Tax Deductions

Start Up Expense Deductions and Amortization Explained

To deduct, or not to deduct, that is the question: Whether ‘tis nobler to write-off thy business expenses or suffer the slings and arrows of the outrageous fortune of capitalizing and amortizing said expenses under IRC §195

 

Internal Revenue Code (IRC) §162 allows those carrying on a trade or business to deduct ordinary and necessary expenses paid or incurred during the taxable year. But, one generally cannot deduct expenses until the business actually commences operations.

 

However, IRC §195 allows for the capitalization and future deduction via amortization of these “start-up” expenses paid in connection with:

 

Tax Deductions“… investigating the creation or acquisition of an active trade or business… creating an active trade or business, or any activity engaged in for profit… before the day on which the active trade or business begins, in anticipation of the activity becoming an active trade or business… if paid or incurred in connection with the operation of an existing active trade or business would be allowable as a deduction for the taxable year in which paid or incurred.”

 

IRC §195 allows the deduction of start-up expenses once the trade or business commences operations. At that time the taxpayer can immediately deduct up to $5,000 of the start-up expenses, an amount that is reduced dollar for dollar for expenditures exceeding $50,000 (in other words, no immediate expensing is available if start-up expenses exceed $55,000). The taxpayer can then begin amortizing any remaining start-up expenses over 180 months (15 years).

 

This article will attempt to more clearly define the line of demarcation for determining when business commences for purposes of deducting start-up and other expenses.  It will also discuss the types of expenses that qualify as start-up expenses within the meaning of IRC §195. One should note at the outset that much of this determination relies on judicial rulings due to the scant statutory and regulatory guidance.

 

Regulations under IRC §248 (relating to organizational expenses) does provide some insight as to when a corporation begins business operations. Although the corporation’s legal existence begins on the date of its incorporation, the regulations clarify that undertaking such organizational activities do not in themselves indicate the start of business operations. Rather this occurs when the corporation’s activities have advanced to the extent necessary to establish the nature of its business operations (e.g., production has begun in the case of a manufacturing firm).

 

The Fourth Circuit Court of Appeals’ decision in Richmond Television Corp. v. United States serves as a seminal case in this area. Here a television station operator incurred employee training expenses prior to receiving its FCC license. The court disallowed the deduction of the training expenses under IRC §162 because the station had yet to “function as a going concern” nor had it “performed those activities for which it was organized.” Subsequent judicial decisions have interpreted the ruling to mean that a trade or business begins only when enterprise acquires all necessary assets (i.e., the nature of the business had been established). The following table illustrates how the courts have applied the Richmond Television ruling to disparate types of businesses.

 

Type of Business

 

Commencement of Trade or Business

 

Manufacturing Trade or business begins when all operating assets have been acquired and put into use; production of salable goods begins

 

Retail Trade or business begins when doors of the business establishment have been opened and business transactions with customers can be undertaken

 

Service Trade or business begins when service is first conducted; can also commence when taxpayer begins holding themselves out as providing services such as a doctor opening a medical clinic

 

Distribution Trade or business begins when all necessary licenses and equipment are acquired and assets are put to use

 

Leasing Trade or business begins when the item of property (whether real or tangible) is available for lease; for example, an apartment complex must be completed, occupied, and producing income

 

However, other courts have imposed laxer standards. For example, in Blitzer v. United States the Federal Court of Claims contravened Richmond Television by ruling that an apartment complex operator began business at the onset of the construction of the complex. The court reasoned that the significant financial commitment borne by the complex operator pushed the enterprise past the introductory stage and it had begun incurring normal recurring expenditures. United States v. Manor Care, Inc., a district court case, involved a consolidated group engaged in operating nursing homes. Two of its subsidiaries incurred expenses for wages, training, utilities, and advertising prior to the receipt of the required operating licenses and its opening of the facilities. In ruling for Manor the court concluded that the business had begun for purposes of IRC §162 because the receipt of the license was virtually assured, the expenses were incurred in the same tax year the business began, the expenses were normal operating expenses, and the expenses produced benefits in the same tax year.

 

Many tax professionals view the precedents set in Blitzer and Manor cases as tenuous. First, they seemingly conflict with the plain language of IRC §162 stating that the taxpayer must be “carrying on” a trade or business in order to claim a deduction. Furthermore, IRC §195 does not allow interest, taxes, or research and experimental expenditures as start-up expenses. Presumably, Congress would not have specifically excluded these recurring expenses from IRC §195 treatment if it viewed the recurring nature of an expense as by itself justifying an immediate deduction pursuant to IRC §162. Similarly, the rulings also do not comport with the language of IRC §§162 and 195 indicating a trade or business begins only when it acquires operating assets. Finally, the legislative history indicates Congress intended to include recurring expenditures as start-up expenses under IRC §195. Thus, taxpayers relying on these rulings to substantiate immediate deductions should do so with the recognition of their somewhat dubious standing.

 

To find out more about when a trade or business commences for purposes of the federal law and how this affects your own business situation please contact a tax professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas. https://www.linkedin.com/in/drquintana