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Small Business Tax Deduction: Capital expenses

Before digging out the capital expenses we should be clear in expenses and losses as both decreases owner’s, shareholder’s equity. The difference between expenses and losses is that we can’t get any benefit from losses vs. we will get benefit from the expenses. Expenses can be of two types: Capital nature expenses and revenue nature expenses. Revenue nature expenses are short term in nature and benefits can be derived only for short period of time e.g. for less than one year. In this article we are going to discuss about capital expenses which can be claimed as amortization. We will discuss Depreciation and revenue nature expenses separately in next article. Any expenditure whose benefit can be derived for more than one year is capital expenditure.

The IRS views capital expenses as investments in the business, thus the business can't simply deduct the money spent on the asset from its gross income. The money hasn't really left the business, it was just transformed into an asset that the business hopes will generate more money. Deductions for capital expenses typically must occur over several years, except where Section 179 applies. Spreading the deduction over multiple tax years - also known as "amortization" or "depreciation" or depletion - helps businesses to accurately assess their profitability from year to year.

The Internal Revenue Service has provided several rules for capital expenses which can be claimed as depreciation, amortization and depletion in preparing income tax return. If the capital nature expenses are incurred to obtain asset which has physical existence those we can touch, feel and see, then this type of expenses can be claimed as depreciation. If the capital expenditure is incurred to obtain benefits for several years whose physical existence does not exist, such type of expenses can be claimed as amortization or depletion.

Amortization of Capital Expenses can be summarized as follows:

a) Start-up Cost: Expenses which could be deducted as an ordinary and necessary business expenses if the business is already operating or in existence and incurs before the active trade or business begins are start-up cost. Start-up cost include an analysis or survey of potential markets, products, labor supply; advertisement for the opening of the business; salaries and fees paid to employees or professionals; travel and other necessary cost for securing prospective distributors, suppliers or customers.

The IRS says that start up costs are amount paid or incurred for:

Creating an active trade or business or

Investigating the creation or acquisition of an active trade or business.

The IRS regulation state that business start-up costs are typically considered capital expenses because they are for the the long term, not just the first year. Start-up cost can be deducted up-to $5,000 in the first year of business. This deduction is restricted if you have over $50,000 in start-up costs. Any start-up cost which can’t be claim as deduction in first year can be deducted in 180 months as amortization.

b) Organizational Costs: Organization costs for tax purposes are costs incurred in forming a partnership or corporation, including the legal fees for drafting a partnership agreement or corporate charter and bylaws, necessary accounting services in forming the entity, filing fees, and costs of organizational meetings of stockholders and directors. Amounts paid to organize a corporation are the direct expenses of creating the corporation or partnership. A corporation using the cash method of accounting can amortize the organizational cost in the first year of business even if doesn’t pay cash to them. A partnership using the cash method of accounting can deduct an organizational cost only if it has been paid in that year.

Examples of cost of organization include cost of temporary directors, the cost of organizational meetings, state registration fees, the cost of legal services etc. The organizational cost treatment for IRS is almost like start- up cost. If the expense is below $50,000, the amount of$5,000 can be deducted in the year of first year of business. Remaining expense can be claimed as amortization in 180 months.

c) Cost of Getting a Lease: Very often when  an existing lease is obtained from another lessee,  the amount must be paid to the previous lessee to get the lease, besides having to pay the rent on the lease Cost paid to previous lessee for getting the lease besides having to pay the rent or lease should be amortized in remaining period of lease. For example, if $10,000 is paid to get a lease and there are 10 years remaining on the lease with no option to renew, $1,000 can be deducted each year. The cost of getting an existing lease of tangible property is not subject to the amortization rules for section 197 intangibles discussed in.

d) Improvements by Lessee: Cost of the improvement in leased property or making permanent improvement to leased property should be depreciated using the modified accelerated cost recovery system (MACRS). Depreciate the property over its appropriate recovery period.  The cost of improvement in leased property can’t be amortized over the remaining term of the lease. If the improvement has to give up at the end of lease, gain or loss should be figured out based on adjusted basis in the improvements at that time.

e) Exploration Costs: The costs of determining the existence, location, extent, or quality of any mineral deposit are ordinarily capital expenditures if the costs lead to the development of a mine. These costs can be recovered through depletion as the mineral is removed from the ground. However, it can be elected to deduct domestic exploration costs paid or incurred before the beginning of the development stage of the mine (except those for oil and gas wells). A corporation (other than an S corporation) can deduct only 70% of its domestic exploration costs. It must capitalize the remaining 30% of costs and amortize them over the 60-month period starting with the month the exploration costs are paid or incurred. A corporation may also elect to capitalize and amortize mining exploration costs over a 10-year period.

f) Barrier Removal Costs The cost of an improvement to a business asset is normally a capital expense. However, it can be elected to deduct the costs of making a facility or public transportation vehicle more accessible to and usable by those who are disabled or elderly. The facility or vehicle for use in connection with trade or business should be owned or leased. The most you can deduct as a The cost of removing barriers to the disabled and the elderly for any tax year can be deducted up-to $15,000. However, any costs over this limit can be added to the basis of the property and depreciated these excess costs.

g) Section 197 Intangibles: Generally, the section 197 intangibles in connection with trade or business or in an activity engaged in for the production of income should be amortized ratably over a 15-year period.

The following assets are section 197 intangibles and must be amortized over 180 months. 1. Goodwill. 2. Going concern value. 3. Workforce in place. 4. Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers. 5. A patent, copyright, formula, process, design, pattern, know-how, format, or similar item. A customer-based intangible. 7. A supplier-based intangible. 8. Any item similar to items 3 through 7. 9. A license, permit, or other right granted by a governmental unit or agency (including issuance and renewals). 10. A covenant not to compete entered into in connection with the acquisition of an interest in a trade or business. 11. Any franchise, trademark, or trade name. 12. A contract for the use of, or a term interest in, any item in this list.

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Small Business Tax Deduction: Capital expenses

What tax strategies can be applied to reduce the tax liabilities of high-income earners?

1. Long term tax planning start from documentation. The documents should be kept for  three years after the tax due date or tax filed date whichever is later. To claim the tax credit, deduction or tax rebate we need proper documentation.

2. Retirement contribution: The individual can reduce their taxable income by contributing to 401K up to $19,000 from their income. The contribution to traditional IRA is another method of tax planning where taxpayer can contribute up to $6,500 for income year 2019. Traditional IRA decreases current year taxes while roth IRA allows assets to be grown as tax free.

By contributing to retirement plan, low to medium income earner can get saving tax credit up to $1,000 per year.

3. Contribute to Health saving account: The amount contributed to HSA reduces the taxable income upto $3,500 for the year 2019 and $3,550 for year 2020. If you are married and filing jointly then contribution limit is doubled. This amount can be expensed for qualified medical expenses.

4. Contribute to Education Saving Account and 529 Saving plan: The amount contributed to these accounts reduces the current taxable income. The funds of ESA can be used for, primary school, secondary school and college but the funds of 529 saving plan can only be used for qualified higher education expenses of designated person. The 529 contribution is limited to $14,000 per year and lifetime $300,000 versus ESA contributions are limited to $2,000 per year only.

5. Get IRS tax credits: If properly plan there are many tax credits which reduces tax liability on dollar to dollar basis.

6. If individual has self-employed income from business, then they can reduce their taxable income by contributing up to $55,000 to SEP IRA.

7. Shoot for Long Term capital gains; An additional benefit from investing in stocks, bonds, and real estate is the favorable tax treatment for long term capital gains. Long term capital gains are taxed at maximum rate of 20% vs short term capital gain can be taxed at 37%. The rate may be as low as zero for those in the lowest tax bracket. But short-term capital gain can be taxed up to 37%. If we plan properly capital gain (Profit on sale) of real estate can be exempted.

8. If you have highly appreciated stock (share) and you are high income earner you can plan tax by transferring those stock to your kids as gift. This will reduce your future tax liabilities.

Wanna know more tax strategies in detail to save your hard-earned money in legitimate way, then contact CN Biz & Tax Services LLC. Our team of expert will find out the right solutions that suits to your situation.