Wednesday, January 27, 2021
One effect of the virus of 2020 is that it has spurred business start-ups by people attempting to generate income in new ways and with new methods. That raises an important tax question - when beginning a business, what expenses are deductible? That’s an interesting question not unlike the “chicken and the egg” dilemma. Which came first – the business or the expense? To have deductible business expenses, there must be a business. When did the business begin? That’s a key determination in properly deducting business-related expenses.
Deducting costs associated with starting a business – it's the topic of today’s post.
Categorization – In General
The Code allows deductions for various expenses that are related to a taxpayer’s investments that don’t amount to a business if the expenses are ordinary and necessary for the production or collection of income or are for the management, conservation or maintenance of property held for the production of income. I.R.C. §212.
Once the business begins, all of the ordinary and necessary expenses of operating the business (on a basis that is regular, continuous and substantial) that are paid or incurred during the tax year are deductible. I.R.C. §162. But, business start-up costs are handled differently. I.R.C. §195.
I.R.C. §195(a) generally precludes taxpayers from deducting startup expenditures. However, by election, a taxpayer can deduct business start-up expenses on the return for the year that the business begins. I.R.C. §195(b). The election is irrevocable. Treas. Reg. §1.195-1(b). The deduction is the lesser of the amount of start-up expenses for the active trade or business, or $5,000 reduced (but not below zero) by the amount by which the start-up expenses exceed $50,000. I.R.C. §195(b)(1)(A); I.R.C. §195(b)(1)(A)(i). Once the election is made, the balance of start-up expenses is deducted ratably over 180 months beginning with the month in which the active trade or business begins. I.R.C. §195(b)(1)(B); Treas. Reg. §1.195-1(a). This all means that in the tax year in which the taxpayer’s active trade or business begins, the taxpayer can deduct the $5,000 amount (if that’s the lesser of, etc.) and the ratable portion of any excess start-up costs.
The election is normally made on a timely filed return for the tax year in which the active trade or business begins. However, if the return that year was timely filed without the election, the election can be made on an amended return that is filed within six months of the due date for the return (excluding extensions). The amended return should clearly indicate that the election is being made and should state, “Filed pursuant to section 301.9100-2” at the top of the amended return. Without the election, the start-up costs should be capitalized.
What are start-up expenses? Amounts paid or incurred in connection with creating an active trade or business are startup expenditures. I.R.C. §195(c). More specifically, start-up costs are amounts that the taxpayer pays or incurs for: investigating the creation or acquisition of an active trade or business; creating an active trade or business; or activities that the taxpayer engages in for profit and for the production of income before that day on which the active trade or business begins, in anticipation of the activities becoming an active trade or business, and which would be deductible in the year paid or incurred if in connection with an active trade or business. I.R.C. §§195(c)(1)(A)(i-iii); 195(c)(1)(B). Common types of start-up expenses include advertising costs; salaries and wages; and expenses related to travel. See, e.g., IRS Field Service Advice 789 (1993). But, interest expense, state and local taxes, and research and experimental expenses are not start-up expenses. I.R.C. §195(c)(1).
Start-up expenses are limited to expenses that are capital in nature rather than ordinary. That’s an important point because it means that I.R.C. §195 does not bar the deductibility of ordinary and necessary expenses a taxpayer incurs in an ongoing activity for the production of income under I.R.C. §212. In addition, it makes no difference that the activity is later transformed into a trade or business activity under I.R.C. §162. For example, in Toth v. Comr., 128 T.C. 1 (2007), the taxpayer started operating a horse boarding and training facility for profit in 1998. The activity showed modest profit the first few years, but had really taken off by 2004. For 1998 and 2001, the taxpayer claimed expenses from the activity on Schedule C as ordinary and necessary business expenses deductible in accordance with I.R.C. §162, but she later determined that the expenses should be deducted in accordance with I.R.C. §212 as miscellaneous itemized deduction on Schedule A (which are presently suspended through 2025). However, the IRS took the position that the taxpayer anticipated that the horse activity would become an active trade or business and, as such, her expenses had to be capitalized under I.R.C. §195. The Tax Court agreed with the taxpayer. Start-up expenses, the Tax Court said, were capital in nature rather than ordinary. Thus, once her income producing activity began her expense deductions were not barred by I.R.C. §195. It didn’t matter that the activity later became a trade or business activity under I.R.C. §162.
When does the business begin? A taxpayer cannot deduct or amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.” See I.R.C. §§195(a), (c). There are no regulations that help define when a trade or business begins, so the question is answered based on the facts and circumstances of a particular situation. To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make a profit, (2) be regularly and actively involved in the activity, and (3) actually have commenced business operations. See, e.g., McManus v. Comr., T.C. Memo. 1987-457, aff’d., 865 F.2d 255 (4th Cir. 1988). In addition, the courts have held that a taxpayer is not engaged in a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965). Likewise, an activity doesn’t have to generate sales or other revenue for the business to be deemed to have begun. Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), aff’g., in part, rev’g. in part, and remanding T.C. Memo. 1994-316; Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th Cir. 1989), aff’g., 86 T.C. 492 (1986). However, merely researching or investigating a potential business is not enough. Dean v. Commissioner, 56 T.C. 895, 902-903 (1971).
Two Tax Court Cases
Recently, the U.S. Tax Court has decided two cases involving the deductibility of start-up costs. In Smith v. Comr., T.C. Sum. Op 2019-12, the Tax Court dealt with I.R.C. §195 and the issue of when the taxpayer’s business began. The Tax Court was convinced that the petitioner had started his vegan food exporting business, noting that the petitioner had been peddling his vegan food products in Jamaica, the Dominican Republic, Brazil Argentina and Columbia. However, he was having trouble getting shelf space. Thus, for the tax year at issue, he showed expenses associated with the activity of about $41,000 and gross sales of slightly over $2,000. The IRS largely disallowed the Schedule C expenses due to lack of documentation and tacked on an accuracy-related penalty. After issuing the statutory notice of deficiency, the IRS said the expenses were not deductible because they were start-up expenditures. Because IRS raised the I.R.C. §195 issue at trial, the IRS bore the burden of proof on the issue. The Tax Court determined that the taxpayer was, based on the facts, engaged in a trade or business. He had secured products to sell, actively marketed those products, attended food shows and other meetings around the Caribbean and South America and had established a network to find potential customers. Thus, I.R.C. §195 did not apply to limit the deduction of the expenses – they would be deductible under I.R.C. §162. Or would they?
To be deductible under I.R.C. §162 as an ordinary and necessary business expense on Schedule C (or Schedule F), the taxpayer must substantiate the expenses. Here’s where the IRS largely prevailed in Smith. The Tax Court determined that the taxpayer had not substantiated his expenses. Thus, the expenses were not deductible beyond (with a small exception) what the IRS allowed. The Tax Court also upheld the accuracy-related penalty.
Earlier this week, in Costello v. Comr., T.C. Memo. 2021-9, the Tax Court addressed the deductibility of start-up costs associated with various farming activities. In the case, the petitioners, a married couple, were residents of California but the wife conducted a farming operation in Mexico for which she reported a net loss on Schedule F for every year from 2007 to 2014. She began raising chickens to sell for meat in 2007, but couldn’t recall selling any of the chickens through 2011 and only had one sale of anything during that timeframe – a $264 loss on the resale of livestock. She then switched to raising chickens for egg production, but soon determined that the venture wouldn’t be profitable due to an increased cost of feed. She then sold what eggs had been produced for $1,068 and switched back to selling chickens for meat in 2012. She didn’t sell any chickens in 2012 or 2013 and her plan to begin selling chickens in 2014 was thwarted when the flock was destroyed by wild dogs. Also, during 2007-2011, she attempted to grow various fruits and vegetables, but the activity was discontinued because the soil was not capable of production due to a nearby salt flat. As a result, she had no sales revenue, only expenses that she deducted. She then tried to grow peppers in 2012, but insects destroyed the crop and there was no marketable production. Later that year, she acquired three cows and three calves in hopes to “make the calves big, sell them, impregnate the mothers…repeat.” She had to sell the cows in 2013 for $4,800 because there was insufficient forage on the 6,500-acre tract. The $4,800 was the only farm activity income reported for 2013. In 2012 and 2013, the taxpayers reported deductible business expenses on their Schedules C and Schedule F, later reaching an agreement with the IRS that the Schedule C expenses should have been reported on Schedule F.
The IRS disallowed the deductions, determining that the wife didn’t conduct a trade or business activity for profit and because the business had not yet started during either 2012 or 2013. The Tax Court agreed with the IRS, concluding that the farming activities never moved beyond experimentation and investigation into an operating business. The Tax Court determined that the overall evidence showed that her activities were still largely pre-operational because she was still planting research crops and the money from the sale of eggs was merely incidental after she had decided to abandon her egg production activity and get into livestock production Accordingly, the expenses were nondeductible startup expenses for the years at issue. In addition, although the Tax Court reasoned that some of the wife’s farming activities could have constituted an active trade or business, costs were not segregated by activity. Also, the there was no itemization of costs or basis in the cattle activity to allow for an estimation of any deductible loss.
When a business is in its early phase, it’s important to determine the proper tax treatment of expenses. It’s also important to determine if and when the business begins. The Tax Cuts and Jobs Act makes this determination even more important. As the recent Tax Court cases indicate, proper documentation and substantiation of expenses is critical to preserve deductibility.