Tax Court Halts Start-Up Cost Deductions

Start-up cost deductions are normally allowed, but as a recent Tax Court case shows, clients need to prove the business is operational.

Background: Normally, a business is required to amortize start-up costs over a period of 180 months. However, you can write off up to $5,000 of qualified start-up costs that would otherwise be deductible as ordinary and necessary business expenses if the operation is “open for business.” Typically, the list of qualified expenses includes the following:

• Studies of potential markets, products, labor supply, transportation facilities, etc.
• Advertisements for the business opening
• Salaries and wages for employee training
• Travel and other necessary costs for securing prospective distributors, suppliers or customers
• Salaries and fees for executives and consultants or for similar professional services

If the business exceeds the $5,000 limit for start-up costs, the excess must be amortized over 180 months. Caveat: The $5,000 write-off is phased out on a dollar-for-dollar basis for costs above $50,000.

Facts of the new case: The taxpayer, a resident of California, purchased ten acres of property in the middle of the Mojave Desert, approximately one mile away from any road and 120 miles away from his home. He bought the property with the intent of developing its natural resources, making it accessible by road, procuring a certification for organic farming, dividing it into parcels and then renting out the parcels to farmers.

To achieve this objective, the taxpayer created a business plan, which first required him to construct an outdoor structure, similar to a barn, on the property. Then he planned to obtain a certification from the U.S. Department of Agriculture (USDA) certifying that the land complied with the standards for organic farming. Finally, the business plan provided for the installation of an irrigation system on the property and the construction of an access road to the property.

In 2015, the taxpayer began construction of the outdoor structure on the property. He purchased building material, rented trucks and trailers, transported heavy loads of materials to the property, established an unpaved vehicle access road to the property, and hired day laborers to assist with the building of the structure.

Key point: Despite all of these actions, the taxpayer did not take any steps to show that a business had actually commenced and that it was operating as a going concern. That was a fatal flaw.

Accordingly, the Tax Court concluded that the venture was not an active trade or business in 2015. The taxpayer wasn’t entitled to a deduction of $5,000 for start-up costs on his Schedule C for that year. He is required to capitalize all his pre-opening expenses. 

Moral of the story: Have your clients go the extra yard to qualify for a current deduction for start-up costs. They have until the end of the year to officially open for business.