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Tax Court: No Current Deductions Before Business Commences

Starting up a business and wondering about how tax deductions will be handled? The most important thing to understand is that most expenses incurred before a business begins functioning cannot be deducted or amortized until the year when the business does become active.

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» A recent Tax Court case illustrates how taxpayers can be denied current deductions for expenses when businesses are still in the start-up phase. Before explaining the decision, let's first cover some necessary background information about how the rules work.

Business Expense Basics

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» Section 162 of the Internal Revenue Code allows current deductions for so-called ordinary and necessary business expenses. Basically, Section 162 expenses are garden-variety expenses incurred in operating an up-and-running business.

Examples include employee wages, rent, utilities, advertising, and so forth. Such expenses can generally be deducted in the year when they are paid or incurred. However many taxpayers are probably unaware that Section 162-type expenses incurred by a start-up operation cannot necessarily be deducted so quickly. In the recent Tax Court decision, the taxpayer found that out the hard way.

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Facts of the Case

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» After retiring, Lawrence McPartland decided to start up a real estate business. He intended to buy residential properties, renovate them, and rent them out.

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Even big plans usually start small. So it was in this case. In 2007, the taxpayer bought a duplex consisting of two side-by-side one-bedroom apartments in "a severe state of disrepair," according to court documents.

McPartland began extensive renovations with the help of local workers that were not completed until 2009.

More specifically, he planned to buy 10 properties, rent them out, and then, do the same thing again and again.

He also learned that he needed approval from the local building inspector before he could hold the property out for rent.

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Facts of the Case- cont.

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» Due to these delays, the property was not rented until 2010. On his 2007 Form 1040, the taxpayer claimed sole proprietorship Schedule C deductions totaling $61,779 for the real estate venture.

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No gross receipts were reported for the venture because, as stated earlier, the duplex was actually not rented until 2010.

After auditing the taxpayer's 2007 return, the IRS denied his Schedule C deductions and assessed $14,243 for under-paid federal income tax.

The IRS claimed the Schedule C deductions were not allowed in 2007 because the taxpayer was not yet "carrying on" an active business.

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The Tax Court's Decision

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» The Tax Court noted that while the taxpayer took steps in 2007 to start up his real estate business, the active conduct of the business did not commence that year.

The renovation of the duplex was not completed until 2009, and no rent was collected until 2010. Since the real estate business was still in the start-up phase, the taxpayer was not entitled to claim any current deductions for his Section 162-type expenses.

Coming to that conclusion was the end of the Tax Court's job in this case, but there is more to the story. The taxpayer could have and should have classified his Section 162-type real estate expenses as Section 195 start-up expenses. The treatment of Section 195 expenses is summarized below. (Lawrence McPartland, TC Summary Opinion 2012-88)

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Section 195 Start-Up Expense Basics

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Start up expenses, which fall under Section 195 of the Internal Revenue Code, are Section 162-type ordinary and necessary business expenses incurred before the active conduct of the business begins. Such expenses include those incurred in connection with:

Investigating the creation or acquisition of a business; Creating a new business; or Any activity engaged in for profit before the day when the active conduct of business begins, in anticipation of such activity becoming an active business.

The current version of Section 195 allows taxpayers to deduct and/or amortize business start-up expenditures. Specifically, up to $5,000 of start-up expenses can be deducted in the year when active conduct of the business begins -- but not before that year.

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However, the $5,000 allowance is reduced dollar for dollar by the amount of cumulative start-up expenditures in excess of $50,000.

Any start-up expenses that cannot be deducted in the year when the active conduct of business begins are capitalized and amortized over 180 months, starting with the month when the active conduct of business begins.

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Conclusion

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The most important thing to understand here is that most expenses incurred before a business becomes active cannot be deducted or amortized until the year when the business does become active. In general, that means the year when the business has the pieces in place to actually begin earning revenue.

If the taxpayer files a return that mischaracterizes Section 195 start-up expenses as garden-variety Section 162 expenses and deducts them too soon, the taxpayer is using an impermissible tax accounting method for those expenses.

Then, the taxpayer must make an accounting method change to correct the treatment of those expenses. That requires IRS permission and can be a difficult process. The same hassle applies if the taxpayer makes a wrong determination of the year when the active conduct of business begins and therefore deducts or amortizes Section 195 start-up expenses too soon.

If you are involved with a start-up operation, consult with your tax adviser early in the game and before filing any tax returns. That way, you can obtain the best tax results without hassling with the IRS.

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