Maximizing Individuals’ Deductions for Startup Expenses

Individuals starting a business or acquiring the assets of an existing business often incur expenses, which can be considerable, in the investigation and acquisition phase before actual business operations begin. Absent any special provision in the Code, such expenses would be capital in nature since they would not be incurred in carrying on a trade or business. However, Sec. 195 allows taxpayers to deduct business startup costs that would be deductible under Sec. 162 if they were incurred in a trade or business.

Taxpayers can immediately deduct up to $5,000 of startup expenses in the year when active conduct of business begins (Sec. 195(b)). However, the $5,000 instant deduction allowance is reduced dollar for dollar by cumulative startup expenses in excess of $50,000 for the business in question. Startup expenses that cannot be immediately deducted in the year business begins must be capitalized and amortized over 180 months on a straight-line basis (the same as Sec. 197 intangibles). In many cases, startup expenses for small businesses will be modest enough to qualify for immediate deduction under the $5,000 instant deduction allowance in the year when active conduct of business commences.

Example 1: Assume that S (a calendar-year taxpayer) incurs $52,000 of startup expenses in 2014 before opening her new car wash, which begins business in November 2014. S's 2014 deduction is $3,544 ($5,000 immediate writeoff ‒ $2,000 (startup costs over $50,000) + amortization of $544 (based on capitalized amount of $49,000 ÷ 180 months × 2 months)). The remaining capitalized cost of $48,456 is amortized on a straight-line basis over the subsequent 178 months ($272 per month).

Planning tip: Alternately, the taxpayer may choose to forgo currently deducting startup costs by affirmatively electing to capitalize (and not deduct) its startup expenditures on a timely filed federal income tax return (including extensions) for the tax year in which the active trade or business begins (Regs. Sec. 1.195-1(b)). The election either to deduct or capitalize startup expenditures is irrevocable and applies to all startup expenditures of the business.

The general rule is that Sec. 195 treatment applies to expenses that would otherwise be currently deductible as ordinary and necessary business expenses under Sec. 162 if they were incurred by an existing business. (Such expenses are referred to as Sec. 195 expenses.) Amounts required to be capitalized under the Sec. 195 rules (i.e., amounts in excess of $5,000 for most taxpayers) must be amortized over 180 months. This relatively favorable treatment is allowed only for startup expenditures that are "Sec. 162–type" expenses (see Sec. 195(c)(1)(B) and Rev. Rul. 99-23).

Most startup expenditures can be segregated into investigatory expenses and business preopening costs.

• Investigatory expenses are incurred before reaching a decision to acquire or create a specific business. They include, but are not limited to, expenses for the analysis or survey of potential markets, products, labor supply, and transportation facilities (H.R. Rep't No. 96-1278, 96th Cong., 2d Sess.). If incurred in investigating the acquisition of an existing business, investigatory expenses are Sec. 195 expenses only if the taxpayer actually acquires an equity interest in the business and then actively participates in managing that business.
• Preopening costs are incurred after the taxpayer decides to establish or acquire a specific business, but before the active conduct of that business actually begins. Such costs can include, but are not limited to, advertising; salaries and wages paid to employees being trained and their instructors; travel and other expenses incurred in lining up prospective distributors, suppliers, or customers; and salaries or fees paid or incurred for executives, consultants, and similar professional services (H.R. Rep't No. 96-1278, 96th Cong., 2d Sess.).

If the activity was previously an activity entered into for the production of income and later converted to a trade or business, expenses that occurred after the taxpayer first engaged in the activity but before the activity was converted to a trade or business and are not investigatory or preopening costs do not need to be treated as startup expenses. Instead, they will qualify as investment expenses deductible on Schedule A, Itemized Deductions, subject to the 2%-of-adjusted-gross-income limitation.

Amounts that must be capitalized under the Sec. 263(a) regulations do not qualify as Sec. 195 expenses. Instead, these capitalized amounts may (or may not) be eligible for amortization or depreciation under other tax rules (see, e.g., the amortization rules found in Regs. Sec. 1.167(a)-3).

In general, Regs. Sec. 1.263(a)-4 requires capitalization of amounts paid to:

• Acquire certain intangible assets, including but not limited to an ownership interest in another entity such as a corporation or partnership;
• Create intangible assets described in the regulations (i.e., costs to create an asset not described in the Sec. 263(a) regulations need not be capitalized under those regulations);
• Create or enhance a separate and distinct intangible asset, defined as a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable state, federal, or foreign law and the possession and control of which is intrinsically capable of being sold, transferred, or pledged separate and apart from a trade or business;
• Create or enhance future benefits to be identified in yet-to-be published IRS guidance; or
• Facilitate the acquisition or creation of intangible assets previously described.

In addition, Regs. Sec. 1.263(a)-5 generally requires capitalization of amounts paid to facilitate:

• Acquisition of assets constituting a trade or business;
• Acquisition of an ownership interest in a business if, immediately after the acquisition, the taxpayer and the business entity are related parties;
• Acquisition of an ownership interest in the taxpayer;
• Certain business entity restructuring, reorganization, capitalization, and recapitalization transactions;
• Formation or organization of a disregarded entity (e.g., a single-member limited liability company (SMLLC) or qualified subchapter S subsidiary (QSub)); and
• Acquisition of capital, stock issuances, borrowing transactions, and the writing of an option.

Amounts capitalized under the Sec. 263(a) regulations are generally added to the tax basis of the intangible asset that is acquired or created.

Example 2: B opens a retail store that is separate and apart from her existing business activities. In establishing the new retail business, B makes various startup expenditures.

Sec. 162–type expenditures that could be currently deducted by an existing retail business must be handled under the relatively favorable Sec. 195 rules (i.e., the first $5,000 can generally be deducted in the year when business begins with any excess expenses amortized over 180 months). In contrast, startup expenditures that must be capitalized under the Sec. 263(a) regulations must be amortized or depreciated (if at all) under other tax rules.

B's startup expenditures to recruit and train employees for the new retail store are Sec. 195 expenses. So are any startup expenditures to advertise the new retail business. These types of expenditures are not required to be capitalized under the Sec. 263(a) regulations.

However, B must capitalize the following startup expenditures under the Sec. 263(a) regulations:

• Amounts paid to acquire a lease agreement for the new retail store and transaction costs to acquire or create the lease, such as attorneys' fees to negotiate an agreement (see Regs. Secs. 1.263(a)-4(c)(1)(vi), (d)(6)(i)(A), (e)(1) and (2), and (e)(5), Example (3)). These capitalized amounts can then be amortized over the life of the lease (see Sec. 167(a)(1) and Regs. Sec. 1.167(a)-3(b)(1)(iii)).
• Prepaid expense items, such as prepayments for liability and casualty insurance coverage for the retail store and any prepaid rent for the retail location. These amounts can generally be deducted in the periods to which they relate.
• Payment to an attorney to establish a new SMLLC for the retail operation. The LLC is a disregarded entity for federal tax purposes. However, amounts paid to facilitate the formation or organization of a disregarded entity generally must be capitalized under the Sec. 263(a) regulations (see Regs. Sec. 1.263(a)-5(a)(6)). Unfortunately, there is apparently no provision allowing amortization of amounts capitalized under this rule (see Regs. Sec. 1.167(a)-3(b)(2)).

B may incur other startup expenditures that must be capitalized under the Sec. 263(a) regulations. The only sure way to identify all these items is to carefully review the regulations.

The Sec. 263(a) regulations include several favorable exceptions that negate the general capitalization requirement. The more important exceptions are the following:

• The $5,000 de minimis rule for certain contract right intangibles (see Regs. Sec. 1.263(a)-4(d)(6)(v));
• The 12-month rule for created intangibles with short lives (see Regs. Sec. 1.263(a)-4(f));
• For certain transaction costs: the exceptions for employee compensation, overhead, and de minimis costs of $5,000 or less (see Regs. Sec. 1.263(a)-4(e)(4));
• For transaction costs specifically to facilitate the creation of financial interest intangibles and contract right intangibles: the exception for the cost of activities performed before the applicable bright-line date (see Regs. Sec. 1.263(a)-4(e)(1)(i)); and
• For costs to facilitate the formation or organization of a disregarded entity (e.g., an SMLLC or QSub): the exceptions for employee compensation, overhead, and de minimis costs of $5,000 or less (see Regs. Sec. 1.263(a)-5(d)).

Startup expenditures eligible for favorable exceptions escape capitalization under Sec. 263(a). Therefore, they fall back into the Sec. 195 expense category and qualify for relatively favorable tax treatment, as explained earlier.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 15th edition, by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).