Capital vs. Current Expenses: What’s the Difference?
Keeping track of business expenses can be difficult, whether you are a seasoned business owner or just starting out. But besides keeping track, for tax purposes you are also required to classify your expenses into capital and current. And it’s not always as simple as it looks. Allow our Maryland business tax preparation experts to offer you a quick overview of these types of expenses and what they mean.
Why it’s Important to Know the Difference
Knowing the difference and separating your expenses into capital vs. current lets you know when you can claim certain deductions. Yes, besides regulating which expenses you can deduct, the IRS also governs what year these deductions should be claimed in. For example, some deductions can be claimed in the same year as the expenses occurred, while others would need to be broken down into chunks and claimed over several years. This is what capital and current expenses help you figure out.
Current expenses are typically (but not always) recurring fees that are essential for keeping your business afloat. The IRS describes them as “both ordinary and necessary.” They may include things like rent, software subscription fees, printer paper and service fees, internet and phone fees, etc. These expenses are summed up and subtracted from your total income during the same tax year.
Cost of Goods Sold
Cost of goods sold are the expenses that may be considered ordinary, necessary and regular, yet the IRS doesn’t count them toward current expenses. Businesses that either manufacture or resell products have cost of goods sold expenses, such as freight charges, storage fees, cost of raw materials, direct labor and factory overhead. Most of these expenses must be deducted over several years.
Capital expenses have to do with purchasing assets. And assets are things that you buy in order to grow or improve your business, such as a new warehouse that can store more products or new equipment that will increase your productivity. For the most part, real estate, equipment and vehicles constitute capital expenses, but depending on your industry you may have other ones. Startup costs are also considered capital expenses, and so are improvements such as a new floor or window replacement in your store or office.
As far as the IRS is concerned, your capital expenses are investments into your business. So because you may expect your investment to pay off over time, the IRS also wants you to deduct it over time. This process of spreading the deductions over several years is referred to as capitalization or depreciation of assets. It helps you judge how profitable you are from year to year, as well as see how well your investments are paying off.
IRS Section 179
Everything has been clear so far, right? Unfortunately, things are not always as clear-cut in real life as they are on paper. And that’s where Section 179 comes into play. Without getting too technical, this section allows you to take some capital expenses and deduct them in the current year instead of capitalizing them over several years. Why would you do that? That would be to pay less in taxes in the current year. Only certain types of property qualify for Section 179, and the deduction limit is $500,000 for 2015. You also can’t claim more than the total income of your business for this year. Property that qualifies for Section 179 includes such material goods as equipment, computers, software, furniture, and some other property. You can use the Section 179 calculator to see how much you could save after taking advantage of this deduction.
As you can see, there is a strategy to which expenses you should deduct and when. If you want to make the most of these deductions, contact CFO Source today for assistance with business tax planning and filing.