October 2003
By JAMES S. ANCHIN, CPA
It is standard operating procedure for every business to purchase tools and supplies, and have routine repairs and maintenance. Chances are you've spent a considerable amount of money on these items and services this year. However, you may not be sure whether you should expense them, or capitalize them. Furthermore, on what exactly do you base your decision to expense or capitalize? The answer to this question has important tax implications, and may even leave you open to scrutiny from the IRS.
While the IRS has offered little guidance on the requirements of capitalization versus expense, recent legal cases have brought the issue into sharper focus. In one case, a healthcare firm expensed more than $350,000 worth of bookcases, chairs, desks, typewriters and medical equipment for two years running. The expensed amounts, which equaled less than one percent of total revenues, were in keeping with Medicare's policy that assets of less than $500, with less than a two-year life could be taken as an immediate write-off.
The health care company relied on prior cases involving railroads in which the courts ruled that taxpayers could deduct de minimus Ñ or minor Ñ expenses for inexpensive capital assets with a useful life of more than one year, providing the calculation method clearly reflects income. The court, however, ruled against the health care company. Here's why: the railroads had undertaken several analyses showing that the expensed items did not materially affect its net income or financial position. Applied to the health care company, these same analyses produced significantly different findings. For example, as a percentage of net income, the expensed items in question ranged from .16 percent to .32 percent for the railroad companies; for the health care company this ratio was a staggeringly larger 83 percent and 189 percent for the two years in dispute. Based on this and several other accounting calculations, the court found that the items in dispute were, in fact, material to the health care company's financial results and not eligible for expensing. In addition, the court gave weight to the fact that the railroads provided evidence indicating their expense policy "clearly reflected income" in accordance with generally accepted accounting principles (GAAP) and was standard in the industry. The health care company provided no such evidence.
Further, the court also noted that expensing items below a certain cost was only a voluntary Ñ not mandatory Ñ practice allowed by Medicare. In the case of the railroads, expensing was required by the Interstate Commerce Commission.
What does all this mean for the construction industry? For one thing, it underscores the potential pitfalls of expensing items or services based solely on the dollar amount. It may work better for contractors to categorize items based on expected service life. In the case of the health care company the items in question had a useful life greater than one year. If you demonstrate that a group of assets have a useful life of less than one year and categorize those items consistently, you would be justified in expensing those items in the year of purchase.
Small tools, a major expenditure for many contractors, typically become broken or lost within a short time and are notoriously difficult to track. It would be permissible to establish an expense threshold for these items if this situation can be established as commonplace. Also, look carefully at the impact of items purchased and repairs made. Contractors often spend considerable sums on repairs and maintenance just to keep assets at a status quo Ñ these sums can be expensed.
In resolving the expense vs. capitalization dilemma, good questions to ask are: does the item purchased have a life greater than one year? Is its purpose to maintain existing quality rather than to improve or upgrade another asset? Does the item or service generate an increase in revenue? Answering "no" to these questions indicates that expensing the item would be appropriate. The less impact the item or service purchased has on another asset's value, use or longevity, the more likely it will pass as a legitimate expense. Also, the less material the expensed items are, then the more likely expensing them qualifies.
Don't assume that the IRS will automatically allow expensing of all items below a certain dollar amountÑparticularly if the total is significant. Evaluate expenditures in light of the criteria discussed above before deciding whether expensing is appropriate. Proper documentation and policies now can avoid potential headaches later.
About the author: Mr. Anchin is a managing partner of Anchin, Block & Anchin, LLP, a regional certified public accounting firm with offices in New York City and Westchester, that specializes in meeting the needs of contractors in the tri-state area.