Current Expenses Versus Capital Expenditures: Tax Implications and Rules

One of the great perks to running a business is that you can spend money on various items and deduct these costs on a pre-tax basis. It is important to keep in mind that the different business tax deductions are not treated the same in the eyes of the IRS. Knowing the difference between current expenses and capital expenses is essential for business owners to understand in order to stay in compliance with the IRS and to maximize the cash they get to keep in their business.

Current expenses are allowed to be taken as a 100% expense in the year it was purchased, while capital expenditures are required to depreciated over the "useful" life of the asset. One other major factor that comes into play with capital expenditures is Section 179. Section 179 is a rule that allows certain capital expenditures to expensed immediately, instead of being written off over many years. Below are the difference between current and capital expenses, the tax implications of each, and how Section 179 comes into play.

Current expenses a tax implications

Current expenses are typically continuing expenses that are needed for normal day to day operation of a business. Most of the time current expenses have a useful life of less than 1 year. Below are some of the common current expenses:

• Current year rent
• Current year utility bills
• Telephone bills
• Advertising expenses
• Stationary
• Legal fees
• Travel expenses

Now you get the idea of what are considered current expenses. Current expenses are typically the preferred type of expenses for businesses because they will receive an immediate 100% expense recognition on their current year's tax bill. Being able to expense these items 100% is favorable because it will lead to fewer taxes in the current year (if profitable), leave more cash on hand for owners draw, more cash for business investments, or cash for paying dividends. Expenditures that don't fall into this class will typically fall into the class of capital expenses, which cannot be deducted all in the year they were purchased.

Capital expenses a tax implications

Capital expenses are typically expenditures that were purchased with the intent of creating future benefit. The type of assets purchased that are considered capital expenses are ones that will have a useful life of more than one year. Below are some examples of common capital expenses:

• Vehicles
• Buildings
• Computers
• Computer components
• Software
• Patents
• Copyrights
• Expenses to improve business property

Capital expenses are not allowed to be deducted in the same manner as current expenses. These expenses must be depreciated over a number of years. Through depreciation you recover the cost of the asset over it's useful life. The IRS has strict requirements as to how many years an asset must be depreciated over. Since these assets cannot be expensed 100% in the tax year they are purchased it will lead to a higher taxable income amount for the company in the given year and therefore higher taxes. Many growing businesses do not like this because it leaves less capital available for further business investment. The IRS realizes that growing companies would prefer to take the full deduction of capital expenditures in the year they were purchased, so they came up with Section 179.

Section 179 and tax implications

Out of all IRS code, section 179 is one of the most important sections that any business owner should be aware of. Section 179 allows for a 100% deduction of some long-term assets in the year that they were purchased. The IRS does set rules on what type of property qualifies, how much can be deducted, how you elect to take the deduction, and when you recapture the deduction. Below are the basic rules behind this section:

• 2010 limit is $250,000
• Asset must be acquired for business use
• Asset must have been purchased by the business (not a gift or inheritance)
• Asset must be tangible personal property or off the shelf computer software
• Assets over $800K will reduce the dollar limit by the amount it cost over $800K. Anything over $1.05M is not eligible

Section 179 is structured to specifically benefit small to medium size businesses grow by allowing them to expense a larger portion of assets purchased in the year they were purchased. This allows small to medium size businesses to keep more cash on hand by reporting lower income and paying less taxes.

Understanding the tax implications of current expenses, capital expenses, and Section 179 can help business owners make educated decisions about how they want to expense assets for the future benefit of the company.