By Steve Barkmeier, CPA
Director of Tax at Whipplewood CPAs
The new IRS regulations allow a great deal of flexibility for companies to adopt capitalization policies. A capitalization policy can save overhead in tracking small assets. It can also reduce taxable income, but it will reduce book income by the same amount. With the flexibility the IRS provides, companies need to put more thought into what policy best meets their needs. It’s tempting to choose a policy strictly to minimize the tax bill. The capitalization policy must be adopted in writing before the start of the tax year and must apply to the financial statements as well as the tax reporting. If a company is overly aggressive on its capitalization policy, the effects on its financial statements can cause large problems.
The IRS has adopted regulations that allow companies to deduct expenditures of less than a capitalization limit, even though those expenditures are otherwise capitalizable as fixed assets. To deduct these expenditures, the company must follow a book accounting policy that expenses those items and is adopted before the beginning of the year. Many companies use these policies in order to reduce the administrative burden of tracking and depreciating all those small assets. Before the IRS adopted these regulations, most of those companies followed the same capitalization limits for tax purposes that they applied for book purposes. Now companies can adopt these policies with confidence that their policies will not create disputes with the IRS.
If a company’s only consideration in adopting a policy is minimizing taxable income, the decision to adopt the maximum limit allowed under the regulations is straightforward. However, many companies need to consider other factors in deciding on a capitalization limit.
Maximum Capitalization Limits Allowed by Safe Harbor
The maximum that the IRS allows a safe harbor is either $2,500 or $5,000 depending on whether or not the company has an applicable financial statement. For most companies a financial statement must be an audited financial statement in order to be treated as an applicable financial statement. However, some financial statements filed with regulatory agencies can also qualify. Under the IRS regulation, the capitalization limit can be applied at the line item detail level of the individual invoices.
It makes sense that the IRS would allow a higher limit for companies with applicable financial statements. If the company has audited financial statements, then an independent auditor has examined the capitalization policy and concluded that the policy does not cause a material misstatement of income. Thus, the IRS has some assurance that the company is not using an unreasonable limit.
Companies may be able to use policies that have a higher threshold than the IRS limit. However, those companies have the burden of proof to demonstrate that their policies do not significantly distort their income.
Companies have a great deal of flexibility in designing their policies. The simplest policies provide for a strict dollar limit. If the expenditure is below that limit, it is expensed even if the expenditure would otherwise be capitalized as a fixed asset. The policy can also provide whether the limit is applied at an invoice level or at the level of each item that is separately stated on an invoice. This distinction can make a large difference in capitalization decisions. For example, a company with a $1,000 capitalization limit might purchase 20 new computers for its staff. If each of those computers cost $800, the total invoice would be for $16,000. If the limit is applied at the invoice level, those computers would be capitalized. If the limit is applied on an invoice item basis, the computers would be expensed.
Many companies include provisions that capitalize the expenditure if it is part of a larger project as long as that project meets a higher capitalization limit. For example, a company might have a $1,000 capitalization limit but require capitalization of all items that are part of a project if that project exceeds $5,000 in total cost. This type of provision can often help a company make sure that its capitalization policy doesn’t create other problems. This type of provision does not affect whether or not the policy meets the IRS safe harbor.
Another possibility is to choose based on the type of item how to apply the policy. For example, a company might specify that all computers be capitalized regardless of their cost.
Whipplewood CPAs has a sample capitalization policy that you can view under “Resources” on our website at whipplewoodcpas.com. This policy should be modified to meet the needs of the particular company.
If the company produces GAAP financial statements, it must consider whether the policy creates a material distortion of those financial statements. If the financial statements are reviewed or audited by a CPA, the company should consult with that CPA before adopting a policy to make sure the CPA agrees with the company’s conclusion.
Most loans agreements include covenants that the borrower must meet specific financial hurdles. Violating those covenants can have catastrophic effects to the company. For example, a bank might call a loan if a borrower is in violation of its loan covenants. If a company is considering adopting a new capitalization policy, it is imperative that it analyze the effect of the policy on each covenant. If the new policy would make it likely that the company might violate one of its covenants, that policy should be modified to eliminate that risk. For example, a loan covenant might require that the loan balance not exceed four times EBITDA. In this example, an expenditure that is capitalized does not directly impact that ratio. However, if the expenditure is expensed, it would lower the ratio. If that lower ratio puts the company at risk of violating its covenant, the company should modify the capitalization policy.
At Whipplewood CPAs, we have a large number of franchisee casual dining clients. Those franchise agreements generally require the franchisee to maintain specific financial ratios. An overly aggressive capitalization policy can put a franchisee at risk of failing some of those ratios. The company should analyze both historical results and future plans to make sure that the new policy won’t put the company at risk. For example, a franchisee might recalculate the ratios for the last two years and conclude that it could easily meet its targets with a $1,000 capitalization policy applied at the invoice item level. However, if that franchisee is planning to refurbish its location, that refurbishment could easily cause it to fail its franchise requirements. If so, the franchisee could specifically require the capitalization of the refurbishment or include a provision to capitalize items if they are part of a larger project.
Some companies may have other agreements that require them to meet performance standards. For example, a company may have provision in its shareholder agreement providing that control over the board of directors changes if certain performance metrics aren’t reached. Companies need to consider the effects of their capitalization policy on all performance metrics they might need to meet.
Property Tax Considerations
The capitalization policy does not affect how items are taxed for property tax purposes. Thus, the adoption of a capitalization policy creates a difficulty with property tax renditions. One simple solution is to create a specific expense account to track items that are expensed because of the policy. For the property tax renditions, the total of this account balance for the year can then be reported as a single line item for the location. Based on the type of property included, the company can then determine the appropriate time to show that line item as retired from the rendition. For example, if a company has expensed predominately computer equipment, it might be appropriate to retire the line item after five years.
Companies have the opportunity to reduce the administrative burden of tracking small assets by adopting a capitalization policy. These policies can also reduce taxable income by immediately deducting the cost of small items rather than depreciating them over a longer life. However, companies should make sure they fully understand all the effects of the new policy on important financial metrics. Meeting those metrics can be exceptionally important for many companies. If a new policy puts the company at risk of failing an important metric, the company should revise the policy to avoid that failure.
About the Author
Steve Barkmeier is the Director of Tax at Whipplewood CPAs.. WhippleWood CPAs redefines the CPA experience through our dynamic, exciting and fun approach to building ongoing relationships with clients and community partners. ColoradoBiz magazine has consistently ranked WhippleWood CPAs one of the top accounting firms in Colorado. We are a full service Denver area CPA firm.