Deducting business start-up and expansion expenses

If you plan on starting a business or expanding an existing business, it is important to know that you will not recoup all the expenses as tax deductions. However, there are steps that you may take to accelerate deductions in certain instances. The first step is to understand how the rules work.

Three categories of expenditures

Taxpayers starting a new business may incur expenses that are deductible, capitalizable, or eligible for the 60-month amortization election. Business expenses that are ordinary and necessary to carry on a trade or business are currently deductible. Yet the Internal Revenue Code specifically requires the expenses connected with buying or creating an asset with a useful life extending beyond one year, to be spread out over time.

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

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 began.

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 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.

Basic rules

In 1999 the IRS issued the first comprehensive guidelines on 60-month amortization in nearly 20 years. According to them, the key questions are "whether and which." That means "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 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.

To determine whether an expense is a "whether and which" decision 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. One example from the IRS includes costs:

-- Incurred to conduct industry research and review public financial information are costs related to a general investigation and are eligible to be amortized.

Additional problems

The IRS's guidelines fall short in ways that create decisions for those involved in start-up businesses. The guidelines do not address who within an organization must make the acquisition decision. They do not address what to do with the costs paid after a final decision has been made.

This overview is just the tip of the iceberg when dealing with all the possibilities of deductibility of business start-up and expansion expenses. If you have questions about how the rules might apply in your situation, please feel free to contact me.

Melvin J. Van de Ven, CPA, CVA is a partner in the certified public accounting firm of Schott & Van de Ven in Cape Girardeau. (mvandeven@schottvandeven.com)