A very unhappy couple came in for a consultation this past week. Up until last year, Gary and Denise Allen (not the clients´ real names) owned and operated a regional moving and storage company. The amount of time they had to devote to the business was taking its toll on their health, and although they had managed to make a living, the income from the business had never taken off the way they had hoped it would when they first started out. So Gary and Denise decided to sell the business. They were unable to find a buyer interested in the business as a whole, so they ended up selling the assets to a couple of other companies.
"We thought the CPA must be looking at the wrong tax return when he told us we were going to owe additional taxes," said Denise. "I mean, we didn´t even operate the business in 2005, and we took a huge loss on everything we sold."
"Yeah!" Gary nodded vigorously. "We should have gotten a refund! Not owed more! We were just in shock"
"We think the CPA must have made a mistake, and we want to get a second opinion." Denise said.
After reviewing the return, I was sorry to have to tell the Allens that their CPA had prepared the return correctly. It was true that the trucks, forklifts, and other equipment had been sold for much less than the Allens paid for them originally. Even the warehouse went for a little less than they´d paid, though their loss on the warehouse was not as great as on the equipment, due to a general increase in real estate values during the years the Allens owned it.
What was going on? If the Allens sold their business assets for less than they paid, why was their tax return showing a substantial gain from the sale of the assets? The reasons, in a nutshell, were depreciation and recapture. But before I can talk about depreciation and recapture, I need to say a few words about capital assets.
The Tax Code does not provide concise definitions of "capital cost" as opposed to "expenses of a trade or business." Broadly speaking, a capital cost is an investment that is expected to have value over a period of longer than one year. Business expenses are payments for goods that will be consumed over a short period of time, or services needed for current operation of the business.
A desk, a building, an air conditioning system, and a fax machine are all capital assets.
The following are examples of current business expenses: repairing a broken lock on a desk drawer, painting a building, replacing air conditioner filters, replacing the drum on the fax machine.
The boundary between capital costs and business expenses can be fuzzy. For example, replacing a small patch of wooden siding on a commercial building is a repair, which is a current business expense. Installing all new siding is probably a capital cost. Where is the dividing line between these two extremes? One way the IRS and the courts have approached the question has been to look at whether the replacement of the siding results in a substantial increase in the value of the building or is merely routine maintenance required in order to preserve the building throughout its expected useful life. Replacing wood siding with a brick veneer looks more like a capital cost, whereas replacing wood siding with identical or similar wood siding, even if 100% of the siding is replaced, could arguably be a maintenance expense.
To be continued next time