How do you account for those large equipment purchases, like a desktop computer or a laptop? Do you expense it (take the full deduction now?) Or do you capitalize it (carry it as an asset on your books and depreciate it over time?)
It’s not a straightforward as you might think. There are rules about this and it behooves you to know what they are.
Two rules about rules:
• Rules are meant to be broken.
• There’s an exception to every rule.
The second certainly applies when it comes to the IRS. You don’t want to knowingly break a rule. That’s not creative accounting, that’s fraud…which will get you free room and board courtesy of the federal government
Making a mistake is OK; you’ll get slapped with penalties and interest and you can sleep in your own bed. The information herein will help you stay on the straight and narrow.
Just a brief caveat before we start: what follows here applies to physical things only, things that are “tangible,” things that you can touch. Different rules apply for “intangibles,” which most small businesses don’t need to concern themselves with. Stuff like “intellectual property” or “goodwill.”
RULE #1: If the tangible item has a “useful life” of more than one year, then you have to “capitalize” and “depreciate” it. And the IRS determines what that useful life is.
• Example: a laptop computer has a useful life of 5 years and you must depreciate it over that period of time. You have your choice of depreciation method (straight-line, accelerated, sum-of-year, double-declining-balance,) but you still have to depreciate it over 5 years.
o Exception #1: IRS Section 179 — which came about as the result of the Economic Stimulus Act of 2008 in order to incentivize business to purchase new equipment and software, thereby stimulating the economy (or so the theory goes) allows you to take the full deduction of new equipment and software (up to $500,000 per year) in the year you purchase it.
o Exception #2: if the item has a value of less than $500, most accountants will expense it because the cost of tracking that asset over its useful life is just too burdensome, time consuming and costly. And the IRS agrees with that. So an external hard drive would last more than a year (hopefully) but cost less than $500, so it’s just worth everybody’s time to expense that puppy.
RULE #2: If a tangible item is going to be used up within the next twelve months, then you can “expense” it. These types of expenses are called “consumables.” Paper clips, copy paper, pens.
While Section 179 is available, it doesn’t mean that you have to take it. Why would some companies not avail themselves of this tax advantage? Because it decreases their bottom line, their net operating income, their profit. And there are lots of reasons why a company would want to show more rather than less profit, like trying to qualify for a loan or a line of credit, for example.
So there you have the basic rule of thumb about when you can expense a purchase and when you have to capitalize and depreciate it.
Hope that helps. Please let me know if you have any questions about this by hitting me up in the comments below.