What is a Capitalization Policy?

What is a Capitalization Policy?

In accounting, you typically treat any large purchases or those items with a life of more than one year (like a dishwasher or furniture) as a capital expense. This means that even though you paid for it this year, you will need to deduct the cost over many years (this is called depreciation, you can learn more about it here). For example, let’s say you purchased a couch used exclusively for your child care business for $700. Even though you paid for it this year, you would only be able to deduct $100 a year over seven years. That means that even though you spent the money this year, you’ll pay extra taxes on it.

This would be a really big pain for small businesses, so the IRS created a “safe harbor” that provides an exception if you have a capitalization policy. With a capitalization policy, you can say that any item you buy that is less than $2,500 can be treated as a current-year expense, even if it has a life of more than one year. In other words, the policy allows you to skip depreciation for items less than $2,500 and deduct them this year, keeping your taxes lower.

How to Create a Capitalization Policy for Your Business

Typically, most small businesses opt to create a capitalization policy at the highest limit: $2,500. You can set it lower, but this level allows you the greatest advantage on your taxes and in your bookkeeping.

Creating a policy is very simple and takes only three steps:

Step 1: Create the Policy

The following items should be included in a capitalization policy:

• Purpose: Clearly state the purpose of the capitalization policy, which in this case is to establish the minimum cost (capitalization amount) for recording capital assets in the company's annual financial statements.

• Capital Asset Definition: Provide a clear definition of what constitutes a "Capital Asset." Typically, you’ll want to include items with a useful life of more than one year and a cost of $2,500 or more.

• Capitalization Thresholds: Set the threshold amount for minimum capitalization, typically $2,500.

• Capitalization Method and Procedure: Outline the method and procedure for capitalizing assets.

• Recordkeeping: Specify the recordkeeping requirements.

Here’s an example of a Capitalization Policy:

1. Purpose: The purpose of this policy is to establish guidelines for recording capital assets in the company's financial statements, ensuring consistent and appropriate treatment of these assets.

2. Capital Asset Definition: A capital asset is defined as a tangible (such as a physical item purchased, like a refrigerator) or intangible asset that meets the following criteria:

   • It has a useful life that extends beyond 12 months.

   • It was acquired or produced for a cost exceeding $2,500.

3. Capitalization Thresholds: The threshold for capitalization shall be set at $2,500. All assets meeting or exceeding this cost must be capitalized, while assets below this threshold shall be expensed during the year it was purchased.

4. Capitalization Methodology and Procedures: Capital assets will be listed in records at the price they were bought for, which includes all the costs needed to get them ready to use. If a tangible asset costs less than a certain amount, it will be counted as an expense in the financial records in the year that it was bought.

5. Depreciation and Amortization: Capital assets that wear out over time will have their value spread across their estimated useful lives using standard depreciation methods. The amount that they lose value by each year will be noted in the financial records in a regular and organized way.

6. Recordkeeping: All supporting documentation, including invoices, contracts, and relevant financial records, validating the total cost of capital assets, must be retained for a minimum of four years from the date the asset is disposed of.

7. Review and Compliance: This capitalization policy shall be periodically reviewed to ensure its relevance and effectiveness.

Step 2: Sign & Date the Policy
Sign on the bottom of the policy. It is important to have as a record in case of an IRS audit, so even if you are a sole proprietor with you as the only employee, you should still sign it.

Step 3: File your Policy

Keep both a paper and an electronic copy of the policy, just in case you need it in an audit. This can be as simple as keeping a paper copy in your files and taking a photo of it for a digital version.

Even though it may seem like some extra steps, creating a capitalization policy will allow you to legally expense many more items and have a clear reason for doing so if you are ever audited by the IRS.