Wednesday, July 6, 2022
It’s costly to start a business – especially a farming or ranching business. From a tax standpoint are the start-up costs deductible? As with many tax questions, that answer is that it “depends.” One item that the answer depends upon is when the business begins. That’s a key determination in properly deducting business-related expenses.
Recently the Tax Court applied the start-up expense rules to a web-based business. When does a web-based business begin? Does the business start when the website is brought online? When sales are generated? Some other time? What costs are deductible? These are all interesting and important questions – many businesses, including those that are ag -related are conducted online or conduct some of the business transactions online.
Deducting costs associated with starting a business – that’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 are 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).
In Smith v. Comr., T.C. Sum. Op 2019-12, the Tax Court was convinced that the taxpayer had started his vegan food exporting business. The Tax Court noted that the taxpayer 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?
Note: 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.
When Does a Web-Based Business Begin?
When does a business begin when the business is web-based? The Tax Court had not previously addressed the application of the start-up expense rules and the active conduct of a trade or business test in the context of a web-based business until it’s decision in Kellett v. Comr., T.C. Memo. 2022-62. In Kellett, the petitioner launched a retail website in 2002, which he operated until 2007. He then accepted a couple of jobs with internet research firms. While working full-time, the taxpayer began work on a website that collated demographic, social and economic data that would be useful to any number of companies. He hired remote engineers to develop the website and develop user interfaces using open code software. The website was functional by March of 2015, the bugs were worked out, and the website launched in September of 2015, but no revenue was generated until 2019. The petitioner claimed deductions for the amount paid to the software engineers, to marketing companies, and for home internet access and other miscellaneous expenses on his 2015 Schedule C as trade or business expenses. The IRS claimed that the expenses were start-up expenses under I.R.C. §195 to be amortized ratably over 180 months beginning in September of 2015.
The Tax Court recognized that the receipt of revenue is not a pre-requisite for a venture to establish that it is a trade or business. But, the Tax Court noted, a venture must at least try to sell goods or services. Here, the website did not even try to sell anything until after 2015. The petitioner claimed that he could not successfully sell access to his website until a significant number of users actively used the website. Thus, he didn’t charge a user fee and marketed the site to institutional users to build up an active user base. The Tax Court accepted the petitioner’s argument and held that the 2015 activity from and after September 30, 2015, when the website launched, would be treated as trade or business activity for federal income tax purposes. Accordingly, the Tax Court allowed the petitioner to deduct all engineering expenses paid after September 30, 2015 and treated all engineering expenses paid on or before September 30, 2015, as start-up expenses.
On other issues, the Tax Court reduced the petitioner’s claimed business use of the internet by one-half due to lack of evidence and denied a deduction for research and development expenses because the petitioner was not developing a new product, but merely using existing software to display and analyze date. The Tax Court also held that the IRS had no statutory authority for its position taken in Rev. Proc. 2000-50, 2000-2 CB 601 that it would not challenge a taxpayer’s deduction for the costs of developing computer software even if the costs did not qualify as research and development expenses.
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. Once these hurdles are cleared, the Smith case illustrates the importance of substantiating expenses to preserve their deductibility, and Kellett applies the start-up expense deductibility principles in the context of a web-based business.