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.
(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 2nd 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.