial statement, may claim a current deduction for the cost of acquiring items of relatively low-cost property, including materials and supplies, if specific requirements are met. The aggregate cost, which may be expensed annually under a taxpayer’s expensing policy, is subject to a ceiling equal to the greater of 0.1 percent of gross receipts, or 2 percent of total depreciation and amortization reported on the financial statement.
Temporary Reg. §1.263(a)-2T(g)(6). Definition of applicable financial statement.
For purposes of this section (g), the taxpayer’s applicable financial statement is the taxpayer’s financial statement listed in paragraphs (g)(6)(i) through (iii) of this section that has the highest priority (including within paragraph (g)(6)(ii) of this section). The financial statements are, in descending priority—
(i) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);
(ii) A certified audited financial statement that is accompanied by the report of an independent CPA (or in the case of a foreign entity, by the report of a similarly qualified independent professional), that is used for—
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose; or
(iii) A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agencies (other than the SEC or the Internal Revenue Service).
Temporary Reg. §1.263(a)-2T(g)(8) Example:
YAZ purchases ten printers at $200 each for a total cost of $2,000. Each printer is a unit of property and is not a supply or material. YAZ has an applicable financial statement and a written policy at the beginning of the tax year to expense amounts paid for property costing less than $500. YAZ treats the amounts paid for the printers as an expense on its applicable financial statement. Assume that the total aggregate amount will be treated as de minimis and not capitalized, including the amounts paid for the printers, and that they are less than or equal to the greater of 0.1 percent of total gross receipts or 2 percent of YAZ’s total financial statement depreciation. The de minimis rule applies and YAZ is not required to capitalize the amounts paid for the ten printers.
This is actually very helpful for those businesses that have “applicable financial statements,” as it gives them a roadmap to determine the basis for their expensing policy, and removes some of the uncertainty that can exist without standards to reference. What about businesses that don’t have “applicable financial statements?” Is there an option for them in determining an expensing policy?
Reg. §1.162-3T provides that a taxpayer without an “applicable financial statement” may claim a deduction for materials and supplies that cost $100 or less.
These new rules are an important step in providing the guidance you need to establish an expensing policy for your business’s tangible asset purchases. If you need any help in drafting or revising your policy and understanding how these rules impact your business, please leave a comment below or email me.