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It’s a Question of Genesis – When Does a Business Begin for Tax Purposes?

This is a relatively simple question that is often difficult to answer. Does it begin when the founder starts the process of building an app or creating a prototype to manufacture? Or is it when the product is fully-developed and available for sale? For tax purposes, this question is important because it affects when a business can start deducting its expenses.

Pre-opening or start-up expenses are not deductible for tax purposes. They become deductible through amortization once the active trade or business begins. After that moment in time, future expenses are deductible if they are ordinary and necessary, unless they are capital expenditures made to create an asset with a useful life that extends beyond the taxable year.

The Eleventh Circuit Court of Appeals recently considered the genesis of a business in an unpublished opinion it filed on June 11, 2021. Here are the simplified facts. The taxpayer developed a visual system that allowed certain television viewers to see a standard two-dimensional image as three dimensional. Between 2005 and 2007, the taxpayer sought and obtained several patents relating to his product and then began the process to develop, manufacture, and market a device that used his system. Since 2007, the taxpayer provided management, product development, and design services to the business.

Between 2007 and 2015, the taxpayer experimented with and tested a variety of product iterations to bring it to a state where it could be manufactured and sold to the public. During 2013 and 2014, the years at issue, the taxpayer put in a tremendous amount of work to design, source materials, and research potential patent issues, but it wasn’t until 2015 that he produced the first product that he could sell to the public. In 2016 and 2017, he created a website, though it wasn’t accessible to the public until many years later, and by 2019, he still had not attempted to market or to sell any of his products because he was still working through pricing and other issues.

The taxpayer first started taking deductions on his 2013 and 2014 federal income tax returns. On audit, the IRS disallowed the deductions, claiming they were start-up expenses that had to be capitalized and amortized. It also assessed penalties. The taxpayer petitioned the Tax Court for review, but he lost after a trial on the merits. The Tax Court acknowledged that the taxpayer took “significant steps to prepare for the business of selling [his] invention,” but found that he had not yet engaged in an active trade or business during the years at issue because he had not “attempted to market or sell a product,” “made any sales,” or “made [his] website public.” The Eleventh Circuit affirmed the decision of the Tax Court, including the imposition of penalties.

On appeal, the taxpayer argued, among other things, that he was in the business of manufacturing and marketing, and that the Tax Court had improperly imposed a “product sale” requirement for his business to exist beyond the start-up phase. The Court disagreed.

The Court first noted that ordinary and necessary expenses are deductible if they are paid or incurred in carrying on a trade or business. This is black-letter law. It also observed that pre-opening or start-up expenses are not deductible because they are not paid or incurred in carrying on a business; rather, they are capital expenditures that “spring from the taxpayer’s efforts to create or acquire a capital asset.” Start-up expenses generally are amortizable over 15 years (except for up to $5,000 that can be deducted) once the active trade or business begins.

In applying to the law to the facts of the case, the Court hewed to existing caselaw which holds that an active or existing trade or business is one that performs the activities for which it is organized. It does not exist when one simply takes steps in preparation to perform those activities. According to the relevant section of the Internal Revenue Code, a start-up expenditure includes any amount paid or incurred in connection with (i) investigating the creation or acquisition of an active trade or business, (i) creating an active trade or business, or (iii) any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.

The Court then analyzed the taxpayer’s activities in 2013 and in 2014 and concluded that he had not yet carried on an active business during those years. As of the end of 2014, the taxpayer was still continuing the process of “creating the manufacturable item,” he did not have a website to sell his product, and he had no sales. He did not create a viable product to bring to market until 2015, he did not have a website until 2017, and he had no sales even as late as 2019. Thus, regardless of whether the taxpayer was considered to be creating a manufacturing business, or a marketing or retail business, or both, he had not operated as a going concern in 2013 or 2014 because he “had not yet manufactured or sold any of the devices, the purpose for which [the business] was organized.”

This case explains an issue that arises for all new businesses – when can it start deducting its start-up or pre-opening expenses? It did not create new law; it simply applied existing tax principles to a particular set of facts. But it is useful to other taxpayers and advisors considering this question.

If you have questions regarding your business, please reach out to your Withum advisor.

Business Tax Services

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