Question

Depreciation recapture and Amortization of Organizational Expense.

Explain with real examples?

Answer 1

Depreciation recapture

Depreciation recapture is the difference between the tax basis of an asset and its sale price. When the sale price exceeds the tax basis, this gain must be reported as ordinary income, since the depreciation originally taken on the asset provided the taxpayer with a reduction of its ordinary income. If the gain exceeds the original amount of the depreciation, the excess amount may be treated as a capital gain.

The first step in evaluating depreciation recapture is to determine the cost basis of the asset. The original cost basis is the price that was paid to acquire the asset. The adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred. For example, if business equipment was purchased for $10,000 and had a depreciation cost of $2,000 per year, its adjusted cost basis after four years would be $10,000 - ($2,000 x 4) = $2,000.

The depreciation would be recaptured if the equipment is sold for a gain. If the equipment is sold for $3,000, the business would have a taxable gain of $3,000 - $2,000 = $1,000. It is easy to think that a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. However, gains and losses are realized from the adjusted cost basis, not the original cost basis.

For example, Apple Inc. buys equipment for $20,000, which Apple Inc. then depreciates over the following four years at the rate of $2,000 per year, resulting in a net book value of $12,000.

ABC then sales the equipment for $13000.

Since the sale price exceeds the net book value by $1000 this difference is treated as depreciation recapture.

Amortization of Organizational expenses

In financial accounting term ‘organization costs’ refer to those expenditures incurred during the formation and launch of a corporation or company. Organization costs can include legal payments, state and federal registration and incorporation fees, promotions, and charges associated with the underwriting of stocks and bonds. In simple words an organizational expense is the early cost incurred to create a company.

The time period allowed for amortizing organizational expenses is 180 months. Once we fix how much our total organizational expenses are, just divide the total by 180 to find the monthly amortization amount.

Example:

Apple Inc. incurred $60,000 of startup costs. It records the startup costs using the following entry:

1. Startup expense $60,000

                 Cash                            $60,000

1. Profit and Loss account      

To Startup Expenses

A taxpayer that elects to deduct and amortize organizational expenses may deduct up to $5,000 of startup costs in the year the active conduct of the business begins.

The taxpayer amortizes any startup costs over the deduction limit for 180 months beginning in the month the active conduct of the business to which the costs relate begins. Because costs that qualify as startup costs will be deductible as ordinary and necessary business expenses when the business becomes active, a taxpayer might want to begin the active conduct of the business before startup costs exceed $5,000. This will help the taxpayer avoid having to amortize costs rather than taking a current deduction.

In addition, if the startup costs related to the business exceed $50,000, the taxpayer must reduce the $5,000 limit on the deduction (but not below zero) by the startup costs over $50,000 (Sec. 195(b)(1)(A)). If the startup costs are $55,000 or more, the taxpayer cannot deduct any of the startup costs except as an amortization deduction. Example 2 illustrates the tax treatment for a corporation that incurred more than $50,000 but less than $55,000 of startup costs.

Example

The startup costs for XYZ Corp. are $52,000. XYZ may deduct $3,000 ($5,000 — [$52,000 — $50,000]) of these costs currently. XYZ amortizes the remaining $49,000 ($52,000 — $3,000) of startup costs over 180 months, beginning in the month it begins the active conduct of its business. The entry to record the startup costs for tax purposes is:

Startup costs expense   $ 3,000

Deferred startup costs $49,000

   Cash                                       $52,000