How to Scale the Deduction Barriers
The IRS is denying deductions for many pre-opening and expansion costs. The IRS seems intent on erecting as many barriers as possible to deny companies deductions for pre-opening and expansion costs, such as due diligence activities before an acquisition, employee training before opening a business or the costs of expanding into new markets. Just how aggressive has the IRS become? In 1999, it imposed a return preparer penalty on a CPA firm for reckless and intentional disregard of the rules in determining a corporate client's business expense deductions. The client had incurred expenses the IRS contended were capitalizable pre-opening costs for a new business. The CPA firm had expensed the costs on the client's return, later saying the client never informed firm members that he had started or was contemplating starting a new business. The firm thought the expenditures were merely an expansion of the client's existing business. Whether a company is expanding or starting a new business is a legitimate issue under IRC section 195 (see exhibit 1 for more details). However, levying a preparer penalty speaks volumes about how far the IRS will go to make its point. To help companies get the maximum deduction possible for pre-opening and expansion costs, this article identifies potential deduction barriers and ways to overcome them. Exhibit 1: IRC Section 195 Guidelines Start-Up Expenditures 195(a) -- capitalization of Expenditures: No deduction allowed for start-up expenditures unless provided in this section. 195(b) -- Election to Amortize: (1) Taxpayer may elect to treat start-up expenditures as deferred expenses and amortize them over not less than 60 months beginning with the month the active trade or business begins. (2) If the taxpayer disposes of the trade or business before the start-up expenditures are fully amortized, the unamortized portion may be deducted to the extent allowable under IRC section 165. 195(c) -- Definitions: (1) The term start-up expenditure means any amount-- (A) paid or incurred in connection with-- (i) investigating the creation or acquisition of an active trade or business, or (ii) creating an active trade or business, or (iii) any activity engaged in for profit and 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, and (B) which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field) would be allowable as a deduction for the taxable year in which paid or incurred. The term "start-up expenditure" does not include any amounts deductible under section 163 (interest), section 164 (taxes) or section 174 (research and experimental). INVESTIGATION EXPENSES New or expanding businesses often incur expenses to investigate a proposed acquisition or expansion. For example, in LTR 9901004, a taxpayer paid several advisers to conduct a due diligence investigation before agreeing to buy a company. One adviser investigated the company's offering memorandum, budgets, products and margins; researched the industry and competitors; designed and directed market surveys; interviewed distributors and management; and coordinated the due diligence activities of attorneys, accountants and others. A law firm reviewed the company's internal documents, lease agreements, union contracts, royalty agreements, personnel files, employment agreements, tax returns and insurance policies. An accounting firm did an extensive review of the company's financial and accounting records and procedures. The discussion that follows describes the potential problems with these types of investigation expenses and how companies can overcome them. Deduction barrier: The date of the acquisition decision. …