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.
Capital Expenditures Versus Operational Expenses
For tax purposes, capital expenditures are generally defined as the purchase of assets whose usefulness, or value to a company, exceeds one year. Capital expenditures are commonly for more expensive business outlays such as facilities, computer equipment, machinery or vehicles, but they can also include less tangible assets, such as research and development or patents.
Operational expenses are for assets that are expected to be purchased and fully utilized within the same fiscal year. Office supplies and wages are two examples of operational expenses.
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 are depreciated on a percentage basis over different time spans – three, five, 10, or more years.
It is advantageous for businesses to be able to 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 stockholders.
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 Internal Revenue Service (IRS) has made 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.
For instance, only tangible property, not real estate, qualifies for the 100% deduction. 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 that a company does not financially overextend itself through capital expenses.