There are several tax laws that have to be considered to determine when and how costs to develop websites are deductible.
These expenses are almost always deductible. These tax laws raise timing questions. It’s a matter of when the expenses are deductible. For those who are developing website businesses as side-hustles, the issue takes on more urgency. These taxpayers will usually have another source of income, i.e., their wages from their day job, that the website development costs can be used to offset. This can reduce their income tax liabilities in the current year–which the IRS may challenge.
The recent Kellett v. Commissioner, T.C. Memo. 2022-62, provides an example of this type of fact pattern. It provides an opportunity to consider these rules.
Facts & Procedural History
The taxpayer had a full-time job. This case does not involve his day job. It involves costs incurred for his side hustle that were likely used to offset the wages he earned from his full-time job.
The side hustle involved creating a website to aggregate and display publicly available financial information. It was intended to organize the data in a way that made it easy to access and distribute.
The taxpayer purchased the domain name in 2013. The website coding was completed by 2015. The website and software were available to the public in late 2015. The taxpayer did not charge customers until 2019. Prior to this the focus was on growing awareness and developing the website.
The taxpayer’s 2015 tax return included a Schedule C to report the expenses for the website. The schedule reported $25,000 of expenses. Most of the expenses were for computer software engineers who were hired as contractors to design the website.
On audit by the IRS, the IRS disallowed all of the expense deductions. The IRS’s position was that the taxpayer did not have a viable business in 2015 as he was not yet charging clients. The IRS turned a blind eye to the expenses the taxpayer incurred in 2015.
After the IRS audit and presumably an IRS appeal, the taxpayer filed a petition in the U.S. Tax Court to dispute the disallowed tax deductions.
The Start-Up Rules
The start-up rules apply to amounts paid for “any activity engaged in for-profit and for the production of income.”
They say that these amounts in excess of $5,000 per year are not deductible for tax purposes until the day on which the active trade or business begins. The taxpayer can incur $55,000 of expenses at $5,000 a year. Amounts in excess of this are not allowed until the taxpayer’s active trade or business begins. Then the previously disallowed expenses are taken as tax deductions over a 15-year period starting on the date the trade or business begins. We have previously described the need for tax planning to avoid the start-up rules (and here is another tax planning article on point, and another one, and yet another one involving a yacht charter business).
These rules are a close corollary to the hobby loss rules, which also have to be considered.
This puts the focus on the date the activity rises to the level of being an active trade or business. The court cases that have interpreted this rule have developed a facts and circumstances analysis.
The court cases have said that a trade or business begins when the business has begun to function as a going concern. The courts have also generally said that it is the date the business is ready for business, not the date that it actually starts the business. So a business that takes all of the steps needed to start and holds itself out to the public as offering its product or service qualifies as a business. This is true even if the business has not earned any revenue or does not earn any revenue for some time.
When is Website Design a Trade or Business?
In the present case, the IRS argued that the taxpayer’s website activity was not a business in 2015 as it had no revenue.
The U.S. Tax Court noted that revenue is not the proper proxy to determine whether an activity has yet morphed into a trade or business. It noted that profit is usually associated with a trade or business:
The typical case determining when an active trade or business begins contemplates a traditional business archetype: If initial operations succeed, the company should start earning revenue as soon as the active trade or business begins. For example, a grocery store will earn revenue by selling groceries as soon as it draws customers. See Piggly Wiggly S., Inc. v. Commissioner, 84 T.C. 739, 745-48 (1985) (allowing a store operator to deduct the cost of equipment placed in open stores, but denying the same deduction for stores not yet open), aff’d, 803 F.2d 1572 (11th Cir. 1986). By the same token, a company operating an apartment or office building should receive rent payments as soon as it admits tenants. See Johnsen v. Commissioner, 83 T.C. 103, 114-18 (1984) (denying deductions for pre-opening costs of rental property and discussing other cases reaching the same result), rev’d on other grounds, 794 F.2d 1157 (6th Cir. 1986).
The court then noted that not all businesses involve a typical case like this:
Vizala does not fit this traditional archetype. Petitioner doubted that any of his revenue strategies could succeed until Vizala built rapport with users and advertisers. He therefore prioritized web traffic over revenue by charging no user fees and marketing the site to institutional customers. Even though petitioner made no attempt to earn revenue in 2015, his business began providing the services “for which it was organized,” with an eye to long-term profit, once he opened the website. See Richmond Television, 345 F.2d at 907. Such activity, at least under these circumstances, constitutes an active trade or business.
Given that the website was available to the public in September of 2015, the court concluded that this was the date that the trade or business started. It was not the later 2019 date that the business started earning revenue.
The taxpayer was allowed to deduct expenses incurred on this September 2015 date and after. For the expenses incurred in 2013 and 2014, the court did not allow most of these expenses. It noted that the taxpayer had to establish that the expenses in these years exceeded $55,000. Absent proof that the expenses were less than this amount, the court did not allow the deductions for these years.
Research & Developmental Expenses
The taxpayer also argued that he was entitled to deduct the website development costs as “research and developmental expenses” under Section 174. The start-up rules specifically carve these expenses out as an exception to the start-up rules.
The court cited research tax credit court cases to explain the Section 174 rules. The research tax credit does incorporate Section 174 as one of the several requirements to be met for that tax credit.
In citing these cases, such as the Suder case, the court seems to note that there are some fact patterns in the court cases that require the use of new software for a new problem:
Vizala followed the Davenport paradigm: Petitioner and his engineers adapted widely used software to solve a complex but familiar problem. Petitioner’s project did not start from the “drawing board” in the same sense as Mr. Suder’s softphone. Petitioner aimed to create a data aggregation website, which companies such as Google Finance had done before, only his website would present demographic, social, and economic data instead of the financial information available on professional-quality platforms. Whereas the softphone required Mr. Suder’s team to write code from a blank slate, Vizala permitted the use of open-source software customized for petitioner’s needs. Like Mr. Davenport’s employees, petitioner described to his engineers how the product should work, and, as an inherent part of designing complex software, collaborated with the engineers to troubleshoot problems before launch. Cf. id. at *39-40 (disagreeing with the IRS’s position that Mr. Suder’s team encountered only the kind of uncertainty inherent in every large development effort). As in Mr. Davenport’s case, we conclude that petitioner may not deduct his expenses under section 174.
With all due respect to the tax court, this reasoning departs from the rules provided in the regulations. Even for the more restrictive research tax credit, the regulations for that stricter credit do not require the taxpayer to use new software or even to solve new problems. The activity just has to be to discover information that is new to the taxpayer.
This replays the widely publicized “discovery test” debacle for the research tax credit. Congress has already openly renounced the very position that the court in this case adopted. This is confirmed in the latest regulations issued by the IRS for the research tax credit. The preamble to those regulations expressly notes and states that this is inconsistent with Congressional intent.
It is not clear whether the taxpayer will challenge this portion of the ruling given the nominal amounts at issue. As a tax court memorandum opinion, this case does not set precedent and cannot be cited by the IRS or taxpayers, but it does muddle the case law in this area.
For those developing websites, they should measure their activities using the language in the regulations, specifically in Treas. Reg. 1.174-2 and the prior court cases on point, such as the Union Carbide court case.
Computer Software Under Rev. Proc. 2000-50
The taxpayer also argued that the website design qualified as an expense under Rev. Proc. 2000-50. The IRS agreed that these costs qualified under this guidance, but that they do not do so until the time the taxpayer is engaged in an active trade or business.
The court questioned and did not adopt the IRS’s argument. Rev. Proc. 2000-50 is not conditioned on being in an active trade or business.
Unfortunately, the court concluded that it was unable to enforce Rev. Proc. 2000-50 against the IRS. The court concluded that since it is not a court at equity, it does not have the authority to enforce Rev. Proc. 2000-50. This is an admission of the inherent limitation of the U.S. Tax Court as compared to a U.S. District Court. The U.S. Tax Court is an executive agency that has gone to some lengths to make itself appear to be a court, but it is not an actual court in a number of respects. This is just one example of that. With that said, whether the court has jurisdiction to enforce Rev. Proc. 2000-50 is open for debate and also could be the subject of an appeal in this case.
Those developing websites and related software should be able to rely on Rev. Proc. 2000-50. These expenses are deductible as set out in Rev. Proc. 2000-50.
Website design costs are generally deductible. This is true whether the taxpayer is actively engaged in a trade or business given the rules in Section 174 and Rev. Proc. 2000-50.
Even ignoring those rules, as in this case, taxpayers can usually still deduct these expenses. Section 195 only limits expenses to the day the website is made available to the public for its intended business purpose. Taxpayers should take care to document this date as expenses after this date should be deductible. Expenses incurred before this date should be carefully analyzed to see if they need to be amortized and deducted over 180 months.
Taxpayers should also consider whether they can take a research tax credit in lieu of deducting these costs. The research tax credit will often produce more tax savings than merely deducting this type of website development costs.