Tax Planning for the Start-up Limitation Rules

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Tax Planning For The Start-up Limitation Rules
Tax Planning For The Start-up Limitation Rules

Our tax laws include start-up rules that limit the ability to deduct certain business and investment expenses. For business owners and investors with other sources of income, this can result in funds being sent to the IRS to pay taxes at a time when the capital is needed to fund the business or investment growth. Luckily, one can plan around these rules. The Primus v. Commissioner, T.C. Summary 2020-2, court case provides an example.

Facts & Procedural History

The taxpayer was an accountant. In 2011, he purchased 266 acres of land in Ontario to start a maple syrup business.

The land included mature maple trees. The plan was to thin the trees and then install pipes to collect the tree sap.

He started thinning the trees in 2011 and he started installing the pipes in 2015.

In 2017 he began collecting sap and producing maple syrup. He sold 18,000 pounds of maple syrup in 2017.

The taxpayer reported substantial losses from this activity in 2012 and 2013. Most of the deductions were for the costs of repairs of various buildings, such as electrical and plumbing repairs, mold removal, window replacements, and roof work.

The IRS audited the taxpayer’s returns and disallowed the losses. It asserted that the expenses were non-deductible start-up expenses.

The Start-up Expense Limitation

Generally, business and investment expenses are deductible. The start-up limitation can make otherwise deductible business or investment expenses not currently deductible.

A “start-up” expense includes an amount paid or incurred in connection with:

  1. investigating the creation or acquisition of an active trade or business,
  2. creating an active trade or business, or
  3. 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.

It does not include interest, taxes, or research expenses.

Instead of being deductible in the current year, up to $5,000 of start-up expenses are allowed (if the taxpayer has less than $50,000 of start-up expenses) and the balance is amortized and deducted over a 180-month period. The 180-month period starts in the year the trade or business starts.

There is often a dispute as to when the trade or business starts. That is the dispute in this case.

When Does a Trade or Business Start?

A trade or business generally starts when the business has its product or service ready for customers.

For example, with rental real estate, the rental activity starts when the building is capable of being rented. For the development and sale of a product, the business activity starts when the product is ready to sell to customers. For a website business, the business starts when the website is live and functioning for the public.

But what about a maple tree farm as in this case? The trees are technically capable of producing tree sap when the taxpayer first purchased the property in 2011. Does it really matter that the taxpayer did not actually start collecting sap in 2017?

The court concluded that it did. According to the court:

Preparing a property to produce a commodity (such as maple syrup or blueberries) is not a trade or business or income-producing activity before sap is collected or blueberry bushes are planted. 

Thus, the taxpayer was not able to deduct his start-up costs during these years.

Planning for the Start-up Limitation

This highlights why it is important to consult with a tax advisor about business ventures (you can call one of our Houston tax attorneys if you have a new or proposed business or investment).

A tax advisor might have instructed the taxpayer to start collecting some tree sap from the start. Even nominal sap gathering activities might have helped to avoid the start-up limitation. This is an easy tax planning idea to implement.

Avoiding this limitation is particularly important for those who can use start-up losses to offset other business income. This often comes up in side gigs or investments like this one, where the business owner or investor has other income, such as wage income, that the losses can be used to offset.

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