Small Business Taxes & Management

Special Report

Timing of Deduction for Start-Up Expenditures


Small Business Taxes & ManagementTM--Copyright 2009, A/N Group, Inc.


Section 195 generally requires taxpayers to capitalize start-up expenditures. Fortunately, the first $5,000 of such expenditures can be expensed in the year in which an active trade or business begins, if the total such expenditures don't exceed $50,000. Expenditures in excess of $5,000 (or where the $5,000 allowance is phased out because of the $50,000 cap) can be amortized over not less than 180 months (15 years). The rule shouldn't be ignored. If a proper election to expense the expenditures isn't made, all the expenditures must be capitalized.

What are start-up costs? Start-up costs can include investigatory expenses such as conducting market surveys, analysis of locations, product sources, etc., amounts paid to evaluate several businesses and to determine whether to enter the business and which business to acquire, and preliminary due diligence to assist in a potential acquisition. However, once the business has been identified, additional due diligence such as a review of the acquisition's books and records by an accounting firm and or law firm don't qualify. Other items that qualify include expenses such as pre-opening advertising, hiring initial employees, training, salaries, travel expenses, etc.

Example--Sue Flood incorporates Madison Dresses, Inc. in April 2009. On May 1 she signs a lease for the store and hires Ann to help her stock the racks, decorate, etc. In addition, Madison is paying $1,000 for rent. Madison opens its doors for business on July 1, 2009. From May 1 through July 1 Madison paid $8,000 in salaries, rent, etc. as pre-opening expenses. On Madison's return for 2009, Sue can deduct $5,000 of the total pre-opening costs. The remaining $3,000 must be amortized over 180 months, beginning in the month business began.

Tax Tip--Clearly, it makes sense to keep the pre-opening expenses as low as possible. One way is to make sure you have all your resources ready before beginning. In the example above it would have made no sense for Sue to hire Ann on May 1 if the racks, dresses, etc. weren't going to be delivered for two months. A second way may be to begin business before the everything is in place. For example, you're opening a bar and grill in a resort area. The bar portion will be ready quickly, but the inspections and permits for food service will take three months. Open the bar now and the additional costs associated with the food service may be expensed as expansion costs. Caution. Check with your tax adviser on this approach.

Organization expenses fall under a different Code Sections, but the rules are similar. They include the costs of incorporating a corporation (Sec. 248) or of setting up a partnership (Sec. 709). Such expenses include setting up the books of the entity, legal fees in incorporating or organizing the partnerships, etc. (Caution. Not all organization expenses qualify.) Expenditures up to $5,000 can be expensed, if the total such expenses don't exceed $50,000. Expenses in excess of $5,000 must be capitalized and amortized over no less than 180 months.

The next issue to deal with is, when does the business begin? This is a factual issue and it's not often clear. Before looking at the nuances, the first question is, do you need a license or permit? If you haven't got the permit from the town, county, etc., you're most likely not in business. If you need a liquor license to sell wines and spirits, you're not in business until you get that license. Same for a restaurant; you'll need a license. On the other hand, if you had the restaurant but not a liquor license you could open for business and serve food only. There can be exceptions, but make sure you're on firm ground. But just because you have a license doesn't mean you're in business. If you don't need a license, business usually begins when your doors are open to customers. Generally that's also the same time you make your first sale, but not always. If there's any question (e.g., you don't have a fixed establishment, but sell over the phone) try to document the time.

Expansion versus new business. If you're just expanding an existing business, pre-opening expenses shouldn't have to be capitalized. For example, you already operate four restaurants in the local area. You decide to open a fifth. The expenses should be deductible as ordinary business expenses. On the other hand, it you set up a new corporation, LLC, etc. to own and operate the additional restaurant, you'll probably have to treat the costs as start-up expenditures. As always, there are exceptions. Check with your tax advisor.

In a recent case (Thomas J. Woody (T.C. Memo. 2009-93)) in February 2004 the taxpayer started investigating the real estate market so he could acquire real estate for investment or rental. Throughout 2004 the taxpayer looked at many properties he was interested in buying for this real estate investment and rental business. He made multiple offers to purchase properties but was out-bid on most of his offers. In May 2004 he entered into a contract to purchase a property on Bradley Avenue in Camden, New Jersey. However, after a home inspection revealed many defects in the property, he canceled the contract because the seller was not willing to make the needed repairs.

The taxpayer did not purchase any investment or rental property until he purchased the property on Randolph Street in Camden, New Jersey, on December 30, 2004, i.e., the next to last day of the year at issue. At that time, there was no tenant in the property, and he did not secure a tenant until sometime after 2004. Furthermore, there was nothing in the record to indicate that he held the property out for rent in 2004.

Throughout 2004 the taxpayer performed many other tasks in conjunction with his alleged business. He created a name for his endeavor -- Value Property Investments -- and began marketing his services via business cards, flyers, and word of mouth. In May 2004 he completed a business outline with "buying, remodeling, and renting property" being the stated purpose of Value Property Investments. On October 17, 2004, he paid $21,490 to the Wealth Intelligence Academy for certain training classes, which he subsequently attended to acquire real estate investment skills. After he took the Wealth Intelligence Academy courses, his business plan shifted from merely buying, remodeling, and renting to also include what the taxpayer referred to as "flipping" or "wholesaling" However, he never consummated this type of transaction during 2004.

In November 2004 the taxpayer applied, and was approved, for a loan from the U.S. Small Business Administration, and he obtained an employer identification number from the IRS. In December 2004 he obtained a credit card in the name of "Thomas J. Woody Value Property Invest" and opened a checking account in the name of "Mr. Thomas J. Woody D/B/A Value Property Investments".

Despite all of the foregoing activity, he did not purchase any investment property until December 30, 2004, and he did not buy or sell any other property, rent out any property, or hold any property out for rent, nor did he engage in "flipping" or "wholesaling" during tax year 2004.

The IRS disallowed the taxpayer's Schedule C expenses for 2004 because it determined that the taxpayer was not engaged in the active conduct of a real estate investment business as alleged. The taxpayer contended he commenced his real estate investment and rental business on May 1, 2004 when he entered into a contract of sale on the Bradley Avenue property. Thus, he contended that all his expenses associated with his business incurred after that date should be deductible business expenses. The IRS asserted that the taxpayer was not actively engaged in the real estate investment and rental business at any time during 2004, because he did not become actively engaged in business, i.e., by buying, selling, renting, or offering to rent property, until he held the Randolph Street property out for rent some time after 2004.

The Court noted that whether a taxpayer is engaged in a trade or business is determined using a facts and circumstances test under which courts have focused on the following three factors that indicate the existence of a trade or business: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer's activity has actually commenced.

The Court held the taxpayer's activities did not rise to the level of a trade or business until, at the earliest, the time he purchased the Randolph Street property on December 30 of the year in suit. More likely, his activities did not rise to the level of a trade or business until he held the Randolph Street property out for rent sometime after the close of the year in suit, but the Court did not have to decide that issue.

Opening a new business is a major undertaking and the pre-opening costs can be substantial. To maximize your tax deductions and your cash flow, plan carefully and get good advice both tax and business. You should be aware that the rules before October 23, 2004 were different. In addition, for expenditures paid or incurred after September 8, 2008, a taxpayer is deemed to have made an election to deduct its start-up expenditures, to the amount allowed.


Copyright 2009 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 05/15/09