It takes money to make money. Generally Congress allows taxpayers to deduct the money it takes from the money they make. That’s the idea in §162. But §162’s deceptively simple language----allowing a deduction for all “the ordinary and necessary expenses paid or incurred in carrying on a trade or business”---has gaps, to be filled by other statutes. For example, §§183 and 212 apply the §162 idea to activities that are not a “trade or business” but still produce income and have associated costs. And then there is that pesky timing issue: which costs are “expenses” that should be deducted in the current year and which costs should only allowed to be deducted over a longer period of time? Sections 168(k) and 179 allow taxpayers to accelerate deductions of certain capital costs that otherwise would not qualify as “expenses” under §162’s simple language.
Section 195 deals with another gap: how to treat the costs of starting a business. Section 162 does not permit deductions until such time as the taxpayer is actually “carrying on” the business. Section 195 allows taxpayers to reach back to the time before the business started and deduct their start up costs. But to get to use §195 a taxpayer must actually start their business. Last week’s case of Steven Austin Smith v. Commissioner, T.C. Sum. Op. 2019-12 (July 1, 2019) (Judge Vasquez) teaches a nice lesson about what it means to start a business. There, the court found that a taxpayer was indeed carrying on his business even in a year where he had no sales income. To be sure, he still lost because he was unable to substantiate his expenses. There’s a bit of a lesson there as well. But the main lesson is about when a business starts.
Law: Treatment of Start Up Expenses
Before Congress wrote §195, courts dealt with start up costs via a common law rule based on conflicting doctrinal foundations. For those who want more details, I found this law review article by Professor John W. Lee to be useful and fun to read.
Under the common law regime, courts rejected taxpayer attempts to deduct the costs of investigating or acquiring a business. Courts interpreted §162 as requiring linkage of costs to an existing business of the taxpayer. The classic case is Frank v. Commissioner, 20 T.C. 511 (1953). There, Mr. and Mrs. Frank traveled around the country after WWII looking for somewhere to get into either the newspaper or radio business. Mr. Frank eventually found newspaper employment in February 1946. The Tax Court rejected their attempts to deduct their pre-February search costs under either (what is now) §162 or §212. The Court held:
“There is a basic distinction between allowing deductions for the expense of producing or collecting income, in which one has an existent interest or right, and expenses incurred in an attempt to obtain income by the creation of some new interest. *** The expenses here involved are of the latter classification. The traveling costs were incurred in an endeavor to acquire a business which might, in the future, prove productive of income. It might reasonably be said that petitioners were engaged in the active search of employment as newspaper owners, but that cannot be regarded as a business.” Id. at 514 (citations omitted).
Nor could taxpayers generally recover start up costs through amortization under the common law rules. Courts tended to associate such costs with the business generally or with some indefinite asset. For example, in Richmond Television Corp. v. United States, 354 F.2d 410 (4th Cir. 1965), the Fourth Circuit first denied the taxpayer a §162 deduction for personnel costs incurred during the two years before the FCC approved the taxpayer’s license to broadcast. The court said that the business did not start until the taxpayer obtained the license.
The same court later rejected the taxpayer’s alternative argument that it could amortize those costs over the three year license period. See 354 F.2d 410 (1965). The court said that the start up costs were more properly associated with the creation of the entire business, an indefinite asset. But not to worry! said the court: “Denying amortization for the reason that the capital asset is one of indefinite duration does not mean that the expenditure is lost to the taxpayer beyond retrieval. It merely means that the item is added to the capital account and will enter into the computation of gain or loss when the asset is disposed of or abandoned.” Ya gotta like that use of “merely.”
Congress tried to fix some of these issues by enacting §195 as part of the Miscellaneous Revenue Act of 1980, Pub. L. No. 96-605, 94 Stat. 3521. In its current iteration, §195 permits an immediate deduction of up to $5,000 of start up costs, phased out dollar-for-dollar when total start up costs exceed $50,000. All other start up costs get to be amortized over a 5 year recovery period. So when total start up costs exceed $50,000, there is no immediate expense and all start up costs are amortized. Treas. Reg. 1.195-1 gives some nice examples.
The statute says that taxpayers may elect §195 treatment but only once they start their business. The regulations, however, flip the presumption quicker than you can say "pro wrestling"! It’s a nice example of the power of regulations. Treas. Reg. 1.195-1(b) just jumps right on that statute and pins the taxpayer into the §195 election unless the taxpayer files a return “affirmatively electing to capitalize its start-up expenditures.” That seems a reasonable move to me. I would love to hear why taxpayers might choose to capitalize their start up costs rather than use §195. I am sure there must be a reason and would be grateful for any enlightenment in the comments.
Figuring out when a business actually starts is a question of fact that depends on the circumstances of each particular case. For example, on the related question of when a corporation begins operations so as to be able to invoke §248, the applicable regulations explicitly refuse to draw any bright line but instead provide that “The determination of the date the corporation begins business presents a question of fact which must be determined in each case in light of all the circumstances of the particular case.” Treas. Reg. 1.248-1(a)(3). The courts have found that to be just a true in figuring out when a business starts for §162 and §195 purposes. See, Richmond Television, 345 F.2d at 905 (“when, in point of time, a trade or business actually begins ... is usually a factual issue”); United States v. Manor Care, 490 F.Supp. 355, 361-62 (D. Md. 1980) (“issues of when a business begins...are issues to be determined on the facts of each case.”).
The Tax Court has long used a functional test to frame the factual inquiry, borrowing from the Richmond Television case. Here is how the Tax Court put it in Weaver v. Commissioner, T.C. Memo 2004-108:
“even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not engaged in carrying on any trade or business within the intendment of section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized.”
It's the language "has begun to function as a going concern and performed those activities for which it was organized" that proves important in today's lesson.
Mr. Smith owns Vegan Worldwide, LLC (“Vegan”), a company whose business is the distribution of vegan food products. The company’s current website explains that it “specializes in the production, distribution, and export of healthy foods and beverages. We offer premium vegan products in American and overseas markets.” The website says the company currently offers seven products for distribution within the U.S. and into five other countries: Canada, Mexico, Columbia, Chile, and the Dominican Republic.
That’s now. But when did the “now” start? More specifically, had it started in 2014, the year at issue in the case? Mr. Smith had incorporated Vegan under the laws of Delaware in 2013, but there is no suggestion that Vegan was in business in 2013.
In 2014, Vegan entered into two distribution agreements with two different food manufacturers. The agreements permitted Vegan to market and distribute those manufacturer’s food products, one under its own label and the other under the label of the manufacturer. In addition, Mr. Smith traveled to various Latin American countries to attend food shows, to find customers, and to market Vegan’s products. Those were pretty much all the activities Mr. Smith did as a Vegan in 2014.
Vegan generated no revenue from exports in 2014. But Mr. Smith did report wage income of over $166,000. It appears he was a Business School professor. He is still listed as such on this faculty page at Southern Connecticut State University.
On his 2014 return, Mr. Smith’s Schedule C for Vegan reported about $2,000 of gross receipts and $41,000 of expenses, thus reporting a net loss of $39,000. During trial, Mr. Smith could not tell the Court why he had reported the $2,000 of gross receipts and that number did not figure into the Court's opinion or reasoning.
The NOD for the 2014 return disallowed all the expenses for lack of substantiation. At trial, however, the Chief Counsel attorney advanced a theory that Mr. Smith had not started business in 2014 and, accordingly, even if he could substantiate the expenses, they were all start up expenses that could only be taken under §195 in the year he actually started the business, a year after 2014.
The IRS position was that Mr. Smith’s 2014 travel and activity was preparatory research, must like Mr. Frank’s travel and that Mr. Smith did not actually do in 2014 what he said the business was all about: export. In short, in 2014 Vegan had not “performed those activities for which it was organized.” So Mr. Smith was not yet carrying on the business.
Lesson 1: A Business Starts When the Court Says It Did
Because the IRS raised the 195 argument as a new issue at trial, Judge Vasquez explains why it had the burden to convince him that the facts supported its assertion. But I do not think the burden shift was important to Judge Vasquez’s conclusion. What was important was how broadly Judge Vasquez used the functional test of when a business starts.
Judge Vasquez gives a nice explanation of the law and the facts and why he finds that Mr. Smith had started his business in 2014, despite the lack of any identifiable revenue from the exports. The key for Judge Vasquez seems to be those two distribution contracts that Vegan entered into in 2014 and the travel Mr. Smith did. To “function as a going concern” means more than just actual sales. Ya gotta have a product first. Successfully securing that product is good evidence of an ongoing business. Those contracts, in turn, make the marketing more than a preliminary activity. The cost of finding potential customers when you have nothing but the idea may be a start up cost. But hey! once you have Soy Curls to offer, buddy, you are in business, even no one pays you to export them that first year.
Thus, while actual sales revenue may be the best evidence that a business has started, it is not the only evidence that will convince a court because sales are not the only activities that an ongoing business engages in. Activities other than sales may be enough to show that a business has started to “function as a going concern” and that constitute part of the "activities for which it was organized." At least that is the lesson I see here.
Lesson 2: Keep Your Emails
Despite the win on the §195 issue, the Tax Court still sustained the most of the NOD’s disallowances and also sustained the proposed penalties. Ouch.
Mr. Smith’s loss here reflects the all-too familiar sad story: lack of substantiation. What I found instructive here, however, was that Judge Vasquez was very receptive to the use of emails to substantiate business purposes. Where Mr. Smith was able to provide relevant emails, he was able to meet his burden of substantiation. For example, he had deducted $150 for a hotel stay in New Orleans. His proof of the business purpose of the trip was not just his own self-serving testimony but was a contemporary email to a business associate about that particular trip. Similarly, emails substantiated his testimony that a trip to Columbia was for a business purpose.
Otherwise, however, Judge Vasquez noted that “the record lacks direct or circumstantial evidence of the business purpose for each reported expenditure. The record also lacks documentary evidence, such as receipts, for most of the entries in petitioner’s summary.”
On the one hand, the lesson I see here is to consider telling clients to find relevant emails that support their deductions. Increasingly, I now receive receipts electronically. While the receipts themselves prove nothing about the purpose of the trip, emails may.
On the other hand, I question how important this lesson really is in the long run. It appears that businesses and individuals are shifting from emails to texting. It appears much more difficult to keep, store, and organize texts than emails.
The bottom line here is not only that your client needs good records, but also that you can be creative in reconstructing events if your client can unearth relevant electronic records and you can convince the IRS or the Tax Court of their authenticity.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.