What’s in This Article:
Is It a Depreciable Asset or Not?
What Is the Current Rule on Capitalization Policies?
Other Safe Harbors and Materials & Supplies
Implications for State Property Tax
Is It a Depreciable Asset or Not?
The Internal Revenue Code (IRC) generally requires businesses to capitalize tangible property acquired, produced, or improved rather than immediately deducting the cost. So, in theory, even the $19.99 USB stick that you bought could require consideration as an asset on your balance sheet.
In reality, you would never get any real work done if you spent all your time managing depreciation schedules for these small items and recording their disposals. Hence, the IRS provides de minimis safe harbor rules, which allow qualifying purchases to be expensed immediately. These regulations generally became effective for tax years beginning on or after January 1, 2014.
What Is the Current Rule on Capitalization Policies?
De minimis safe harbor means that you can use a specified amount at which you determine to expense tangible property rather than capitalizing and depreciating it. The amount must be consistent with your financial accounting procedures.
If you have an applicable financial statement (AFS), the safe harbor amount can be up to $5,000 per invoice or item. If you do not have an AFS, the amount is $2,500 per invoice or item, increased from $500 effective for tax years beginning in 2016.
Applicable financial statements generally include certain SEC-filed financial statements, qualifying audited financial statements with an independent CPA’s report, and certain financial statements required to be provided to government agencies. Most small businesses will not have an AFS.
If you do not have an AFS, the regulations do not require a written accounting procedure at the beginning of the tax year to qualify for the election. However, you must have consistently followed an accounting procedure for expensing qualifying items, as reflected in your books and records.
If your capitalization policy is higher than $2,500 and you do not have an AFS, amounts above that threshold may still be deductible under other applicable tax rules. However, those amounts do not automatically qualify for the de minimis safe harbor.
Expect that a capitalization policy so high that virtually all tangible property is expensed immediately could attract IRS scrutiny. This is why the $2,500 amount is called a safe harbor.
Other Safe Harbors and Materials & Supplies
In addition, the regulations address a safe harbor for improvements by small taxpayers, as well as a safe harbor for routine maintenance.
Under the safe harbor for small taxpayers, qualifying businesses with average annual gross receipts of $10 million or less may deduct certain costs related to eligible buildings with an unadjusted basis of $1 million or less. The total annual cost of repairs, maintenance, improvements, and similar activities for each eligible building must not exceed the lesser of 2% of the building’s unadjusted basis or $10,000.
Under the routine maintenance safe harbor, qualifying recurring activities performed to keep business property in ordinarily efficient operating condition generally do not have to be capitalized. The rules include specific expectations about how often maintenance must recur. Betterments generally do not qualify.
To elect the de minimis or small-taxpayer safe harbor, you generally attach the appropriate election statement to your timely filed original federal tax return, including extensions. These elections are made annually. The routine maintenance safe harbor, however, does not require a separate annual election statement.
The regulations also clarify the treatment of materials and supplies.
Materials and supplies generally include tangible, non-inventory property used and consumed in operations, such as components used to maintain or repair property, consumables expected to be used within 12 months, property with an economic useful life of 12 months or less, or property costing $200 or less. The timing of deductions depends on the applicable rules and how the items are used.
Implications for State Property Tax
The IRC provides safe harbors for federal income tax purposes; however, these do not automatically apply to state property taxes. State and local requirements vary, and some jurisdictions require businesses to report tangible personal property even when it was expensed for federal income tax purposes.
This is where the bookkeeping nightmare can begin.
While cumbersome, CJA recommends that non-capitalized equipment be kept in a separate expense account from office supplies and other consumables to help facilitate property tax reporting.
In addition, you should include sufficient descriptions in your accounting records so you can easily identify items that have been disposed of and determine whether they need to be removed from applicable property tax filings.
Now is a good time to discuss capitalization policies and their implications for income tax, property tax, and accounting records with your CPA.
At Cheryl Jefferson & Associates, we help small businesses maintain accurate financial records and establish sound accounting practices. Contact CJA to learn more.
Frequently Asked Questions
What is the IRS de minimis safe harbor limit for small businesses?
Businesses without an applicable financial statement may generally elect to expense qualifying purchases costing up to $2,500 per invoice or item. The limit is $5,000 for businesses with an applicable financial statement.
Does every purchase over $2,500 have to be capitalized?
No. Purchases exceeding the safe harbor threshold may still qualify for deductions under other applicable tax rules.
Do federal capitalization rules also apply to state property taxes?
Not necessarily. State and local property tax requirements vary, so businesses should review the rules in each jurisdiction where they own taxable property.
