Starting A Business In The Desert

 

Tax has something called “startup costs.”

The idea is to slow down how quickly you can deduct these costs, and it can hurt.

Let’s take a common enough example: starting a restaurant.

You are interested in owning a restaurant. You look at several existing restaurants that may be available for purchase, but you eventually decide to renovate existing space and open your own- and new – restaurant. You lease or buy, then hire an architect for the design and a contractor for the build-out of the space.

You are burning through money.

You still do not have a tax deduction. Expenses incurred when you were evaluating existing restaurants are considered investigatory expenses. The idea here is that you were thinking of doing something, but you were not certain which something to do – or whether to do anything at all.

Investigatory expenses are a type of startup expense.

The contractor comes in. You are installing walls and windows and floors and fixtures. The equipment and furniture are delivered next.

You will depreciate these expenses, but not yet. Depreciation begins when an asset is placed in service, and it is hard to argue that assets are placed in service before the business itself begins.

You still do not have a tax deduction.

You will be the head chef, but still need your sous and line chefs, as well as a hostess, waitpersons, bartender and busboys. You have payroll and you have not served your first customer.

It is relatively common for a restaurant to have a soft launch, meaning the restaurant is open to invited guests only. This is a chance to present the menu and to shakedown the kitchen and floor staff before opening doors to the general public. It serves a couple of purposes: first, to make sure everyone and everything is ready; second, to stop the startup period. 

Think about the expenses you have incurred just to get to your soft launch: the investigatory expenses, the architect and contractor, the construction costs, the fixtures and furniture, employee training, advertising and so on.

Carve out the stuff that is depreciable, as that has its own rules. The costs that are left represent startup costs.

The tax Code – in its wisdom or jest – allows you to immediately deduct up to $5,000 of startup costs, and even that skeletal amount is reduced if you have “too many” startup costs.

Whatever remains is deductible pro-rata over 15 years.

Yes, 15 years. Almost enough time to get a kid through grade and high school.

You clearly want to minimize startup costs, if at all possible. There are two general ways to do this:

·      Start doing business as soon as possible.  Perhaps you start takeout or delivery as soon as the kitchen is ready and before the overall restaurant is open for service.

·      You expand an existing business, with expansion in this example meaning your second (or later) restaurant. While you are starting another restaurant, you are already in the business of operating restaurants. You are past startup, at least as far as restaurants go.

Let’s look at the Safaryan case.

In 2012 or 2013 Vardan Antonyan purchased 10 acres in the middle of the Mojave desert. It was a mile away from a road and about 120 miles away from where Antonyan and his wife lived. It was his plan to provide road access to the property, obtain approval for organic farming, install an irrigation system and subdivide and rent individual parcels to farmers.  

The place was going to be called “Paradise Acres.” I am not making this up.

Antonyan created a business plan. Step one was to construct a nonlivable structure (think a barn), to be followed by certification with the Department of Agriculture, an irrigation system and construction of an access road.

Forward to 2015 and Antoyan was buying building materials, hiring day laborers and renting equipment to build that barn.

Antoyan and his wife (Safaryan) filed their 2015 tax return and claim approximately $25 thousand in losses from this activity.

The IRS bounced the return.

Their argument?

The business never started.

How did the IRS get there?

Antonyan never accomplished one thing in his business plan by the end of 2015. Mind you, he started constructing the barn, but he had not finished it by year-end. This did not mean that he was not racking-up expenses. It just meant that the expenses were startup costs, to be deducted at that generous $5,00/15-year burn rate starting in the year the business actually started.

The Court wanted to see revenue. Revenue is the gold standard when arguing business startup. There was none, however, placing tremendous pressure on Antonyan to explain how the business had started without tenants or rent – when tenants and rent were the entirety of the business.  Perhaps he could present statements from potential tenants about negotiations with Antonyan – something to persuade the Court.   

He couldn’t.

Meaning he did not start in 2015.

Our case this time was Safaryan v Commissioner, T.C. Memo 2021-138.

Maple Trees, Blueberries and Startup Expenses

It is one of my least favorite issues in tax law. It is not a particularly technical issue; rather, it too often imitates theology and metaphysics:

When does a business begin?

For some businesses, it is straightforward. As a CPA my business starts when I take office space or otherwise offer my services to the public. Other businesses have their rules of thumb:

·        An office building begins business when it obtains a certificate of occupancy from the appropriate municipal government.

·        A restaurant begins (usually) after its soft opening; that is, when it first opens to family, friends, possibly food reviewers and critics - and before opening to the general public.

What can make the issue difficult was a 1980 change in the tax law. It used to be that start-up costs could not be immediately deducted. Rather one had to accumulate and deduct them over a 5-year period.

Unfortunate but not ruinous.

In 1980 the law changed to allow a $5,000 deduction; the balance was to be deducted over a 15-year period.

Can you imagine the potentially fraught and tense conversations between a taxpayer and the tax advisor? Rather than injecting moderate but acceptable pain, Congress introduced dispute between a practitioner and his/her client.

Let’s look at a case involving startup costs.

James Gordon Primus lived in New York and worked as an accountant at a large accounting firm. In 2011 his mother bought 266 acres in southwest Quebec on his behalf. The property contained almost 200 acres of maple trees. The trees were mature enough to produce sap, so I suppose he could start his new business of farming.

But there were details. There are always details.

He wanted to clear the brush, as that would help with production later on. He also wanted to install a collection pipeline, for the obvious reason. He also had plans for blueberry production.

He started thinning the maple brush in 2011, right after acquiring the property.

Good.

In 2012 and 2013 he started clearing for blueberry production. 

He ordered 2,000 blueberry bushes in 2014.

In 2015 he began installing the pipeline and planted the blueberry bushes.

In 2016 he readied the barn.

In 2017 he finally collected and sold maple sap.

Got it: 6 years later.

On 2012 he deducted over $200 grand for the farm.

On 2013 he deducted another $118 grand.

That caught the attention of the IRS. They saw $318 grand of startup expenses. They would spot him $5 grand and amortize the rest over 15 years.

Not a chance argued Primus.

He started clearing in 2011, and clearing is an established farming practice. He was in the trade or business of farming by 2012.

Clearing is an accepted practice, said the Court, but that does not mean that one has gotten past the startup phase. Context in all things.

Primus offered another argument: a business can start before it generates revenues.

That is correct, responded the Court, but lack of revenue does not mean that business has started.

Here is the Court:

Petitioner’s activities during 2012 and 2013 were incurred to prepare the farm and produce sap and plant blueberries. Those are startup expenses under section 195 and may not be deducted under section 162 or 212.”

The taxpayer struck out.

Get this issue wrong and the consequences can be severe.

How would one plan for something like this?

I do not pretend to be an expert in maple farming, but I would pull back to general principles: show revenues. The IRS might dismiss the revenues as inconsequential and not determinative that a startup period has ended, but one has a not-inconsequential argument.

That leads to the next principle: once one has established a trade or business, the expenses of expanding that trade or business (think blueberries in this instance) are generally deductible.

I wonder how this would have gone had Primus tapped and sold sap in 2012. I am thinking limited production but still enough to be business-consequential. Perhaps he could market it as “rare,” “local,” “artisanal” and all the buzz words.

Perhaps he could have followed the next year with another limited production. I am trying to tamp-down an IRS “not determinative” argument.

Would it have made a difference?

When Does A Business "Start"?

There is a category of deductions that the tax Code refers to as “start up” or “pre-opening” expenses.

For the most part, you do not want to go there.

An active trade or business is allowed to deduct its normal and operating expenses (as defined and limited by the Code, of course). There is a trap in that description, and the trap is the word “active.”

What does it mean be active?

It means the business is up and running.

How can a business not be up and running?

Let's say that you are opening a Five Guys Burgers and Fries restaurant. You have all kinds of expenses - in addition to building the place - before you open the doors. You have to turn on the lights, hire and train employees, establish suppliers and receive inventory, and so forth.

All this before you sell your first hamburger.

The problem is that you cannot deduct these expenses, because you have not yet started business. You have to be in business before you can deduct your expenses. There is a Kafkaesque absurdity to the whole thing.

The Code however does step-in and provide the following safety valve in Section 195:

(a)Capitalization of expenditures

Except as otherwise provided in this section, no deduction shall be allowed for start-up expenditures.

(b)Election to deduct 

(1)Allowance of deduction If a taxpayer elects the application of this subsection with respect to any start-up expenditure
(A)the taxpayer shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the lesser of

(i) the amount of start-up expenditures with respect to the active trade or business, or

(ii) $5,000, reduced (but not below zero) by the amount by which such start-up expenditures exceed $50,000, and

(B) the remainder of such start-up expenditures shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the active trade or business begins.

I do not consider it much of a safety valve, as the best you can get is $5,000. Let the expenses go over $55,000 and you lose even that. You deduct the balance over 180 months.

That is 15 years. Think about it: you can start a kid in first grade and almost put him/her through college before you get to fully deduct your Five Guys start-up and pre-opening expenses.

And that is the problem: the period is so long that it effectively is a penalty. It is one thing when Walmart opens a super store, as they are towing the resources (and cash flow) of a Fortune 500. It is a different issue when a budding entrepreneur heads out there with a hope and a prayer.

Let’s look at the Tizard case.

Julie Tizard graduated from Baylor and entered the Air Force as a 2^nd lieutenant. While serving at Wright-Patterson in Dayton, Ohio, the USAF announced that women would be allowed to apply for pilot positions. Julie was all over that, becoming a pilot and rising through the ranks as instructor pilot, flight commander and wing flying safety officer.

In 1990 she started working as a full-time commercial pilot with United Airlines, where she flew 737s, 757s, 767s and the Airbus 320.

The FAA requires commercial pilots to retire at age 65.

Knowing that, she looked for things to do after she turned 65. She decided to start an aviation business in Arizona. She selected an airplane model (the Slingsby T-67C “Firefly”), a single engine propeller model that is fuel-efficient, has excellent visibility, is responsive and is “acrobatic.” Acrobatic apparently has a different meaning to pilots than to ordinary people – think of intentionally rolling or stalling the plane. You have as much chance of getting me on that plane as the Browns have of winning the Super Bowl this year.

She purchased the plane for $54,200. It turned out that the guy selling the plane was a real estate developer with a development in Phoenix. He expressed interest in her services. She was off to a promising start.

She posted a picture of herself with the plane on Facebook. She received 50 “likes.”

The same day she got the plane home, she took out an acquaintance whom she considered a potential client. Being promotional, Julie did not charge her.

Julie set-up an LLC (Tizard) for the business.

She worked up a business plan. She would start by offering aerial land surveys, flight charters and aviation photography, as well as professional aviation and safety consulting. The Firefly was well-designed for this use, and to the best of Julie’s knowledge she was the only person in central Arizona offering this menu of services.

She crunched the numbers and figured that she would break-even at 2.5 aviation hours per month. At 15 hours she was earning a meaningful profit.

Sounds like Julie knew what she was doing.

Time came to prepare her 2010 tax return. She had no income from the airplane and over $13 thousand of expenses.

The IRS bounced her return. They said she had not yet started business.

There are several factors that one considers in determining whether business activities have started:

         (1) Sales

         This is the best evidence, but she did not have any.

         (2) Advertising and marketing

She posted on Facebook and had approached both the seller of the plane as well as an acquaintance as potential customers.

         (3) Business Plan

She had given the matter some thought. She researched potential competition and had analyzed costs to the extent she knew how many flight hours per month were required to break-even.

Seems to me that she had one solid (factor (3)) and one so-so (factor (2)).

Problem is that factor (1) is the elephant in the room. Nothing gets the IRS to back off more than a real person handing over real money.

The Court seemed to like Julie:

The Court found the petitioner's testimony to be credible and forthright."

But the Court was not impressed with Julie's marketing:

However, other than the picture and short statement (that makes no mention of her aviation business) that she posted on her personal Facebook page ..., petitioner did nothing in 2010 to formally advertise to the general public ... or describe the various services that Tizard would offer to its clients."

That left a lot of pressure on factor (3). It was too much pressure, unfortunately:

Petitioner's ... efforts ... do not impress the Court as evidence that Tizard was actually functioning and performing the activities for which it was organized."

The Court decided she had not started business in 2010.  She had to run her expenses through the Section 195 filter. The best she could deduct was $5,000, and the balance would be allowed over the next 15 years.

Is there something she could have done differently?

She could have tried harder to line-up that first paying customer. To be fair, she acquired the plane late in the year, which allowed her little time to react.

Absent revenues, marketing became a critical factor. The Court wanted more than a hopeful conversation or Facebook photo of her next to her new plane. 

I am thinking she should have set-up a business website - including history, services, photos - for the airplane business. Perhaps that, with her business plan, would have been enough.