New business ventures will typically incur losses in the first year or years. These losses can sometimes be used to offset the business owner’s other income. In a way, this tax loss offset and the tax savings is akin to an interest-free loan from the Federal government.
Congress has imposed some limitations on this type of tax-free loan. The limitations are not absolute. Many taxpayers can take steps to plan ahead to avoid having expenses limited by the so-called “start-up” rules. If the rules cannot be avoided, their impact can be limited in some cases.
The Provitola v. Commissioner, No. 20-12615 (11th Cir. 2021), case provides an opportunity to consider the start-up rules in light of patent attorney expenses.
Facts & Procedural History
The taxpayer-husband is a patent attorney. He owned and operated a law firm that was taxed as an S corporation.
The taxpayer-husband also owned a business that was trying to develop a three-dimensional television device. This business was taxed as a Schedule C disregarded entity.
The tax dispute focuses on funds the taxpayers contributed to the Schedule C business. The funds were used by the Schedule C business to pay the taxpayers’ law firm for services rendered to the Schedule C business.
Presumably, the taxpayers reported the payment as income from their law firm. If that was the case, the taxpayers paid income tax on the payment (i.e., deduct it on Schedule C and pick it up as income on Schedule E). It would seem that the taxpayers may have only avoided paying self-employment taxes on the payment.
The IRS audited the taxpayers’ personal income tax returns and disallowed the deduction for these payments. The IRS asserted that the deductions were not allowed pursuant to the start-up rules.
The U.S. Tax Court agreed with the IRS. This appeal followed.
About the Start Up Rules
The start-up rules are found in Section 195 of the tax code. They disallow most costs incurred before a business is actually a viable business. The disallowed expenses are capitalized and deducted over a five-year period.
This raises the question as to when an activity changes from an effort to put together a business and to an actual business?
The courts have considered this very issue several times. The court in this case summarizes the leading cases as follows:
The determination of when a trade or business begins presents a question of fact requiring an examination of all the relevant facts. Stanton, 399 F.2d at 330. An active or existing trade or business is generally one that is “perform[ing] those activities for which it was organized,” not simply taking steps in preparation to perform those activities. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated on other grounds, 382 U.S. 68 (1965); see also Jackson v. Comm’r of Internal Revenue, 864 F.2d 1521, 1526 (10th Cir. 1989) (“Taxpayers’ activities in this case clearly did not rise to the level of a functioning business, and taxpayers did not perform the ultimate activity for which their business was organized—attempting to sell player/recorders.”).
Thus, one has to have the business in a state of readiness to sell its goods or services to avoid being classified as a start-up.
In the present case, the appeals court noted that:
according to Anthony’s own testimony, Viovision was still engaged in the process of “creating the manufacturable item” in 2014 and did not produce its first units until 2015, after the tax years at issue. In addition, Viovision’s website did not exist until 2015, and it had not sold any products as of the trial in 2019. Thus, whether viewed as a manufacturing business or a marketing or retail business, or both, Viovision had not begun “to operate as a going concern” in 2013 and 2014 because it had not yet manufactured or sold any of the devices, the purposes for which it was organized.
The appeals court upheld the decision of the U.S. Tax Court.
Planning for Start-up Expenses
One should consider the start-up rules when planning for early-stage businesses.
The court’s statements about having an early prototype available for sale, having a website, etc. are instructive. It may be possible to take these steps sooner, which can free up tax deductions. One also has to document the date the start-up actually started. This can be particularly helpful if the taxpayer-owner has other income that the start-up’s tax losses can offset.
The research and development deduction should also be considered (as should the research tax credit). Many new businesses incur expenses that can be deducted under Section 174 as research and experimentation expenses. These expenses are not counted as start-up expenses under the Section 195 start-up rules. Thus, for example, the patent expenses paid to the taxpayer’s law firm, in this case, might have qualified as research and experimental expenses and been deductible even if the business was a start-up.
This research and experimental expense exception can help cover the costs for expensive consulting services, such as software development costs. To qualify, taxpayers should take care to record the R&D expenses as such on their books and records and report them as such on the timely-filed tax returns.