Deducting Business Start-Up and Expansion Expenses

By Peter Jason Riley

How much of your start up or expansion business expenses can be immediately deductible from your taxes? Although you may be spending a considerable amount of cash and going into substantial debt to finance your new or expanded business venture, it is important that you understand that you will not recoup all of those expenses as tax deductions either this year or even next year. Nevertheless, there are steps that you may take to accelerate deductions in certain instances. The first step in accomplishing this, however, is to understand how the rules work. Here's an executive summary of these tax laws for your consideration.

Three categories of expenditures. Taxpayers starting a new business may incur expenses which are currently deductible, capitalizable, or eligible for the 60-month amortization election. Business expenses which are ordinary and necessary in the carrying on of a trade or business are currently deductible. Yet the Internal Revenue Code specifically requires the expenses connected with the buying or creating an asset with a useful life extending beyond one year to be spread out over time. Specifically, an election is available to amortize business start-up expenses over a period of at least 60 months, beginning with the month in which the active trade or business begins.

Although this election to amortize sounds simple, its application can get complicated. For a example, a conditional election to amortize is not permitted. As a result, taxpayers who treat an expense as an immediately deductible business expense and lose on audit cannot elect 60-month amortization as a fall back position. The IRS intends this to induce taxpayers to make conservative choices.

Amortization requirements. Under the Internal Revenue Code, taxpayers can elect to amortize business start-up expenditures over a period of at least 60 months beginning with the month in which the active trade or business begins. Start-up expenses for which an election to amortize is not made must be capitalized. The election must be made by the due date of the return, including extensions, for the tax year in which the trade or business begins.

There are three types of start-up expenditures which qualify for the amortization election:

• Investigative costs associated with the creation or acquisition of an active trade or business;
• Start-up costs incurred after a decision to establish a particular business is made but before the business begins; and
• Pre-opening costs of the business which are related to any activity engaged in for profit and for the production of income before the day the active trade or business begins in anticipation of becoming an active trade or business.

Who can, and who must, amortize. Only a taxpayer who incurs the start-up expenses and actually enters the trade or business can amortize the expenditures. The taxpayer must have an equity interest in the trade or business, and must also actively participate in it. In the case of a corporation (including S corporations), the corporation, rather than a shareholder, gets the deduction. In the case of a partnership, the amortization deduction is taken into account in computing the taxable income of the partnership, unless otherwise required under the partnership regulations. Qualifying investigatory expenses incurred by a prospective partner in connection with acquiring a partnership interest are taken as a deduction by the partner who incurs the expenses.

More "basic" rules. In 1999, the IRS issued the first comprehensive guidance on 60-month amortization in nearly twenty years since its enactment. According to these guidelines, the key questions are "whether" and "which": "whether" to acquire a business and "which" business to acquire. Investigatory costs must be incurred in furtherance of these questions in order to be amortizable. Any costs which do not satisfy these questions must be capitalized.

Expenses in the course of a general search for, or an investigation of, an active trade or business (in other words, expenses to determine whether to enter a new business and which new business to enter, other than costs incurred to acquire capital assets that are used in the search or investigation, are investigatory costs that qualify as Section 195 start-up expenses.

In order to determine whether an expense facilitates the whether and which decisions or is an acquisition cost, the IRS will apply a facts and circumstances test. The nature of the cost must be analyzed based on all the facts and circumstances of the transaction, and the label used by the parties involved is not determinative. Examples provided by the IRS include the following:

• Costs incurred to conduct industry research and review public financial information are typical of the costs related to a general investigation and are eligible to be amortized.
• Costs relating to the appraisals of a business's assets and review of its books and records to establish the purchase price to facilitate the acquisition are capital acquisition costs.
• Costs to evaluate a business's competitors would be amortizable only if incurred before the whether and which questions are decided.
• Costs incurred to draft regulatory approval documents prior to the time a decision is made are not investigatory costs, even if incurred during a general search, since they are incurred to facilitate the acquisition, not answer the whether and which questions.

Costs related to preliminary due diligence services provided prior to the time a decision is made (determined to be the time the taxpayer requested the draft of a letter of intent) are amortizable investigatory costs (costs related to preliminary due diligence services provided after the decision) and must be capitalized.

Additional problems. IRS's new guidance still falls short in ways that create tough decisions for those currently involved in start-up businesses. For example, the guidelines do not address who within an organization must make the acquisition decision. Moreover, they do not address what to do with the costs paid after a final decision has been made. Fortunately, the Congressional Report which accompanied this Internal Revenue law explicitly refers to eligible expenses which include start-up costs incurred subsequent to a decision to establish a particular business and prior to the time when the business begins. An example of this type of expenditure would include training and travel expenses, and salaries paid executives or consultants working on the acquisition.

This overview in many ways is just the tip of the iceberg when dealing with all the permutations possible in dealing with the deductibility of business start-up and expansion expenses. If you have any questions about how the new rules might apply to your particular situation, or if you'd like to consider more aggressive tax planning in connection with your current expenses, please feel free to call.