Opinion ID: 357
Heading Depth: 3
Heading Rank: 1

Heading: Capitalization and Deduction

Text: The income tax law distinguishes between business expenses and capital expenditures. Under 26 U.S.C. § 162(a), taxpayers may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. By contrast, under 26 U.S.C. § 263(a)(1), no immediate deduction is allowed for capital expenditures, which are [a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. As the Supreme Court has explained in the leading case on this distinction, immediate deduction of a cost is more favorable to the taxpayer than is capitalization: The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 83-84, 112 S.Ct. 1039, 117 L.Ed.2d 226 (1992). The significance of the distinction is only slightly different where, as here, the expense would be capitalized to inventory. For inventoryespecially inventory held for salethe taxpayer usually does not have to rely on depreciation or wait for dissolution of the enterprise in order to obtain cost recovery. Instead, the taxpayer has to follow complex inventory accounting rules in order to get deductions over time. See 26 C.F.R. § 1.263A-1(c)(4) (Costs that are capitalized under section 263A are recovered through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service, or otherwise disposed of by the taxpayer.). These rules are designed to achieve a result that is as similar as possible to what would happen if it were administratively feasible to keep track of each individual inventory item, so that whenever an item were sold its cost basis would be known, and the taxpayer would pay income tax on the gain (or deduct the loss) from the sale of that inventory item. In other words, costs of merchandise and produced goods are capitalized and held in abeyance until they can be matched against sales revenues. Bittker & Lokken, Federal Taxation of Income, Estates and Gifts ¶ 105.8.1 (2009); see also 26 U.S.C. § 471(a) (giving the Secretary authority to prescribe inventory accounting rules to clearly reflect[ ]... income); INDOPCO, 503 U.S. at 84, 112 S.Ct. 1039 ([T]he Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes.). With ideal matching, a taxpayer would be permitted to deduct the costs of producing an inventory item no earlier, and no later, than the taxable year in which that particular inventory item is sold. Unfortunately, when a company has, say, 100,000 identical spatulas on hand at any given time and it is constantly creating and selling such spatulas (along with any number of other products), perfect matching may be difficult and the costs of producing an inventory item are sometimes recovered earlier or later than they ought to be. A distortion of income results.