The Difference between Current and Capital Expenses

Capital expenses and current expenses are treated very differently for tax and reporting purposes. Capital expenses are those which create an asset for a business, and can be used to generate income in the future. These expenses must be “capitalized” or written off over a period of years, depending on what type of asset is in question. Current expenses are those necessary for the daily operation of a business, and are fully deductible in the current year. Recognizing the difference between the two is very important in terms of reporting the expense to the IRS and correctly reporting it on the company balance sheet and income statement.

Capital expenses can generally be divided into three categories: business start-up costs, assets, and the cost of improvements. Examples of these expenses are land, buildings, equipment, furniture, and repairs, which extend the life expectancy of an asset more than a year. All of these expenses create an investment for the business and allow for future revenue. These assets belong on the balance sheet of a company and can be capitalized, or expensed, through depreciation or amortization over time.

The tax code dictates the number of years allowed for expensing capital assets and can be quite confusing. Assets can be written off over a period of anywhere from 3 years on up. This means that the business can write off a portion of the cost of the asset over a given number of years. Refer to the tax guidelines on the IRS website and/or consult a C.P.A. for the correct recovery period.

Current expenses are those created in running the business on a day-to-day basis. They include things such as rent, utilities, supplies, payroll, and repair and maintenance expenses, which do not prolong the life of an asset.

Normal repair costs are considered current expenses and are deductible in the year the cost is incurred. If, however, the repair is considered an improvement, adding value or lengthening the useful life of an asset by more than a year, it is considered a capital expense and cannot be written off in the current year.

Current expenses reduce the taxable income of the business and are reported on the company profit and loss statement as an expense. These expenses reduce the tax liability of a business.

According to the IRS rules, certain capital assets can be expensed in the current year through the IRC Section 179 deduction. Specific rules and limitations must be met in order for a business to take this deduction. If allowed, a business should take full advantage of the section 179 deduction, reducing taxable income for the current year. Follow the link for more information.

The difference between capital and current expenses can sometimes create a “gray” area, whereby it is not obvious which type of expense should be taken. It is critical that a C.P.A. be consulted to clarify the rules and ensure that the business remains within the boundaries imposed by the IRS, while concurrently maximizing profit and minimizing tax liability.