What could be simpler? You pay or incur a legitimate business expense, so you claim a tax deduction for it. If that expense was necessary to help earn the income upon which you currently pay taxes, doesn’t it make sense to deduct that expenditure now? Unfortunately, our tax laws attempt to match all expenditures with the income that they affect. In other words, if you buy new equipment this year, it will still be used by the resort operation to generate income for several years to come. Thus, the deduction for most equipment is spread out over its “useful” life—or what our lawmakers feel is its useful life.
On the surface, the fact that you may pay for something today and yet be denied an income-tax deduction for the expenditure in the current tax year seems to defy logic. In reality, however, two important factors work toward limiting the tax deductions that your ski resort business can legitimately claim each year. Those factors are the accounting method you use and the fact that the expenditures may have been for items that can’t be immediately deducted.
A good example of how confusing it can get recently surfaced when the U.S. Tax Court handed down a decision that businesses must “capitalize” expenses benefiting future tax years. Generally, those so-called “capitalized” expenses must be deducted by means of depreciation, amortization or depletion. If the expense is not subject to those factors, it is generally added to the cost basis (book value) of the property and recovered when the property is sold or otherwise disposed of. Capital expenses include those for buildings, improvements or, as a business owner discovered in the example below, long-term betterments.
Licenses and insurance
The U.S. Tax Court ruling said that a trucking company, using the accrual method of accounting, is not entitled to a current tax deduction for the amounts spent on license and insurance expenses because the benefits extended substantially beyond the tax year in which the company incurred those costs.
The judge in the case agreed with the IRS that as an accrual-method taxpayer, the company, USFreightways, had to capitalize and amortize the license and insurance expenses ratably over the respective tax years those licenses and insurance benefits extend substantially beyond the current tax year. The trucking company futilely argued that the “substantially beyond” language used in the tax regulations should be construed as meaning more than one year beyond the taxable year, so an expense could be deducted if its benefit extends “less than 12 months into the subsequent tax period.” But the judge explained that the relevant question was whether the “life of the contested benefit exceeds the tax year in which it is incurred, not whether it endures beyond one 12-month period.”
Why the company was contesting the IRS’s disallowance of an immediate write-off for their expenses is somewhat of a mystery in light of the judge’s final comments. Even if the company’s construction of the one-year rule were recognized, the judge continued, it would be inapplicable to an accrual-method taxpayer such as USFreightways.
Accrual vs. cash-basis accounting
The taxable income of every ski resort operation must be computed not only on the basis of a fixed accounting period but also in accordance with a regular method of accounting. A “method of accounting” includes the overall method of accounting for income and expenses as well as special items such as depreciation. There are two common methods of accounting for income: the cash basis and the accrual basis.
The cash basis (cash receipts and disbursements) is the method of accounting used by most individuals and many small ski resort businesses. Income is generally reported in the year that it is actually or constructively received in the form of cash, its equivalent or other property. Deductions or credits are generally taken for the year in which the related expenditures were paid, unless they should be taken in a different period to more clearly reflect income (such as depreciation allowances and prepaid expenses like licenses and insurance).
Under the accrual method, income is accounted for when the right to receive it comes into being. That is when all the events that determine the right to that income have occurred. It is not the actual receipt of the income but the right to receive that governs. On the accrual basis, expenses are deductible in the year they are incurred, so that once all the events have occurred that fix the amount of the item and determine the liability to pay, it’s possible to deduct.
Every ski resort that is required to use inventories must use the accrual method to account for purchases and sales. The same is also true for regular “C” corporations and partnerships with corporations as partners. The far easier, cash-method may be used if the ski resort is not what the IRS views as a tax shelter or a qualified personal-service corporation and if average annual gross receipts for the three tax years ending with the prior tax year do not exceed $5 million.
Write-off basics
A taxpayer, whether doing business as a corporation, an individual or a partnership, is permitted to deduct (from gross income) all of the ordinary and necessary expenses of running a business that are paid or incurred in the tax year. However, no tax deduction is permitted for any expenditure that is a capital expense.
An expense that adds to the value or useful life of property is considered to be a capital expense. Generally, those capital expenses must be deducted by means of depreciation, amortization or depletion. Depreciation is defined as a deduction allowed to a taxpayer that represents a reasonable allowance for the wear and tear of property used in the business or held for producing income. Amortization is the systematic write-off of costs incurred to acquire an intangible asset, such as a patent, copyright, goodwill or expense. Depletion is best described as a process whereby the cost or other basis of a natural resource (such as a coal interest) is recovered upon the extraction and sale of the deposit.
Current deductions that are permissible despite the restrictions of our tax laws include barrier removal. You can deduct up to $15,000 of the costs of removing certain architectural and transportation barriers for handicapped or elderly persons in the year paid or incurred instead of capitalizing and depreciating such costs. And, don’t forget, up to $20,000 ($19,000 for 1999) of qualified equipment acquisitions may be written-off in the year of acquisition as a so-called “Section 179” expense.
Expenses that keep a ski resort’s property in efficient operating condition and don’t add to its value or appreciably prolong its useful life are generally deductible as repairs. These include repainting, mending leaks, plastering and reconditioning gutters. However, the costs of installing a new roof and bricking up windows to strengthen a wall are capital expenditures.
When is it deductible?
Every expenditure made by a ski resort does not automatically warrant an immediate deduction. Many owners and operators work to ensure that each expenditure is matched with the income that it impacts on. It’s good tax planning. The goal of tax planning after all is to manipulate income and expenses in such a way that the ski resort operation has a consistently low tax bill year after year. Deducting or capitalizing expenses, guaranteeing accurate lives for depreciable assets and making the most of the loopholes will result in that low tax bill that every owner and operator hopes for; not only for the year ahead but for many years down the road.
Mark E. Battersby is a freelance writer, lecturer and corporate advisor specializing in business taxes and other financial matters.
