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A new decision by the U.S. Tax Court drove home the importance that current deductions are not allowed for most new businesses start-up expenses. The appropriate tax treatment for start-up costs has been a continuous confusion for taxpayers, leading business owners to wonder just how does the Tax Court apply these rules?

Section 162. The IRS’s code section 162 permits current deductions for “ordinary and necessary” expenses related to your business. These expenses are basically routine expenses incurred in operating a start-up company. Some examples of these expense are payroll, utilities, rent, and advertising. These expenses can be deducted in the same year the fee was paid.

What most taxpayers don’t know, is that Section 162 expense types cannot be deducted right away necessarily because the expenses are classified as Section 195 expenses for start-ups until the “active conduct” of business begins. Once the active conduct standard is met, the cost becomes a section 162 expense, and it can be deducted currently.

Section 195. Section 162-type expenditures that are acquired before the business actively starts operations are considered Section 195 start-up costs. These expenses can include costs to:

  • Investigate the acquisition or creation of a business
  • Launch a new business
  • Engage in a for-profit activity before the active conduct of business begins, in anticipation of such an activity becoming an active business.

Some of the Section 195 expenses may include: training an employee, utility bills, rent, and any marketing expense that came before the launch of the business.

Section 195 start-up expenses excludes interest expense, research and development or tax costs. Those payments are subject to precise rules that determine the timing of the deductions.

What to consider. The Tax Court has traditionally focused on the following three elements to regulate if a taxpayer has begun the active conduct of business:

  1. Did the taxpayer embark on the activity aiming to make a profit?
  2. Was the taxpayer repeatedly and actively involved in the operation?
  3. Has the action actually begun?

When you acquire business start-up expenses, it’s imperative to think of two crucial facts. First, start-up costs can’t always be withheld in the year they are paid or acquired. Secondly, no amortization or deductions write-offs are permitted up until the year when active operations for your new business starts. Usually, that means the same year when the business begins earning revenue.

Time is of the essence if you have start-up costs that could be subtracted in the present year. Communicate with your tax adviser to describe your plans. Failure to provide your tax adviser with advance notice of your proposed strategy often leads to negative tax consequences.