Can A Business Start Before Having Revenue?

 

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.

Benefitting Too Much From A Charity

I suspect that many of us know more about public charities and foundations than we cared to know a couple of years ago.

What sets up the temptation is that someone is not paying taxes, or paying extraordinarily low taxes. For example, obtain that coveted 501(c)(3) status and you will pay no taxes, barring extreme circumstances. If one cannot meet the "publicly supported" test of a (c)(3), the fallback is a private foundation - which only pays a 2% tax rate (and that can be reduced to 1%, with the right facts).

We should all be so lucky.

Let's discuss the issues of charities and private benefit and private inurement.

These rules exist because of the following language in Section 501(c):

No part of the earnings [of the exempt organization] inures to the benefit of any private shareholder or individual….”

In practice the Code distinguishes inurement depending upon who is being benefitted.

If that someone is an “insider,” then the issue is private inurement. An insider is someone who has enough influence or sway to affect the decision and actions of the organization.

A common enough example of private inurement is excessive compensation to a founder or officer.  The common safeguard is to empower an independent compensation committee, with authority to review and decide compensation packages. While not failsafe, it is a formidable defense.

If that someone is an “outsider,” then the term is private benefit.

Here is a question: say that someone sets up a foundation to assist with the expenses of breast cancer diagnosis and treatment. Several years later a family member is so diagnosed. Have we wandered into the realm of private inurement or benefit?

The Code will allow one to receive benefits from the charity – if that individual is also a member of a charitable class. In our example, that class is breast cancer patients. If one becomes a member of that class, one should sidestep the inurement or benefit issue.

The “should” is because the Code will not accept too small a charitable class. Say – for example - that the charitable class is restricted to the families of Cincinnati tax CPAs who went to school in Florida and Missouri, have in-laws overseas and who would entertain an offer to play in the NFL. While I have no problem with that charitable class, it is very unlikely the IRS would approve.

By the way, the cost of failing can be steep. There may be penalties on the charity and/or the insider. Push it too far and the organization's exempt status may be revoked altogether.

Or you may never be exempt to begin with. Let’s look at a recent IRS review of an application for exempt status.

A family member has a rare disease. You establish a foundation to "assist adolescent children and families in coping with undiagnosed and/or debilitating diseases."

The Code allows you to operate for a while and retroactively apply for exemption, which you do.

Sounds good so far.

You and your spouse are the incorporators.

This is common. You can still establish an independent Board.

Your organizing paperwork does not have a "dissolution" clause.

Big oversight. The dissolution clause means that - upon dissolution - all remaining assets go to another charity. To say it differently, remaining assets cannot return to you or your spouse.

The charity is named after your son, who suffers from an unidentified illness.

Not an issue. I suspect many foundations begin this way.

Your fundraising materials specifically request donations to help your son.

You are stepping a bit close to the third rail with this one.

Since inception, the only individual to receive funds is your son. Granted, you have said you intend to make future distributions to other individuals and unrelated nonprofits with a similar mission statement. Those individuals and organizations will have to apply, and a committee will review their application. It just hasn’t happened yet.

Problem.

The IRS looked at your application for exemption and bounced it. There were two main reasons:

First, the problem with the paperwork, specifically the dissolution clause. The IRS would likely have allowed you the opportunity to correct this matter, except that ...

Secondly, there were operational issues. It does not matter how flowery that mission statement is. The IRS reserves the right to look at what you are actually doing, and in this case what you were actually doing was making your son's medical expenses tax-deductible by introducing a (c)(3). Granted, there was language allowing for other children and other organizations, but the reality is that your son was the only beneficiary of the charity's largesse. The rest was just words.

The IRS denied the request. All the benefits of the organization went to your family, and the promise of future beneficiaries was too dim and distant to sway the answer. You had too small a charitable class (that is, a class of one), and that constitutes private inurement.

And you still have a tax problem. You have an entity that has collected money and made disbursements. The intent was for it to be a charity, but that intent was dashed. The entity has to file a tax return, but it will have to file as a taxpaying entity.

Are the monies received taxable income? Are the medical expenses even deductible? You have a mess.

The upside is that you would only be filing tax returns for a year or two, as you would shut down the entity immediately.