Many people started businesses in 2020, and many others plan to launch new ventures in 2021. Entrepreneurs often have questions about whether business expenses for a start-up can be deducted in the year they're incurred or paid — or whether they must be capitalized and deducted over time. Here's some guidance.
Lesson from the Tax Court
The IRS often contests current deductions for start-up costs if it's unclear that business operations have officially commenced. Consider this recent example in a case decided by the U.S. Tax Court. (Primus v. Commissioner, TC Summary Opinion 2020-2, Jan. 1, 2020.)
In 2011, a taxpayer purchased real estate with maple trees to produce sap. Through 2016, the taxpayer spent time thinning out the maple tree forest (to make the remaining trees produce more sap, which is then turned into syrup) and installing a pipe system to collect the sap. In 2017, he began to collect sap, as well as produce and sell syrup.
When the taxpayer acquired the property, he also decided to grow blueberries. He cleared areas for planting blueberry bushes in 2012 and 2013. The taxpayer ordered 2,000 blueberry bushes in 2014 and planted them in 2015.
The Tax Court determined that the active conduct of the business hadn't commenced as of the tax years in question (2012 and 2013) because the taxpayer didn't collect any sap or harvest any blueberries during those years. Because the taxpayer failed to meet the "active-conduct" standard, the court ruled that the taxpayer couldn't currently deduct start-up expenses.
Basic Tax Rules
Internal Revenue Code Section 162 allows current deductions for "ordinary and necessary" business expenses. Deductible Sec. 162 expenses include those incurred to operate an established business. Common examples are employee wages, rent, utilities, and advertising expenses.
Generally, you deduct Sec. 162 expenses in the tax year in which they're paid or incurred (subject to certain special rules and limitations). Therefore, your business gets near-instant tax gratification from these expenses.
However, business expenses incurred by a start-up can't necessarily be deducted right away. That's because these expenses are classified as Section 195 start-up expenses until the "active conduct" of business begins.
Once a taxpayer meets the active-conduct standard, Sec. 195 expenses qualify for current write-offs. (This treatment assumes that other provisions — such as the passive activity loss or at-risk basis rules — don't come into play and prevent current deductions.)
Current Deduction Ground Rules
Essentially, Sec. 195 start-up expenses are Sec.162 expenses that are incurred before the business actively commences operations. Typically, start-up costs may include the following:
- Wages paid to employees and instructors for their training,
- Fees for consultants and payments for professional services,
- Surveys of potential markets, products, labor supply, and transportation facilities,
- Advertisements for opening the business, and
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
In the tax year when active conduct of the business commences, a taxpayer can choose to currently deduct start-up expenses. The election potentially allows an immediate deduction for up to $5,000 of start-up expenses. However, the $5,000 deduction allowance is reduced dollar-for-dollar by the number of cumulative start-up expenses above $50,000. For example, if your start-up costs total $50,500, your deduction is limited to $4,500.
Any start-up expenses that can't be deducted in the tax year the election is made must be amortized over 180 months on a straight-line basis. Amortization starts in the month in which the active conduct of business begins. A taxpayer is deemed to have made this election in the tax year when active conduct of business commences unless the taxpayer elects instead to capitalize start-up expenses on a timely tax return.
Important: Sec. 195 start-up expenses don't include interest expense, taxes, or research and development costs. These expenses are subject to specific rules that determine the timing of the deductions. Sec. 195 start-up expenses also don't include corporate organizational costs or partnership or limited liability company (LLC) organizational costs, although the tax treatment of those expenses is similar to the treatment of start-up expenses.
When you incur business start-up expenses, keep two key points in mind. First, start-up expenses can't always be deducted in the year when they're paid or incurred. Second, no deductions or amortization write-offs are allowed until the year when active conduct of the business commences. That usually means the year when the business has all the pieces in place to begin earning revenue.
Timing may be critical if have start-up expenses that could be currently deducted. Contact your tax advisor to discuss your situation.