Capitalization and Cost Recovery Outline, Federal Income Tax

I.  INTRODUCTION TO CAPITALIZATION AND COST RECOVERY.
1.  Capital Expenditures [§263]

a.  §263, §263(a): purely business expense not deductible if capital expenditure (no limitations on personal deductions).

1.  Capital expenditure: asset with a useful life well beyond a taxable year.

b.  Methods to give credit:

1) Current (deduction).

2) Depreciation (some each year).

3) Disposition (gain/loss at sale).

c. Relationship: at a constant rate of tax, allowing a current deduction (expensing an investment) is the equivalent of exempting the income from that investment from tax..

1) Allowing a deduction is appropriate under a consumption tax, but inappropriate under an income tax.  

d. What costs have to be capitalized?

1) Stock, bonds, plant.

i) §263(A): Direct costs must be capitalized (e.g. bricks and mortar, employees who only build the new plant).

ii) §263(A): Indirect costs should also be capitalized (e.g. things that would be passed along, including construction equipment).

2) Advertising?

i) Advertising has short-term and long-term benefits; increased sales and improved goodwill.

ii) Service has historically taken the position that normal advertising is deductible.

a) In some cases (e.g. advertising to raise support for zoning variance), capitalized.

e.  Woodward v. Commissioner; costs incurred in acquisition or disposition of capital asset (appraisal litigation) treated as capital expenditures.

f.  INDOPCO, Inc. v. Commissioner; I-banking and legal fees from friendly takeover capitalized under §263 b/c creates or enhances a “separate and distinct” asset.

g.  PNC Bancorp, Inc. v. Commissioner; costs for marketing, research, and originating loans deductible as “ordinary and necessary business expenses under §162(a).

1) Things down repeatedly are deductible; one-time expenses (e.g., closing on real estate) not.

2.  Depreciation: Accelerated Cost Recovery System [§168].

a.  Everything is divided into tangible (§168(a)) and intangible (167(a)) (e.g., goodwill).

b.  Depreciation of tangibles and real estate; §168(a): its method, period, & convention that matter.

1) §168(b)(1)(a) [depreciation method] = 200% DDB switching to straight-line.

a.  §168(b)(3): if residential, method = straight line.

2) §168(c) [recovery period] = 5 years on a 5y property.

3) §168(d) [convention] = 1/2 year.

a.  §168(d)(2): if residential, convention = mid-month.

4) §168(e)(1): table on how to treat property.

5) §168(k): meant to stimulate investment post-9/11.

a.  (k)(1)(a): depreciation deduction includes 30% of adjusted basis of the qualified property.

b.  (k)(1)(b): you still get the regular §168 deduction after the 30%.

c.  (k)(2): qualified property if it’s ‘tangible personal property’ with 20Y or less.

d.  (k)(4): 50% bonus depreciation for certain property.

c.  §179: taxpayers allowed to expense a portion of the purchase price for tangible property or certain computer software.

1) Note: §1245 property is only personal property - not real estate at all.

d. §280F: limit on depreciation for luxury automobiles.

1) §280F(d)(5): trying to separate cars from light trucks - 6,000 lb. limit for “luxury car”.

a) Toyota would qualify as a car, but Hummer is deductible.

§263 specifically disallows deduction of a capital expenditure.

Capital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year. CAPEX is used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings. In the case when a capital expenditure constitutes a major financial decision for a company, the expenditure must be formalized at an annual shareholders meeting or a special meeting of the Board of Directors. In accounting, a capital expenditure is added to an asset account ("capitalized"), thus increasing the asset's basis (the cost or value of an asset adjusted for tax purposes). CAPEX is commonly found on the cash flow statement under "Investment in Plant Property and Equipment" or something similar in the Investing subsection.

For tax purposes, CAPEX is a cost which cannot be deducted in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property's useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question. Further to the above, CAPEX creates or adds basis to the asset or property, which once adjusted, will determine tax liability in the event of sale or transfer. In the US, Internal Revenue Code §§263 and 263A deal extensively with capitalization requirements and exceptions.

Included in capital expenditures are amounts spent on:

1. acquiring fixed, and in some cases, intangible assets
2. repairing an existing asset so as to improve its useful life
3. upgrading an existing asset if its results in a superior fixture
4. preparing an asset to be used in business
5. restoring property or adapting it to a new or different use
6. starting or acquiring a new business

An ongoing question for the accounting of any company is whether certain expenses should be capitalized or expensed. Costs which are expensed in a particular month simply appear on the financial statement as a cost incurred that month. Costs that are capitalized, however, are amortized over multiple years. Capitalized expenditures show up on the balance sheet. Most ordinary business expenses are clearly either expensable or capitalizable, but some expenses could be treated either way, according to the preference of the company. Capitalized interest if applicable is also spread out over the life of the asset.


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