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.

Deducting Everything - The Tanzi Doctrine

I admit: I got a chuckle from reading the case.

The taxpayers (Tanzi's) are married, and for the year in question they were employed by Seminole State College, which is Sanford, Florida. I remember a conversation with a Sanford CPA a year or two ago lamenting that there no longer was separation between Orlando and Sanford. I was in Orlando this year, and he is right - there isn't.

Our taxpayer was an adjunct instructor teaching communications, and his wife worked at the campus library. Although an adjunct, he held a PhD in communications, so we can presume he was hoping for a permanent full-time position.

On their 2011 return they deducted the following as employee expenses:

            (1) 100% of their telephone, internet and television

            (2) depreciation

            (3) books, CDs and DVDs

            (4) computer expenses

The IRS bounced the employee expenses and sent them a notice for approximately $3,000.

Employee expenses are a subset of "miscellaneous deductions." One has to itemize to get to miscellaneous deductions, and even then these miscellaneous deductions are not what they used to be. The common itemized deductions are mortgage interest, real estate taxes and contributions. Living in Florida, our taxpayers did not have to concern themselves with another common itemized deduction - state income taxes. Chances are the first three got them into itemized deduction range, and their miscellaneous deductions then became usable. It is rare that miscellaneous deductions by themselves will be enough to get you to itemize.

Miscellaneous deductions are not tax-efficient, though. The Code requires that you reduce your miscellaneous deductions by 2% of your adjusted gross income, so that portion is immediately forfeited.

EXAMPLE: You and your spouse make a combined $150,000. You would have to immediately reduce your miscellaneous deductions by $3,000 (i.e., $150,000 times 2%). If your miscellaneous deductions totaled $3,500, only $500 would be deductible. And yes, it is intentional. It is a way for Congress to pry a few more tax dollars from everyone who incurs employee expenses.

COMMENT: My daughter is working before returning to graduate school. She is required to use her car for work. Although reimbursed something for mileage, it is not the full rate permitted by the IRS. Her employer explained to her that she could deduct the difference come tax time. As her dad and tax advisor, I explained that this was not true. She would not have enough to itemize, and her unreimbursed mileage would be deductible only if she itemized.

By the way, you forfeit all miscellaneous deductions if you are subject to the AMT (alternative minimum tax). As I said, they are not efficient.

The Tanzi's were deducting employee business expenses. The IRS was questioning how 100% of their telephone and internet - just to start - became business. There is a long-standing doctrine that an employee is "in the business" of being an employee, but one still has to show some nexus between the expenses and being an employee. I receive a W-2, for example, but I cannot deduct my Starbucks tab solely for the reason that I am an employee. I would have a business nexus if I met a client there, but not because I was picking up coffee for my commute to the office.

The IRS wanted to know what that nexus was.

The Tanzi's argued that they must constantly expand their "general knowledge" to be effective at their jobs. Mr Tanzi explained that individuals holding terminal degrees - such as himself, coincidently - especially bear a lifelong burden of "developing knowledge, exploring [and] essentially self-educating."   Mr. Tanzi insisted that all expenses paid in pursuing his general knowledge should be deductible as unreimbursed business expenses.

COMMENT: If Mr Tanzi won this argument, I would immediately try to expand the Tanzi doctrine to include tax CPAs with Masters degrees who also maintain a tax blog. Our burdened ranks must constantly expand our general knowledge to be effective at our jobs. I for example sometimes work with and write about international tax matters. Seems to me that a trip overseas to visit my wife's family should be deductible, as it expands my knowledge of being overseas, or some reasoning along those lines.

The tax Code recognizes that some expenses are simply personal in nature. There is even a Code section that says this out loud:

  Section 262 - Personal, living, and family expenses

      (a) General rule

Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.

Here is the Court:

While we find credible the Tanzi's testimony that they spent significant time and resources educating themselves, we do not believe the expenses are ordinary and necessary for the trades of being a professor or a campus librarian but rather are personal, living or family expenses nondeductible under section 262(a)."

No surprise for the Tanzi's, but I am a bit disappointed. Looks like I won't be able to deduct my life expenses as ordinary and necessary to the business of being a tax CPA and blogger. Those tax refunds would have been sweet.

If Your Job Requires It, Can You Deduct It?

I was recently talking with a friend about job opportunities available to him.

Some locations – like New York and L.A. – he dismissed immediately.

Then he mentioned that another location would require him to “suit and tie” every day.

I could not help but laugh. We both worked together in a mandatory “tie” environment, and I have worked in a mandatory “coat and tie” one. I suspect the latter is because the firm was downtown, and the firm wanted to project a certain image as its employees walked about. 

Still, suiting up gets expensive.

Sure would be nice if you could get a tax deduction out of it.

It’s almost impossible.

There is a famous case that laid down three requirements for clothing to be deductible:

(1) The clothing is of a type specifically required as a condition of employment;

(2) It is not adaptable to ordinary day-to-day wear; and

(3)  It is not used for day-to-day wear.

All in all, that seems to cover almost all clothing, unless you wear uniforms or are an astronaut.

But let me give you a few odd situations, and you tell me if there is hope of a tax deduction:

(1) You are a painter and are requested by the union to wear the traditional white-on-white painter’s outfit.

(2) You are a television news anchor and have to dress the part.

(3)  You are a Swedish rock band and wear clothing that looks like it has been dragged and ripped by wild dingoes.

(4) You are a musician and dress like a gypsy (or Welsh witch) for your performances.

There is a fellow who works for Ralph Lauren Corp. The company requires him to wear Ralph Lauren apparel while representing the company. As a consequence he has quite the extensive collection (and investment), and he tried to deduct some of it as a miscellaneous deduction on his Schedule A.

The Tax Court just said no dice. The clothing could be used day-to-day and therefore did not rise to the level of a deduction. The cost and restrictions imposed upon him by his employer were not tax relevant.

In truth, I wonder why he even pursued this matter. There is a case from before I came out of school where an Yves Saint Laurent employee tried the same deduction and failed.

Back to our examples:

(1) No deduction. The clothing could still be worn, although one is unlikely to do so. There may be an argument if the union required you to dress that way. The tax trigger would be more the requirement and less the clothing.

(2) Almost impossible. There is a case involving a news anchor with a wardrobe she considered too conservative for everyday use. She segregated it and wore it only at work. Not only did the Tax Court disallow the deduction, they also assessed penalties.

(3) This was the band ABBA, and they got the deduction. If you google their photographs, it is clear you would not wear that clothing outside of a performance or on Halloween.

(4) This was Stevie Nicks of Fleetwood Mac. She deducted over $40 grand on her 1991 tax return for costumes and hair styling. The IRS disallowed these and selected other deductions on her return. While the matter was docketed for Tax Court, it was returned to IRS Appeals. It was there resolved, and unfortunately tax practitioners (other than Stevie’s tax advisor) do not know how it turned out.

Then for the extreme tax athletes there is the woman who was able to deduct her body makeup, and I freely admit I am not sure what that is. She did not deduct clothing, as she wore none. She was an actress for the Broadway performances of Oh! Calcutta!

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat 

When Can You Take That Deduction?

Sometimes the most mundane things can cause a tax issue. For example, an asset must be “placed in service” before one can claim depreciation. Consider that 2013 was the last year one could claim 50% bonus depreciation, and you can see how someone would want that big-dollar asset in service by year-end.

But what does “place in service” mean?

Let us go through a couple of examples.

Let’s say that you purchase a single-family home. You know someone who wants to rent. With that in mind you purchase the property, incur approximately $10 thousand in repairs and then verify the credit worthiness of the potential renter. You are surprised and disappointed with the result, and decide not to rent to that individual.

It is now the following year. The next applicant is eligible for Section 8 assistance. HUD sends an inspector, who unfortunately wants additional repairs before approving the application. You do the repairs. HUD approves. You have a renter.

The issue here is that expenses must be associated with a trade or business (or an income-producing activity) that is up and running in order to be deductible. Prior to then, the expenses are likely “start up” expenses, which are not immediately deductible. The classic example is a restaurant “dry run,” which occur before the restaurant opens to the public. Family and friends are invited to put the kitchen and service through its paces.

Most accountants would take the position that the house was placed in service (that is, its “activity” as a rental had started) when it was available to be rented. You had a renter lined up. Granted the renter did not pass the credit test, but there was a house, you were willing to rent the house and someone wanted to rent the house. Unfortunately, you did not otherwise try to “market” the house, perhaps by listing it on Craig’s List or advertising in the newspaper.

Oh, by the way, you did not start depreciation until the HUD renter moved in, which is year two in our example.

     Question: Can you deduct the $10 thousand in repairs?

Let’s go on to example #2.

There is a life insurance salesman who specializes in the uber-wealthy. He generally sells life policies of $10 million or more. He has developed quite the network of CPAS and other insurance agents. When prospective clients appear he will charter planes rather than rely on commercial flights. He had a bad experience when a commercial flight ran late, causing him to miss an important meeting and costing him a possible $8 million commission.

He decides to purchase his own plane. He needs to fly nonstop from cost-to-coast, as many of his clients are on the west coast. He eventually finds a $22 million Bombardier Challenger 604 that fits the bill. Unfortunately it is closing in on December 31, and he needs that bonus depreciation deduction. Problem is he also wants to customize the plane. He wants a conference table, for example. He wants to be able to work while he is flying coast-to-coast.

What to do? He tells the company that he absolutely positively needs the plane before year-end. On December 30, he gets the plane. He makes a trip to Seattle for a business lunch, then to Chicago to meet with another insurance agent. He gets in that business use.

He then returns the plane so the modifications can be made. He wants that conference table. He also wants 20-inch display screens rather than the standard 17-inch screens. Who wouldn’t?

     Question: When would you start depreciating the plane?

How would I have handled these two cases? In the first example I am inclined to start depreciation on the house in year one, the same year that the potential renter flubbed his credit check. The house was ready for rent, evidenced by have a potential renter wanting to rent.

And I would have been wrong. The Court decided that the house was not ready for rent in year one. It needed repairs, for example. The Court also observed that the potential renter was lined-up before the purchase of the house. After the credit check, the landlord did not resort to referrals and other means to rent the house. Instead she applied for Section 8 approval. Since HUD would not approve the house until repairs were made, the house could not be placed-in-service before then.

I understand the Court’s position, and I disagree with the Court. Unless the landlord bought the house specifically for Section 8, then HUD’s approval or disapproval sways me very little. Having a potential renter sways me a lot. Were the repairs substantial enough to prevent a renter from moving in? We do not know.

The Court also observed that the landlord did not try “other” means to rent the house, such as newspapers or Craig’s List. That bothers me. Just about every small landlord I know rents exclusively by word of mouth and referral. The idea of “advertising” their duplex or fourplex would be unimaginable, especially given today’s litigious environment. I have run into this position before on audit, so it does represent the IRS party line.  Can you rebut the position? You can, but it may require documentation of one’s efforts to rent the property. In my case, the IRS wanted my client’s referral sources to document her efforts to obtain a tenant.

And I suspect that the taxpayer’s decision to delay depreciation until year two may have been fatal.

What about the plane? It seems to me that the purpose of a plane is to fly, and that plane flew by December 31. Unless the flights were not really business-related and constituted only smoke and mirrors, I would say that plane was placed in service by December 31.

And I would have been wrong. The Court decided that the plane was not placed-in-service until the modifications were made, and the modifications were not made until the following year.

The Court is not without basis. IF those modifications were really THAT IMPORTANT to the insurance salesman, then one could reason that the plane was not ready for use in his trade or business as an insurance salesman. It was not enough to fly. It was necessary that he fly with a conference table. I get the nuance.

I do not think that was it, though. The Court went on to talk about how the salesman had understated his income by tens of millions of dollars and how he used nominees to conceal ownership and control of entities from the IRS. He had created false paperwork to support illegitimate deductions. Me thinks that he had hacked off the Court, and the Court – seeing an opportunity to disallow millions of dollars of depreciation – took the opportunity.

I tell you what I would have recommended to the salesman: do not give the plane back immediately. Wait three or four months. Use the plane extensively. Then install the conference table. Tax accountants refer to this as “cool down.”

Yes, sometimes tax planning is that simple.