Same-Year Tax Deductions and Capital Expenditures

Everyone pays taxes. Your annual tax liability depends on how much you make and whether you're an individual filer or a business entity. The Internal Revenue Service (IRS) treats personal and business taxes separately. Current tax laws do not allow the vast majority of capital expenditures to be fully tax-deducted for the year in which the expenditures occur. Businesses may be opposed to such tax regulations, preferring to be able to deduct the full amount of their cash outlays for all expenses, whether capital or operational. Keep reading to find out more about the tax treatment of corporate expenses.

Key Takeaways

  • Capital expenditures are purchased assets whose usefulness or value to a company exceeds one year. 
  • Operating expenses are used for assets that are expected to be purchased and fully utilized within the same fiscal year.
  • While OPEX can be tax-deducted in the year they are made, but CAPEX must be depreciated over a period of years considered as constituting the life of the asset purchased. 

Capital Expenditures and Operating Expenses

Capital expenditures are generally defined for tax purposes as the purchase of assets whose usefulness or value to a company exceeds one year. Capital expenditures, or CAPEX as they are commonly referred to, are often used by companies and other organizations to fund new projects and investments. These costs are commonly used for more expensive business outlays such as facilities, computer equipment, machinery, or vehicles. They may also include less tangible assets such as research and development or patents.

Operating expenses, on the other hand, are used for assets that are expected to be purchased and fully utilized within the same fiscal year. Office supplies and wages are two examples of operating expenses, also called OPEX. These costs are necessary in order to meet the needs of a business and its day-to-day operations and, therefore, cannot be avoided. Business entities can, however, find ways to reduce their OPEX in order to find savings and remain cost-effective.

It's important to note that the IRS treats both capital expenditures and operating expenses differently. We explore the differences below.

How Tax Deductions Are Handled

Operational expenditures can be fully tax-deducted in the year they are made, but capital expenditures must be depreciated, or gradually deducted, over a period of years considered as constituting the life of the asset purchased. Different types of assets depreciate on a percentage basis over different time spans—three, five, 10, or more years.

Businesses can take advantage of the fact that they can deduct expenses in the year in which they occur. More deductions translate to a lower tax bill for the year, which leaves more cash on hand available for the business to expand, make further investments, reduce debt, or make payouts to shareholders.

From the tax agency's point of view, since capital expenditures purchase assets that continue to provide value or income for several years beyond the purchase year, it makes sense to have a multi-year taxation plan. Depreciation allowances can be looked at as a company gradually recovering the full cost of an item over its useful lifespan.

There are specific rules that govern the number of years over which an asset is to be depreciated. For example, computer hardware is commonly depreciated over a period of five years, while office furniture is depreciated over a seven-year period.

Exceptions for Certain Types of Capital Expenditures

The IRS has some concessions to business owners through Section 179, which allows 100% same-year tax deductions for some capital expenditures. There are rules on the total amount that can be deducted for capital expenses in a single year, and regarding what types of property qualify for the full deduction.

Business owners are allowed full same-year tax deductions for capital expenditures through Section 179 for tangible property—not real estate.

For instance, only tangible property qualifies for the 100% deduction—not real estate. S corporations are not allowed to pass the deduction on to stockholders unless the company has net income. Section 179 is designed to primarily benefit small or new businesses that need to make substantial outlays of capital to grow and develop.

Capital expenditures are usually substantial amounts of money that significantly reduce a company's cash flow or require it to take on additional debt. Since businesses cannot completely deduct these expenditures in the year they are incurred, careful planning is required so companies do not financially overextend themselves through capital expenses.

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