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Creating separate entities for business expansion will prevent current deduction of costs.

In Letter Ruling (TAM) 9331001, the Service reaffirmed the holding in Specialty Restaurants Corp. and Subsidiaries, TC Memo 1992-221, that costs may be currently deducted when incurred under Sec. 162 only when they are ordinary and necessary and in furtherance of an ongoing trade or business.

Taxpayer, a manufacturer and distributor, created a new division; within this division it embarked on a retail operation to further the distribution of its products. When Taxpayer opened its first retail outlet, it made a Sec. 195(b) election to capitalize and amortize the start-up expenditures over five years. This election was necessary to recover the costs in a reasonable amount of time, and Sec. 162 treatment was not permitted because the retail operation was not yet a trade or business. A Sec. 195(b) election may be made if the costs incurred are start-up expenditures as defined under Sec. 195(c). It is important to note that in order to qualify for the Sec. 195(b) election, such costs must have been deductible under Sec. 162 had they been incurred in connection with the operation of an existing trade or business.

The corporation subsequently opened several other retail outlets in other locations. All of the outlets were kept within the same division. Because the first retail outlet was already in existence as a going concern, the IRS looked at the opening of the other outlets as an expansion of the retail business. Accordingly, the Service permitted the current deduction of the costs incurred in establishing the new retail outlets as ordinary and necessary business expenses under Sec. 162.

This TAM is in agreement with Specialty Restaurants. In that case, a parent company created a new subsidiary every time it decided to open a new restaurant. The parent attempted to deduct the costs incurred to open each new restaurant under Sec. 162, but the Tax Court agreed with the IRS that the costs were not deductible by the parent (if deductible at all). The subsidiaries created for each new restaurant venture were all entities separate and distinct from the parent company. At the time the costs were incurred for each restaurant, the restaurants were not yet in operation (i.e., operating as an existing trade or business). As such, by following Richmond Television Corp., 345 F2d 901 (4th Cir. 1965), the court regarded each subsidiary's costs as preopening expenses for the purpose of establishing each restaurant, and treated them as nondeductible capital contributions. Specialty Restaurants did not address an election for startup costs under Sec. 195. However, in such a situation, a taxpayer should be able to make a Sec. 195(b) election to amortize startup costs incurred (such as those in this case) over 60 months.

As these two decisions indicate, the structure used to establish and operate a trade or business contributes significantly to the determination of the tax treatment of costs incurred for expanding the activity. Accordingly, thoughtful consideration should be given to the structure of an entity when planning to expand its operations.
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Author:Lee, Andrew B.
Publication:The Tax Adviser
Date:Jan 1, 1994
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