Capital Assets

The importance of understanding what capital assets are and how they're applicable to your organization can be summed up in four words: the Internal Revenue Service.

How you allocate your information technology budget can depend heavily on how an asset is taxed. And determining whether to buy or lease an asset often depends on how it will be treated for tax purposes.

"An asset that does not have a life of more than one year can be treated as an expense and deducted immediately from a company's income," says Howard K. Warshaw, a partner at New York-based accounting firm Leipziger & Breskin LLP. "These items might include office supplies - the point here is that you can immediately expense these items."

Another way to look at a capital asset: "It is anything not held for sale in the business," says Joseph Clare, a partner at San Francisco accounting firm Clare, Chapman, Storey & Castro LLP.

Depreciating Disk Drives

Capital assets, such as a mainframe computer or a $10 million storage silo, are typically depreciated over several years instead of expensed as an up-front, one-time charge. Using various depreciation methods, companies can write off the cost of the asset following a schedule produced by the IRS.

For example, the IRS says computers can be depreciated over five years, whereas software purchased separately from the computer can be written off over a three-year period. If you can't separate the software from the hardware, then you must select the five-year schedule, according to IRS regulations.

Rules exist for depreciating different kinds of assets for tax purposes, says Warshaw. Most accountants will use the Modified Accelerated Cost Recovery System, which tells you how to depreciate different pieces of equipment, as some have longer lives than others.

Typically, computers are depreciated using what's known as the "double-declining balance" over five years. This is an accelerated method of depreciation that "allows you to write off a higher percentage of the cost in the beginning," notes Warshaw.

Being able to write off a larger portion of an asset earlier in its life can have several effects: It can reduce the amount of income on which the company must pay tax. In addition, by writing off an asset early, your balance sheet isn't full of assets that aren't generating cash flow. But what if you decide you want to get rid of the computers before the five years are up?

"If you paid $1,000 for the machine, and you already depreciated $600 of it after two years and then sold it for $400, you would be able to recognize a loss of $600 against your income," explains Warshaw.

In this case, you get the write-off against income using depreciation and you get to deduct the loss of $600 against ordinary income, thereby lowering the amount that's taxed.

Trying to define the exact nature of an asset can get a little tricky if your company is selling capital assets and claiming a loss.

"Some people look to lease certain assets," says Warshaw. "When [you] are signing a lease for tax purposes, the IRS has certain rules as to whether you can expense the lease payment each month."

Of course, the IRS is interested in knowing whether your company is using a lease to purchase something in order to get the interest deduction. One way to make this clear is to have a portion of the contract state that your business can purchase the equipment for fair market price at the end of the lease.

Attempting to buy the equipment for the nominal sum of $1 won't fly with the IRS. The agency will most likely claim that you purchased the equipment and must depreciate its value rather than deduct the payments.

Maximizing Cash Flows

Another reason to consider leasing equipment is the Holy Grail of cash flow. "Most businesspeople, as well as Wall Street analysts, look for a steady cash outflow from a capital asset," says Clare.

"Everyone wants to manage big expenditures, to smooth out the big capital outlays to avoid big blips in cash flow," Clare adds. "From an economic basis, it could be better for the company. For an IT manager, his or her job is to get purchases or leases organized in such as way so that capital expenses don't bump up all at once."

Warshaw points out that some companies may want to show investors a lot of income, which would favor depreciation of assets over time, rather than expensing them all at once. "If, on the other hand, the company is making lots of money and wants to maximize its deductions up front, it might look to expense the equipment payments each month. It really depends on your situation," he says.

That's one reason why it's worth doing a projection in December to see if your organization is likely to owe the government a sizable amount in taxes. If so, your company might want to use its cash to purchase office supplies, new stationery or other items that won't last a year so it can receive the immediate deduction, says Warshaw.

"Maybe the write-off is more important this year than the depreciation," says Warshaw. "And your balance sheet will look different, too, the more you capitalize your asset. For technology companies, that might mean capitalizing the interest expense related to the cost of a project."

For example, a company may decide to purchase a large computer or other piece of equipment. By leasing and claiming the deduction of lease payments, it would have a steady amount to deduct from income, smoothing out the company's cash flow.

Then again, depreciation could produce significant changes in deductions from income each year, making cash management more difficult.

The choice comes down to a pay-now vs. pay-later scenario.

"For the IRS, a business would want to write off things quickly, getting the deduction, while for shareholders, you would want to show a longer life for your assets," says Clare.

Copyright © 2000 IDG Communications, Inc.

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