Tax Season Lesson #6: Proper Treatment of Organizational and Start Up Costs

Tax Season Lesson #6: Proper Treatment of Organizational and Start Up Costs

Willie Moore (Moore) spent his 9-5 as a system support analyst for the city of Houston. On the side,Moore started a usedcar dealership, and for the first year the dealership was in existence, he attached a Schedule C to his tax return reflecting no revenue and $35,000 in expenses.

The IRS disallowed the $35,000 loss incurred by the dealership, and the Tax Court upheld the disallowance. The courtdidso despite acknowledgingthat most of the expenses were legitimate, substantiated costs necessary to get the dealership off the ground.

So then, why were the expenses disallowed?

Because in general, when a taxpayer incursexpenses in forming a Schedule C business or separate corporation (together, “a business,”) those costs createan asset with a lifelonger than one year, i.e., the business. And as a basic tenet of tax law, those types of expenses must be capitalized. Making matters worse, because a business does not have a readily determinable lifespan, barring a statutory exception, these initial expenses would not be eligible for amortization.

And though Congress granted a reprieve with the enactment of Code Sections 248 (dealing with organizational costs) and 195 (dealing with start-up costs.) — which allow a new business to elect to expense or amortize costs that would otherwise go unamortized— each of these sibling sections contains a triggering date that signals the appropriate time to deduct the expense or begin the amortization. Attempt to deduct these costs prior to that triggering date — as Willie Moore did — and you face disallowance at the hands of the IRS.

Organizational Costs

Think of organizational costs as the expenses that give birth to a new business, such as legal services to draft corporate charters, by-laws, and articles of incorporation, accounting and consulting services incurred to choose the entity type, and expenses of initial meetings of directors and shareholders.

As discussed above, absent I.R.C. § 248, these expenses would be required to be capitalized and would not be eligible for amortization, as they create an asset with an indefinite life. Under I.R.C. § 248, however, up to $5,000 of organizational costs can be deducted in the year the taxpayer begins business. This deduction is reduced for every dollar the total organizational expenditures exceed $50,000, and any remaining expenses are amortized over a 15-year period beginning with the month in which the taxpayer begins business. [i]

As emphasized above, organizational costs cannot be deducted or amortized until the taxpayer “begins business;” a date that is separate and distinct from that on which the taxpayer comes into existence. For example, while a corporation comes into existence on its date of incorporation, it doesn’t “begin business” until it starts the operations for which it was organized. The regulations provide that in general, the acquisition of operating assets which are necessary to the type of business contemplatedshould constitute the beginning of business.

Start-Up Costs

Start-up costs, on the other hand, are the next expenses incurred as part of the business life cycle; they are incurred after a business is born, but before it begins its “active trade or business.” As with organizational costs, these expenses are considered to be part and parcel with creating the business, and thus would not be deductibleor amortizable in the absence of I.R.C. § 195.

Typical start-up costs upon the creation of a new business include initial advertising and marketing costs, salaries and benefits prior to starting production or generating revenue, initial accounting and legal fees beyond those incurred as part of the organizational process, and rent and utilities in thepre-opening phase.

Given those examples, perhaps its best to simply default to treating all expenses incurred by a corporation prior to starting an “active trade or business” as falling within the gambit of Section 195. [ii]

Like organizational costs, upon election a corporation my deduct up to $5,000 of start-up costs (phased out for each dollar total start-up costs exceed $50,000), and amortize the remaining costs over 15 years beginning with the first year in which the taxpayer beings an “active trade or business.”[iii] .

Also similar to organizational costs, the real crux of applying I.R.C. § 195 is determining on what date to begin deducting or amortizing the expenses. The regulations offer little help inclarifying when an “active trade or business” begins, and thus the determination of when tobegin amortizing start-up costs has been frequently litigated.

In general, the courts have established that it is reasonable to mark the taxpayer’s start of its active trade or business in part based on the nature of its business. For example, the courts have held that for a manufacturing business, an active trade or business begins when the taxpayer acquires all necessary assets and places them in service, even if no income has been generated. [iv] To the contrary, the courts take a more stringent view of retail businesses; holding that an active trade or business begins only when the doors are open and revenues are flowing. [v]

What Can We Learn?

Willie Moore was deinied a $35,000 loss on his start-up car dealership not because the expenses incurred were fabricated or unsubstantiated, but rather because they were incurred prior to the date the dealership began its active trade or business, and thus were not yet eligible for deduction or amortization pursuant to Section 195.In denying the expenses,the Tax Court issued a reminder to all taxpayers that just because you’ve “started your business,” it doesn’t mean you’ve started your business.

[i] No affirmative election is made; the taxpayer is deemed to have made the election by deducting/amortizing the organizational costs in the year business begins.