Expense or Depreciate Items on Your Taxes
Should you depreciate or expense capital or current assets?
When you prepare your income taxes, the general rule is that you write off your daily operating business purchases, such as office supplies or mileage on your business vehicle, as expenses and your purchases of long-term business assets, such as factories and equipment, as depreciation.
Daily Operating Expenses
An excellent guide to the daily operating expenses that you can deduct is Federal Schedule C. The IRS cautions that these expenses must be necessary and ordinary to the operation of the business. They must also be reasonable and directly related to the business. Among the operating expenses the IRS lists as being deductible on Schedule C are the following:
- Car and Truck Expenses
- Commissions and Fees
- Contract Labor
- Depreciation (transferred from Federal Tax Form 4562)
- Employee Benefit Programs
- Insurance (other than health)
- Interest on Mortgages or Other Interest
- Legal and Professional Services
- Office Expense
- Pension and Profit-Sharing Plans
- Rent or Lease (Vehicles, Machinery, Property)
- Repairs and Maintenance
- Taxes and Licenses
- Travel, Meals, and Entertainment
The exclusion of expenses that are not necessary and ordinary prevents a taxpayer who is in a budget-oriented car leasing business, for example, from buying a pleasure boat and expensing its maintenance and operations costs. Since the company's clients are relatively low-income persons looking primarily at price as the criterion for leasing the car, it's unlikely that in the ordinary course of business the company would be taking them on pleasure cruises. If the company were a very high-end leasing company -- one that leased the most expensive cars and other recreational vehicles, including boats -- the argument that this kind of entertainment expense was necessary to gain favor with its wealthy clients might be defensible.
The other limitation on these expenses, that they must be reasonable and directly related to the business, is illustrated by the same example. It would likely not be held reasonable for the budget-oriented leasing company to expense maintenance expenses on a boat its customers would probably never see. Similarly, the boat has no direct relation to the business of a budget-oriented car leasing company but could be directly related to selling a high-end client on the pleasures of a yacht lease.
Some Depreciation Exceptions
As a general rule, it's better to expense an item than to depreciate because money has a time value. If you expense the item, you get the deduction in the current tax year, and you can immediately use the money the expense deduction has freed from taxes. If you depreciate it instead, it may take several years before you receive the full tax benefit of the series of annual depreciations.
In this regard, tax law embodied in Federal Tax Form 4562 offers small business an exceptional benefit. Section 179 depreciation allows a business to deduct up to $250,000 of the total cost of small capital assets in full. There are some limitations and qualifications that apply. The most important requirement is that the decision to expense rather than depreciate must be made in the year the item is put into service.