Act Now! Get Your Safe-Harbor Expensing in Place

Here are two tax words that you have to love: “safe harbor.”

And here are five additional tax words to love: “tax-favored expensing with no recapture.”

To create and protect your safe-harbor expensing, you make-or your corporation or partnership makes-a formal election on your tax return to use the de minimis safe harbor to expense assets costing $2,500 or less (or $5,000 with applicable financial statements, as explained later).

This wonderful safe-harbor election eliminates the burdens of

■ tracking those small-dollar assets,

■ depreciating and/or Section 179 expensing them in your tax returns and account books, and

■ remembering to remove them from your books when you remove the assets from your business.

The term “safe harbor” means that the IRS will accept your expensing of the qualified assets if you properly abided by the safe-harbor rules. For asset purchases that don’t qualify for safe-harbor expensing-no problem: you have Section 179 expensing and Section 168(k) bonus depreciation available.

Big Picture

You want your safe-harbor expensing for 2024 in place on January 1, 2024. That’s why you are seeing this article in September 2023. We want to give you time to get your safe harbor in place for 2024.
If you used safe-harbor expensing in prior years, you should see your safe-harbor election on those prior-year tax returns.

Overview of This Big Benefit

Say you are a small business that elects the $2,500 ceiling for safe-harbor expensing, and you buy two desks costing $2,100 each. On the invoice, you see the quantity “two” and the total cost of $4,200, plus sales tax of $378 and a $200 delivery and setup charge, for a total of $4,778. Before this safe harbor, you would have capitalized each desk at $2,389 ($4,778 + 2) and then either Section 179 expensed or depreciated the two desks. And you would have kept the desks in your depreciation schedule until you disposed of them. With the safe harbor, you expense the desks as office supplies-eliminating the need to track the desks in your account books.

Safe Harbor

The de minimis safe harbor, when implemented,

■ requires you to immediately deduct as business expenses any assets with less than a specific dollar
amount that you select (within limits), and

■ gives you a regulatory advance agreement from the IRS that it will not, in an audit, challenge your
election to expense.

What’s Your Limit?

The rules contain two safe harbors; one applies to you. You either have or don’t have an “applicable financial statement” for your business. If a certified public accountant (CPA) audit or something similar is done to your financial statements, you have an applicable financial statement (AFS).
The difference between having an AFS and not having one is this:

■ With an AFS, you can create tax-deductible $5,000 expensing per invoice or item.

■ Without an AFS, you can create tax-deductible $2,500 expensing per invoice or item.

Creating the Safe Harbor

To benefit from the safe harbor, you need to take four steps.

Step 1: Have-and Stick to-an Expense Policy

For safe harbor protection, you must have in place an accounting policy-at the beginning of the tax year-that requires expensing of an amount of your choosing, up to the $2,500 or $5,000 limit.
And you must comply with this expense policy in your books and records. If you establish a policy to expense items costing $2,500 or less, you must expense every such item in your books. You can’t expense some of those items and capitalize others. So why wouldn’t you always set your expense policy threshold to the maximum safe harbor? Because your expense limit applies not only to your tax return but also to your financial statements, and you may have reasons to look better to your banker or shareholders than you look to the IRS.

Key point. The $2,500/$5,000 limit operates as a “cliff.” If the cost exceeds your limit, it does not qualify for the safe harbor.

Step 2: Put the Expense Policy in Writing

If you have an AFS, the IRS requires that you have your expense policy in writing at the beginning of the tax year. If you don’t have an AFS, the IRS says you must have accounting procedures in place at the beginning of the year that treat the safe-harbor amounts as expenses for non-tax purposes.

Key point. The non-AFS “accounting procedures” requirement does not have to be in writing. This means it is “what you do” and “what you have been doing.” But let’s be real: put this in writing to avoid having the IRS ask what or where your procedure is. Here’s another reason to have it in writing. In the preamble to its expensing regulations, the IRS states: “The de minimis safe harbor is intended to provide recordkeeping simplicity to taxpayers by allowing them to follow an established financial accounting policy for federal tax purposes, and allowing retroactive application is inconsistent with such purpose” (emphasis added). So you can’t go back and change things, and you can’t make mistakes in your books. The solution: Put your expense policy in place now. Don’t waste a minute. Here’s some language you can use:

Note the added proof that this policy is real and in place. It’s signed by the owner, dated, and also signed by a witness and dated. In fact, consider having the statement notarized, because that sets the date in stone.

Step 3: Save Your Invoices

The safe harbor applies only to items documented by invoices.9 That’s good. Remember the records rules:

■ The invoice proves the purchase.

■ The canceled check, bank transfer, or credit card charge proves that you paid the money.

You want both proof of purchase and proof of payment in your tax files.

Itemized versus lump-sum invoices. To apply the safe harbor on a per-item basis, you want the invoice to identify the separate items. Say you buy 20 computers that cost $2,000 each. If the invoice lists each computer separately-or at least notes the number of computers and the per-unit cost-the safe harbor lets you deduct the entire $40,000. Suppose the invoice includes delivery fees; installation costs; or similar, related service costs. In that case, you must allocate those costs to the items using a reasonable method such as specific identification, pro rata allocation, or weighted average (based on price).

Example. If the freight charge for the 20 computers is $2,000, you could reasonably allocate $100 ($2,000 + 20) to each computer, making their cost $2,100. You don’t include separately invoiced additional costs in the cost of the property. For example, say you hire a different company to install the computers in your office on your network, for a fee of $6,000. None of the $6,000 is allocable to the 20 computers for purposes of the safe harbor.

Step 4: Make the Election on Your Tax Return

You must make the election on your tax return every year you want to use the safe harbor. To make the election, you attach a statement to your federal tax return and file that tax return by the due date (including extensions). The statement must be titled “Section 1.263(2)=1.(f). De Minimis Safe-Harbor Election” and must include your name, address, and Social Security number, plus a statement that you are making the de minimis safe-harbor election under Reg. Section 1.263(2)=1.(f).

Here’s some language to use for the safe-harbor election:

Two things to remember. First, the election with your tax return is an annual event. Second, you can change your accounting policy on expensing any year. But if you make a change, make sure you have that change noted in a new or amended beginning-of-the-year written expense policy or statement. In general, you may not file an amended return either to make or to revoke the election.

Sale or Disposition of Safe-Harbor Property

You don’t treat safe-harbor property as a capital asset under Section 1221, or as property used in a trade or business under Section 1231, when you sell or otherwise dispose of it. Any proceeds from sale create ordinary income that’s not subject to self-employment taxes.

Takeaways

Because it saves time and trouble, you want to use safe-harbor expensing when you can. Here’s why:

1. Safe-harbor expensing is superior to Section 179 expensing because you don’t have the recapture period that can complicate your taxes.

2. Safe-harbor expensing takes depreciation out of the equation.

3. Safe-harbor expensing simplifies your tax and business records because you don’t have the assets
cluttering your books.

4. Safe-harbor expensed assets do not reduce your overall ceiling on Section 179 expensing.

To put safe-harbor expensing in place:

1. Have an expense policy in place at the beginning of the year.

2. Put the expense policy in writing, and comply with it.

3. Keep the invoices.

4. Make the annual election to expense on your federal income tax return.