Under United States income tax law, to make a deduction in the current taxable
year, a taxpayer must be able to show that a particular cost is a business
expense and not a capital expenditure. Capital expenditures either create cost
basis or add to a preexisting cost basis and cannot be deducted in the year the
taxpayer pays or incurs the expenditure. In terms of its accounting treatment, an
expense is recorded immediately and impacts directly the income statement of
the company, reducing its net profit. In contrast, a capital expenditure is
capitalized, recorded as an asset and depreciated over time.
Four ways costs can be capital expenditures
The Internal Revenue Code, Treasury Regulations, and case law set forth a
series of guidelines that help to distinguish expenses from capital
expenditures, although in reality distinguishing between these two types
of costs can be extremely difficult. In general, four types of costs related to
tangible property must be capitalized: 1. Costs that produce a benefit that
will last substantially beyond the end of the taxable year.
2. New assets that have a useful life substantially beyond one year. For
example, in Commissioner v. Idaho Power Co., the taxpayer used its own equipment
to construct and improve various facilities that it owned. The taxpayer
sought to have the depreciation of the construction equipment treated as a
deduction. The Court held that because the equipment was used to invest in a
capital asset – the new and improved facilities – the costs had to be treated
as capital expenditures. 3. Improvements that prolong the life of
the property, restore property to a “like-new” condition, or add value to
the property. For example, in Fedex Corp. v. United States, the taxpayer
performed repairs upon jet engines by removing them from the airplane and then
having parts replaced. The taxpayer argued that these expenses were
deductible, but the IRS stated that the costs should be capitalized. The court
held that the inspection and replacement costs could be deducted because the
improvements did not add to the value and did not prolong the life of the
airplanes as a whole. In Midland Empire Packing Co. v. Commissioner, the
taxpayer added a concrete lining to its basement floor to prevent oil from
seeping into where the taxpayer stored meat. The taxpayer argued that the costs
of installation were deductible and the tax court agreed. The costs of
installation only permitted the taxpayer to continue the plant’s operation. The
expenses did not add to the value of the business or permit the taxpayer to make
new uses of the basement. 4. Adaptations that permit the property
to be used for a new or different purpose. In contrast to Midland Empire
Packing Co., in Mt. Morris Drive-In Theatre Co. v. Commissioner, under
threat of litigation, the taxpayer was forced to create a new drainage system
to prevent run-off rainwater from flooding his neighbor's farm. The
taxpayer argued that these costs were deductible, but the tax court disagreed.
Because the taxpayer knew in advance the property had an inadequate drainage
system, the costs to accomplish this adaptation of the property were a
capital expenditure. The costs were not simply an improvement of the preexisting
drainage system, but rather a completely new addition to the property that
permitted the taxpayer to use the property as a drive-in theater.
Though it is an oversimplification, when trying to distinguish between expenses
and capital expenditures it can be helpful to remember that the U.S. tax
code attempts to levy tax on those most able to pay it.
Illustrative Example Imagine that a business buys a truck for
$50,000 and uses $5,000 this year on gasoline to distribute tomatoes upon
which it earned $20,000. If we want to apportion tax on the business according
to its abilities to pay we should ask, "how much better off is the businesses
businesses in Year One?" It seems unfair to say that the business is $20,000
better off than at the beginning of the year - after all it spent $55,000 to
earn those $20,000. However, it also seems unfair to say that the business is
$35,000 worse off – after all it also has a truck which it will use for years
to come. Probably the fairest characterization is
to say that in Year One the business earned $20,000, spent $5,000 on gas, and
"spent" some of the value of the truck it purchased. Since the $5,000 on gas
was consumed in Year One and all of its value has been provided during Year One
its full cost is properly offset against the income of Year One. In other words
it is an expense, and it is recorded right away as such. On the other hand,
the truck will contribute to income in Year One, but also contribute to income
in future years. Since the truck’s benefits are spread over the years that
the truck is in use, we will want to spread the cost of the truck over those
subsequent years as well. Otherwise the business would appear overly burdened in
Year One and unnaturally profitable every year thereafter. Thus the truck is
a capital expenditure which should be depreciated. However, keep in mind that
while depreciation spreads the cost of a capital asset over several years it is
not intended to actually mirror the real world wear and tear on the asset.
See also Capital expenditure
References External links
Expense or Capitalize training costs Capitalize or Expense