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Quasi Sec. 195 regulations.

Taxpayers are not permitted to currently deduct business start-up costs. However, they may elect under Sec. 195 to amortize these costs over 60 months--beginning with the month in which an active business begins. Because of the lack of regulations, many taxpayers ignore Sec. 195 and continue to deduct start-up costs without making the Sec. 195 election. IRS Letter Ruling 9047032 emphasized that start-up costs are not deductible and can be amortized only with an election for the appropriate tax year.

In enacting Sec. 195, the Miscellaneous Revenue Act of 1980 granted taxpayers the ability to amortize start-up costs; these are not deductible under Sec. 162 since, by definition, they are incurred before a business starts. According to Sec. 195(c)(2)(A), the determination of when an active business begins is to be made in accordance with regulations. However, these regulations have yet to be even proposed.

The House Ways and Means Committee Report on the original version of Sec. 195 stated that "the definition of when a business begins is to be made in reference to the existing provisions for the amortization of organizational expenditures (Code secs. 248 and 709)."

The regulations under Secs. 248 and 709 use a facts and circumstances test in determining when business begins. If the underlying corporate or partnership activities have advanced to the extent necessary to establish the nature of the business operations, the entity will be deemed to have begun business (Regs. Secs. 1.248-1(a)(3) and 1.709-2(c)).

In the early 1980s, Congress perceived three court cases as limiting the scope of Sec. 195. In Blitzer, 684 F2d 874 (Ct. Cl. 1982), the then Court of Claims intimated that newly organized business entities could currently deduct, under Sec. 162(a), amortization of organization and loan costs, telephone and utility bills, rent, stationery, and salaries and wages--regardless of whether the entity had completed construction of its income-producing assets.

In Hoopengarner, 80 TC 538 (1983), the Tax Court held that rent paid under a leasehold interest in land on which the taxpayer was to construct an office building was not deductible under Sec. 162 before the building was completed, since the taxpayer was not carrying on a business when the payments were made. However, the court further held that a portion of the payments was deductible under Sec. 212--since they were ordinary and necessary expenses paid or incurred for the management, conservation or maintenance of property held for the production of income.

In Brotherman, 6 Cls. Ct. 407 (1984), the Claims Court determined that revenue collection and an FCC license were not prerequisites to a community antenna television (CATV) system partnership's carrying on a business if the partnership acquired a CATV system. Consequently, the taxpayers could deduct certain ordinary and necessary business expenses incurred before receiving their broadcasting license.

In an effort to clarify the definition of start-up costs and decrease the controversy and litigation arising under prior law, the Deficit Reduction Act of 1984 (DRA) amended Sec. 195. In explaining the amendment, the "Blue Book" stated that

the definition of start-up expenditures is broadened to include any expenditures made with respect to any activity engaged in for profit or for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.

Under this explanation, the expenses permitted as deductions in Blitzer, Hoopengarner and Brotherman would be subject to Sec. 195.

Letter Ruling 9047032 discussed the following factors in determining the beginning of a manufacturer's business.

* The business must acquire necessary operating assets.

* The assets must be put to productive use.

* The business must be producing income.

The letter ruling acknowledged that the Senate Finance Committee Report on the original version of Sec. 195 referred to Secs. 248 and 709 for determining when a business begins. However, the ruling pointed out that the DRA amended Sec. 195 to refer to an "active" business. Accordingly, a stricter standard than that under Secs. 248 and 709 is required.

Letter Ruling 9047032 viewed the going concern concept as the appropriate standard in determining when an active business begins for Sec. 195 purposes. This concept was first enunciated in Richmond Television Corp., 345 F2d 901 (4th Cir. 1965), vac'd and rem'd on other grounds, 382 US 68 (1965), in which the court stated that a taxpayer "has not 'engaged in carrying on any trade or business' within the intendment of section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized."

Taxpayers should be cautious in trying to amortize start-up costs before eligibility for Sec. 162 deductions. Letter Ruling 9047032 stated:

In spite of the 1980 Act's legislative history, the Service follows the concept of carrying on a trade or business under section 162(a) of the Code to determine when a trade or business begins under section 195 because business start-up expenditures are expenses of a taxpayer that would have been ordinary and necessary business expenses, except for the fact that the taxpayer had not yet begun the trade or business at the time the expenses were incurred. "Ordinary and necessary" expenses incurred before the taxpayer is entitled to claim deductions under section 162(a) will qualify under section 195. After the trade or business begins, the expenses will be deductible under section 162(a). If the Service treated a trade or business as "beginning" before the time at which section 162(a) deductions become allowable, expenses incurred in the interim would not be deductible under section 162(a). Consequently, it would be necessary either to require that these expenses be capitalized or to treat them as "start-up expenditures" incurred after the trade or business begins.

According to the House Report, the Sec. 195 election does not apply to businesses that have an ascertainable useful life of less than 60 months. Therefore, start-up costs for such businesses generally must be capitalized and deducted only when the business terminates.

As the definition of when a business begins becomes clearer, opportunities arise for certain taxpayers to structure their start-up activities to trigger Sec. 195 sooner rather than later. A good example for manufacturers can be taken from Letter Ruling 9047032. During the initial start-up of a manufacturing process, products are usually manufactured on a test basis until a particular predetermined quality or production standard is met. Manufacturers could set their quality or production standards at a level so that, when met, these products would be satisfactory for public sale. As soon as the manufacturing process meets these standards, start-up cost amortization could begin.

Real estate developers also may be in an advantageous position for early Sec. 195 application. For example, developers could plan to construct their projects in phases, enabling them to lease a portion of the overall project. It might be reasonable to argue that start-up cost amortization may begin once the first phase is ready for leasing.

Sec. 195(d)(1) requires the election to amortize start-up expenditures to be made not later than the due date of the taxpayer's return (including extensions) for the tax year in which the business begins. Sec. 195(d)(1) not only makes it important for taxpayers to make the election, but to make the election for the proper year. Because the right to make the election will be lost if not made for the year business begins, a protective election should be considered for the initial year of operation. (See the Tax Clinic item, "Protective election to amortize start-up expenditures," TTA, May 1982, at 301.)

Sec. 195 has evolved through the 1980 and 1984 legislation with the net result that very few deductions are available to businesses until they are ready to receive revenue from their operating assets. Therefore, taxpayers should structure their start-up activities to trigger Sec. 195 amortization as soon as possible. Tax advisers also should be aware of deductions that may be characterized as Sec. 195 start-up costs and consider a protective election for the initial year of operation.
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Author:Cassidy, Gerald E.
Publication:The Tax Adviser
Date:May 1, 1992
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