Tax treatment of due diligence and start-up costs remains uncertain.

Under Sec. 162, ordinary and necessary expenses paid or incurred in carrying on an existing trade or business are deductible. Since 1980, however, if a taxpayer acquires or creates a new business, expenses incurred prior to beginning the business are not immediately deductible, but are eligible to be amortized over a 60-month period under Sec. 195. Expenses eligible for the 60-month amortization include start-up and investigatory expenses, such as due diligence.

Recent developments, however, have raised several questions.

1980 Legislation

Prior to 1980, investigatory and start-up costs incurred to expand an existing trade or business were immediately deductible. These same costs, however, if incurred to acquire or create a new business, were required to be capitalized without amortization. Controversies inevitably arose as to whether the costs were incurred in connection with an existing (rather than a new) trade or business.

To decrease these controversies and to encourage the formation of businesses, Congress enacted Sec. 195, which allowed costs incurred to acquire or create a new business to be amortized over a period of not less than 60 months. The following costs were eligible for the 60-month amortization:

* Investigatory expenses (including due diligence costs) incurred in reviewing a prospective business, as well as expenses incurred to analyze or survey potential markets, products, labor supply, transportation facilities, etc.

* Start-up costs, including costs incurred after a decision to establish a particular business, but prior to the time the business began. These costs include advertising, salaries and wages paid to employees who are being trained, travel and other expenses incurred in lining up prospective distributors, suppliers or customers.

According to the legislative history, investigatory and start-up expenses are to be treated as follows:

* Expenses incurred to acquire or create a new business qualify for amortization if incurred prior to the final decision to acquire or create that business. On the other hand, expenses do not qualify for amortization if incurred as part of the acquisition cost of the trade or business. Whether expenses are considered as part of the acquisition cost depends on the facts and circumstances.

* Expenses incurred by an existing business do not qualify for amortization, as "these expenses will continue to be currently deductible."

Acquiring or Creating a New Business

The IRS recently issued Letter Ruling (TAM) 9825005, in which a taxpayer incurred certain expenditures before its final decision to acquire a target company. The taxpayer then attempted to amortize the expenditures over 60 months. The Service held that costs incurred after the taxpayer decides to acquire a specific business must be capitalized, even if that decision was not final or legally binding. This approach is inconsistent with the language in the 1980 legislation that suggests the line of when to capitalize investigatory costs is not drawn until there is a final decision. Based on case law cited in the TAM, however, the IRS believes the final decision is not important.

Expanding an Existing Business

Prior to 1992, courts generally held that costs incurred in expanding an existing trade or business were deductible, based on the conclusion that the expenses did not create a "separate and distinct asset."

In INDOPCO, Inc., 503 US 79 (1992), however, the Supreme Court clearly rejected the separate-and-distinct-asset test. Instead, it developed a "presence of a significant future benefit" test in holding that the costs incurred in a friendly merger were subject to capitalization. Having attacked the very underpinnings of the judicial precedents allowing expanded business costs to be immediately deductible, the Supreme Court placed this entire area in question.

The Service was quick to respond with Letting Ruling (TAM) 9310001, suggesting that business expansion costs "might not be currently deductible." However, it later issued a TAM indicating that expansion costs were deductible. The impact of INDOPCO on the tax treatment of investigatory and start-up costs was recently addressed in FMR Corp., 110 TC 402 (1998).

In this case, the taxpayer argued that expenses in promoting and expanding an existing business were deductible, citing both the legislative history accompanying Sec. 195, as well as case law applying the separate-and-distinct-asset test. The court, however, interpreted the 1980 legislation simply to mean that Congress recognized that if an expenditure is currently deductible, the legislation did not change that characterization. Instead, it concluded that the 1980 legislation did not create a new class of deductible expenditures for existing businesses, if these expenses would not have otherwise been deductible.

To determine if the expenses were otherwise deductible, the court rejected the separate-and-distinct-asset test. Instead; it applied the INDOPCO theory by not assigning the expenditures to a specific classification, such as expansion costs, but by testing whether the expenditures provided a significant future benefit to the taxpayer.

By holding that neither prior case law nor the 1980 legislative intent required that every business expenditure incurred in a business expansion be currently deductible, the court concluded the expenses must be capitalized, as a significant future benefit was provided.

IRS Counters 1980 Legislation

If the IRS continues to take the position that investigatory and start-up costs to expand an existing business are not deductible, it could effectively nullify Sec. 195. Because amortization is only available for costs otherwise deductible if incurred in connection with operating an existing trade or business, if these costs were not deductible, expenditures to create a new business would not qualify for 60-month amortization.

Interestingly, the Service, in INDOPCO, stated unequivocally that the 1980 legislation recognized that expenditures incurred in carrying on or expanding an existing business are generally deductible. Additionally, the IRS repeatedly asserted that INDOPCO does not change the fundamental legal principles for determining if expenditures must be capitalized. Yet, FMR Corp. departed from developed case law by rejecting the separate-and-distinct-asset test and adopting the INDOPCO test of a significant future benefit against the taxpayer.

Rethinking Tax Strategies

Prior to these recent developments, taxpayers often took tax return positions that investigatory and start-up costs were incurred to expand an existing business. Even if the Service successfully argued that the costs were, instead, incurred to acquire or create a new business, the taxpayer would lose the immediate deduction but could argue for 60-month amortization.

With the IRS now maintaining that the costs to expand a business are not necessarily deductible (and with these expenses otherwise having to be deductible to even benefit from 60-month amortization), taxpayers may have to rethink their tax strategies.

Taxpayers will need to carefully break out the costs associated with acquiring a target and will want to be able to identify costs incurred prior to identifying the specific business to acquire. Additionally, taxpayers will want to break out costs that may inadvertently get bundled with acquisition costs (such as fees related to preparing annual financial statements or for tax planning).

To avoid capitalization of investigatory and start-up costs incurred to expand an existing business, taxpayers may have to successfully argue no significant future benefit is present.

Accounting Treatment

Perhaps the financial accounting treatment required of start-up costs may shed some light on this issue. The recently issued Statement of Position (SOP) No. 98-5, "Reporting on the Costs of Start-up Activities," requires all nongovernmental entities to expense start-up and organization costs. Start-up activities for financial statement purposes are defined broadly to include those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer, initiating a new process in an existing facility or beginning a new operation.

If the future benefit of these start-up costs is too uncertain to require that they be capitalized for financial reporting purposes, arguably no significant future benefit should exist for tax return purposes. Conversely, taxpayers may want to argue that costs to expand a business are really ordinary and necessary expenses incurred to protect an existing business or market share.

The uncertainty surrounding the tax treatment of due diligence and start-up costs will remain, at least in the near future. For example, the Service has publicly acknowledged that conflicting interpretations exist regarding the relevant tax provisions, but has, at the same time, indicated that business expansion issues are the most difficult issues it has yet to face.

From Dean Jorgensen, CPA, Washington, DC