It is one of my least favorite issues: when does a
business start?
The reason is that expenses incurred before the
start-up date are considered either organizational or start-up expenses and
cannot be immediately deducted. The IRS allows a small spot (of $5,000) and
expenses over that amount are to be amortized over 15 years.
It used to be five years. The issue was less of a
blood sport back then.
For many of us, the start-up date is easy: it is when
you open your doors to customers or clients. Let’s say you are a chiropractor. Your
start-up date is when the office opens. What if you do not have a patient that
day? Same answer: it is the day you open the doors.
Let’s kick it up a notch.
Say you open a restaurant. When is your start date?
The day you have first serve customers, right?
Yes, with a twist. Many restaurants have a soft
opening, which is a seating for a limited number of people (think family, friends
and media critics) to test service and the kitchen. This might be days or
weeks before the actual grand opening – that is, when doors open to the general
public.
Many tax accountants – me included – consider a
restaurant’s soft opening to be the start date.
The reason we want an earlier rather than a later date
is to start deducting expenses. If you are reaching into your pocket or borrowing
money to pay rent, utilities, promotion and staff, you want a tax deduction now.
You might consider me to be crazy man Michael were I to talk about deducting over 15 years.
Let’s kick it up another notch. Let’s talk about a
web-based business.
Gregg Kellett graduated from college in 2002 and opened
a website. He went corporate in 2007, and in 2011 he moved to Bloomberg, a
publisher of legal and business information. While there he saw an opportunity
to better aggregate and access online demographic, social and economic data. If
he could pull it off, he could offer a more user-friendly interface and make a
couple of bucks in the process.
So in 2013 he bought a website (vizala.com). He formed
a company by the same name. He hired remote computer engineers to develop
features he wanted in the website. They finished core work in March 2015 and
resolved bugs through September 2015. An example of a “bug” was an interactive
table that would not presently correctly in the Firefox browser.
Kellett figured to make money at least four ways:
(1) Selling advertising space
(2) Implementing a paywall
(3) Selling personalized charts and other
information
(4) Licensing data
He did not pursue any of those strategies during 2015.
However, he did deduct approximately $26 grand on his
2015 return.
He also did not earn any revenue until 2019.
Sure enough, the IRS disallowed the $26 grand because
Kellett was not in an “active” trade or business. They wanted him to deduct the
expenses over (almost) the same period as putting a kid though grade school and
then college.
Off to Tax Court.
If we pull back to the general rule – the date of
first revenues – this is going to hurt.
But the website was available by September 2015. It
wasn’t rocking like Netflix upon release of the 2022 season’s second half of Stranger
Things, but it was available.
The Court wanted to know what happened between 2015
and 2019.
Kellett explained that maximizing his long-term profit
potential required building trust among users. After that would come the
advertisers. He started building trust by promoting the website to over a
hundred universities and professional organizations. This was enough work that
he hired a marketing professional to assist him. The work paid-off, as about
50% on the institutions added Vizala to their lists of research databases.
The Court understood what he did. The website was
available by September 2015. It was not all it could be as Kellett had plans
for its long-term profitability, but that did not gainsay that the website was
available. Considering that the business was the website, that meant that the
business also started in September 2015. Expenses before that date were startup
expenses. Expenses after that date were immediately deductible.
Revenues did not play into the decision, fortunately.
It was the website version of the chiropractor opening
his/her office, albeit with no patients on the first day.
Kellett won, but it cost a visit to Tax Court.
Our case this time was Kellett v Commissioner,
T.C. Memo 2022-62.
