Costs incurred by a business are currently deductible, deductible over future time periods or never deductible. Costs deductible over future time periods are treated as assets and as such are added to the capital of the business (capitalized). The issue of detectability vs. capitalization is one of timing and present value. The sooner an item can be deducted, the sooner the business saves the taxes related to that item. Cash received today is worth more than cash received in the future.
Fixed assets are those that aren't expected to be consumed or converted to cash within one year. They are categorized as tangible or intangible. Tangible assets include buildings, machinery and equipment and furniture. Intangibles include patents, trademarks and franchise costs. Some costs are clearly capital in nature, while others are open to interpretation.
In any fixed asset built or acquired, direct costs of labor and material are clearly capital in nature. But, according to the Internal Revenue Service, or IRS, other, indirect costs must also be capitalized completely or partially. These are usually thought of as currently deductible and include items such as bidding costs, engineering and design, employee benefits, handling costs, indirect labor and material, insurance, interest, licenses, officers’ compensation, rent, quality control, taxes, utilities, repairs and maintenance and tools.
The IRS has set out rules for allocating indirect costs between capitalizing and deducting. True to its fashion, there are four prescribed methods, plus “any other reasonable method.” For example, if an officer spent 10 percent of his time on the acquisition of a building, 10 percent of his salary would be added to the cost of the building and depreciated over its useful life. Since many indirect expenses are not this simple, one of the methods prescribed by the IRS should be followed.
The capitalization rules apply to all fixed assets and inventory (items held for resale). The rules are far from unambiguous and are open to much interpretation. The IRS is focusing their audit guidelines on these, so businesses would be well advised to establish clear and consistent methods of allocating indirect expenses between capitalizing and deducting currently.
- Wiley GAAP: Interpretation and Application of GAAP; Barry J. Epstein et al, 2011
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