Capitalization in taxation involves recognizing and distinguishing between expenses that can be claimed immediately and those that must be spread over future periods. When an expense is capitalized, it is recorded as an asset in a company’s financial statements and its cost is allocated over multiple accounting periods, matching the expense to the revenue it generates. This is done to ensure accurate financial reporting and prevent distorting current period earnings. Capitalization of tax is specifically related to treating eligible expenses, such as research and development costs, as capital expenditures rather than deducting them as operating expenses immediately.
Tax Basis and Capitalization
Capitalizing tax means including the tax as an expense of the underlying asset. This increases the asset’s tax basis, which reduces the taxable gain or increases the tax loss when the asset is sold or disposed of.
Tax Basis
- The tax basis is the amount that you paid for an asset, plus any improvements you made to it.
- It is used to calculate the gain or loss when you sell or dispose of the asset.
- The gain or loss is the difference between the proceeds you receive and the tax basis.
Capitalization
When you capitalize tax, you add the tax to the cost of the asset. This increases the tax basis, which reduces the gain or increases the loss when the asset is sold or disposed of.
There are two main types of taxes that can be capitalized:
- Sales tax
- Property tax
Example
Here is an example of how capitalizing tax can affect the gain or loss on the sale of an asset:
| Without Capitalization | With Capitalization | |
|---|---|---|
| Purchase Price | $100,000 | $100,000 |
| Sales Tax | $5,000 | $5,000 |
| Tax Basis | $100,000 | $105,000 |
| Selling Price | $110,000 | $110,000 |
| Gain/Loss | $10,000 | $5,000 |
As you can see, by capitalizing the sales tax, the tax basis is increased by $5,000. This reduces the gain on the sale by $5,000.
## Tax Deductibility and Capitalization
When it comes to taxes, businesses have two options for dealing with certain expenses: deducting them or capitalizing them.
### Deductibility
Tax deductibility refers to the ability to reduce your taxable income by subtracting certain expenses from your revenue. Deductible expenses are typically ordinary and necessary business expenses, such as:
– Advertising
– Rent
– Utilities
– Salaries
– Supplies
When you deduct an expense, you are essentially reducing the amount of money you are taxed on. This can save you money on your tax bill.
### Capitalization
Capitalization refers to the practice of adding certain expenses to the cost basis of an asset. Capitalized expenses are typically long-term investments that will benefit the business for more than one year, such as:
– Building improvements
– Equipment
– Furniture
– Land
When you capitalize an expense, you are essentially increasing the value of the asset. This can have two benefits:
1. It can increase your depreciation deduction, which can save you money on taxes.
2. It can increase the value of your business, which can make it more valuable when you sell it.
## Table of Deductible and Capitalizable Expenses
| Expense | Deductible | Capitalizable |
|—|—|—|
| Advertising | Yes | No |
| Rent | Yes | No |
| Utilities | Yes | No |
| Salaries | Yes | No |
| Supplies | Yes | No |
| Building improvements | No | Yes |
| Equipment | No | Yes |
| Furniture | No | Yes |
| Land | No | Yes |
Capitalizing Taxes
In accounting, capitalizing taxes means treating certain taxes as an asset on the company’s balance sheet instead of expensing them in the period they are incurred. The most common example of capitalized taxes is sales tax on a purchase of a fixed asset, such as a building or equipment. Other types of taxes that may be capitalized include property taxes and certain types of excise taxes.
Depreciating Capitalized Taxes
Once taxes are capitalized, they are depreciated over the life of the asset to which they relate. This is because the taxes are considered to be a part of the cost of the asset and should be matched to the revenue generated by the asset over its useful life. The depreciation expense is recorded in the income statement, and the accumulated depreciation is recorded on the balance sheet as a reduction to the asset’s carrying value.
- Sales tax on a purchase of a fixed asset
- Property taxes
- Certain types of excise taxes
| Tax | Capitalized? |
|---|---|
| Sales tax | Yes |
| Property tax | Yes |
| Excise tax | Maybe |
Capitalizing Taxes
Capitalizing taxes refers to the accounting practice of adding certain taxes to the cost of an asset rather than expensing them immediately. This increases the asset’s value and is typically done when the asset is expected to generate revenue over several years.
Several types of taxes can be capitalized, including:
- Sales taxes
- Property taxes
- Income taxes
To determine if a tax can be capitalized, the following criteria must be met:
- The tax must be related to the acquisition or production of the asset.
- The asset must have a useful life of more than one year.
- The amount of the tax must be material.
| Income Tax | Sales Tax | Property Tax | |
|---|---|---|---|
| Expense | Immediately | Immediately | Over the property’s useful life |
| Capitalize | No | Yes | Yes |
Expensing Capitalized Taxes
In certain situations, capitalized taxes may be expensed in a subsequent period. This is typically done when the asset is sold or otherwise disposed of.
- When an asset is sold, any capitalized taxes are expensed in the period of sale.
- When an asset is disposed of in a non-sale transaction, such as a donation or abandonment, any capitalized taxes are expensed in the period of disposition.
Thanks for hanging in there with me while I talked about capitalizing tax. I know it’s not the most thrilling topic, but it’s important stuff if you’re a business owner or freelancer. If you have any more questions, feel free to drop me a line. And be sure to check back later for more helpful tips and tricks on all things business and finance.