How to Scale the Deduction Barriers
The IRS is denying deductions for many pre-opening and expansion costs.
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.
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. The IRS position is that a company’s expenditures after it decides to acquire an entity are acquisition costs, which do not qualify as investigation costs. While the IRC is unclear on this point, the legislative history says investigatory costs are eligible for section 195 amortization only if incurred before reaching a “final decision” to acquire or enter the business. The IRS interprets final decision to mean the date the taxpayer decides to acquire a business—a significant barrier because the IRS will apparently try to say the taxpayer’s decision occurred at the earliest date the facts support. This means due diligence activities after that date fall into a black hole; they must be permanently capitalized but there is no amortization escape hatch. According to the IRS, the date of the taxpayer’s decision, not the date of a binding agreement, is crucial because only the costs of a general or preliminary investigation are start-up costs. A preliminary investigation answers the questions of whether an acquisition should be made and which transaction to enter. The IRS buttresses its position that expenditures after a company decides which transaction to undertake are acquisition costs with rulings and cases on IRC sections 162, 165 and 263 (for example, see revenue ruling 99-23, discussing revenue ruling 77-254 and sections 165 and 263), but there is no judicial precedent.
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In revenue ruling 99-23, the IRS clarified its position on the point at which the taxpayer forms its intent. If the acquiring and acquired companies signed a preliminary letter of intent, the IRS simply assumes activities after the date of the letter are acquisition costs ineligible for section 195 amortization. If there is no letter of intent, the IRS will examine the facts and circumstances in determining deductibility. In the ruling, the IRS gives examples of the types of costs that clearly qualify for amortization and those that may be in dispute. A company hired an investment banker to research several industries and evaluate publicly available financial information on many different businesses. When the focus narrowed to one industry, the banker evaluated a variety of potential companies within it. When the spotlight finally fell on one, the banker commissioned appraisals of the target’s assets and an in-depth review of its books and records to arrive at an acquisition price. The IRS concedes that under section 195 a company can amortize the costs of conducting industry research and evaluating public information. On the other hand, its activities to establish a purchase price are clearly acquisition costs ineligible for amortization. Other costs to evaluate the target and its competitors are more difficult to classify without a letter of intent. The burden is on the taxpayer to demonstrate which costs it incurred before forming an intent to purchase the business. Scaling the date barrier. The IRS focus on the taxpayer’s decision as the watershed for whether investigation costs are amortizable makes it imperative for companies to carefully break out acquisition costs incurred before deciding which business to acquire. If the parties did not sign a letter of intent, the acquiring company should try to substantiate as late a date as possible for its acquisition decision by documenting that substantive negotiations continued to take place. Deduction barrier: The allowable test. The IRC permits amortization only if an expenditure would be deductible in connection with the operation of an active business in the same field; this requirement is a barrier no matter how interpreted. However, the IRS makes it a virtual roadblock due to how it defines operation. It interprets the term to include expansion activities. (See LTR 9901004.) Thus, the IRS will not allow a company to amortize an expenditure as a start-up cost if it would require an expanding company to amortize it. The catch, of course, is that the IRS currently denies deductions for most expansion costs. Scaling the test barrier. A taxpayer can do very little to overcome this objection if an IRS agent raises it. However, the company may be able to convince IRS decision makers that its case would not be a very good one for the government to litigate. In those circumstances, or in the event the case goes to court, the IRS position has many weaknesses. The primary argument a company can make against the IRS position is that if the result were upheld, it would virtually eliminate section 195 from the code. The IRS is busy using the “significant future benefit” test from the Indopco decision to require capitalization of many types of costs (see the box below for a summary of Indopco .) While it is one thing to require capitalization, it is quite another to use the same theory to deny a taxpayer the right to amortize a cost that neither the IRS nor the taxpayer denies is capitalizable. The Indopco decision is not relevant to section 195. The question in Indopco is simply whether an expenditure should be capitalized. Section 195 assumes capitalization and proceeds directly to the criteria for amortization. The taxpayer should argue that an IRS interpretation that all but eliminates a code section cannot possibly be correct.
CREATION AND EARLY OPERATING EXPENSES Taxpayers incur creation expenses after deciding to establish a particular business but before operations begin. Revenue ruling 99-23 does not specifically discuss creation costs, but they are a separate category in section 195 and the accompanying House report. They include training and travel expenses, salaries and advertising for the opening of the business. Creation costs may qualify for section 195 amortization if the business could deduct them once it began. Example. Roberta started a new retail business selling tennis equipment on August 1, 2000. Early in 2000 she had incurred costs to research potential markets and demand/supply factors before deciding to open the business. After deciding to do so, she incurred expenses during June and July to survey her target market, travel to line up distributors, and pay wages and salaries for employee training and advertising. The costs before Roberta decided to open her business may qualify as investigatory costs amortizable under section 195. Creation costs during June and July should also qualify because they would be deductible if Roberta incurred them after starting the business. Deduction barrier: IRS views creation costs as acquisition costs. The IRS does not appear to recognize creation costs, arguing that all costs after the decision to acquire or establish a business are not start-up costs. Scaling the creation cost barrier. Taxpayers should remind the IRS that the House committee report clearly says section 195 costs include not only investigation expenses but also costs incurred “subsequent to a decision to establish a particular business” and before the time a business begins (HR Report no. 1278, 96th Congress, 2nd session, 1980). In filing an election to amortize start-up costs, it may be helpful for a company to include a schedule that breaks down preopening costs into three categories: investigation costs incurred before the decision to acquire or establish the business, creation costs incurred after the decision and capital expenditures not subject to section 195. A company’s good faith effort to distinguish between costs that would be deductible by a going business (the first two categories) and costs a going business would have to capitalize (the third category) may pay off in later negotiations with the IRS. ORGANIZATION EXPENSES To qualify for amortization under IRC section 248, an organization expenditure must be directly incident to the corporation’s creation, chargeable to the corporation’s capital account and of a character that, if expended when creating a corporation with a limited useful life, would be amortizable over that life. Qualifying expenditures do not have to be incurred before the date of incorporation, but must be incurred before the end of the tax year in which the corporation begins business. Deduction barrier: No direct relationship between expenditure and creation of new business. There is a direct relationship only if the activity for which the expense is incurred relates directly to creating the corporation and if creation would not have taken place but for this activity. Costs to issue stock, transfer assets and reorganize are not organizational costs under section 248. In Deering Milliken (59 TC 461 [1972]), the court held the appraisal costs, legal fees and other costs of contesting a dissenting shareholders’ suit in a consolidation proceeding were not directly incident to the creation of a corporation and therefore not organizational expenditures. Scaling the relationship barrier. For organizational expenses to be amortizable, a company must incur them before the end of the taxable year in which business begins. This applies to both cash and accrual basis taxpayers. In addition, the taxpayer must make the amortization election by attaching form 4562 to the return for the year the business begins. The company must amortize the expenses over 60 or more months, beginning with the month the business begins. ORDINARY AND NECESSARY BUSINESS EXPENSES Under section 162(a), ordinary and necessary business expenses are fully deductible in the period a company incurs them. Deduction barrier: Taxpayer must establish that business has begun. The trade or business incurring the expense must be beyond the point of mere preparation and actually engaged in the business’ primary activities. Organizational activities alone are not sufficient to establish the beginning of a business. Because taxpayers can currently deduct section 162(a) expenditures, to deny a deduction the IRS often tries to push back a new business’ start date or takes the position that an existing business is starting a new business rather than expanding. A taxpayer who deducts an expense under section 162 and loses on audit cannot then elect section 195 as the next best thing. Treasury regulations section 1.195-1(c), adopted December 16, 1998, prohibits this so-called protective election. Scaling the start date barrier. The taxpayer needs a firm start date for the business. Exhibit 2, below, describes some guidelines for determining when a business begins.
EXPANSION EXPENSES Existing businesses have an easier time deducting expansion-type expenditures; in many cases, it is not difficult to argue that expansion activities are an extension of the existing business rather than the beginning of a new one. Indeed, before 1992 business expansion costs were generally deductible. However, the case law on what constitutes deductible expansion costs was built around whether the expenditure created a “separate and distinct additional asset.” This test came from the U.S. Supreme Court decision in Lincoln Savings and Loan (403 U.S. 345 [1971]). But in Indopco the Court said that while this test was sufficient to require capitalization, it might not be necessary. Under Indopco, an expenditure creating a significant future benefit may require capitalization regardless of whether the facts support the creation of a separate and distinct asset. In requiring capitalization under the separate and distinct asset test, the IRS often had to prove that the expenditures created a new trade or business. But it does not now believe this step is crucial to the significant long-term benefit criterion. Rather, the IRS has chosen to focus on the type of products or services and markets involved in the expansion. In FSA 9999-9999-65, the IRS identified several business expansion scenarios, none a safe harbor from capitalization. Deduction barrier: Entering new markets. If the IRS has its way, many of the costs of moving into a new market may fall into the black hole of permanent capitalization. Consider a taxpayer that wholesales fragrances, cosmetics, clothing and accessories. After developing its wholesale business over a number of years, the company decides to expand into the retail market by selling its products through boutiques. Costs to open the boutiques include payroll expenses to stock merchandise and hire and train a new sales staff and manager and other costs to prepare for opening day. The IRS said this foray into a new market should be viewed as two steps. (See LTR 9331001.) The opening of the first store was the start of a new trade or business, followed by the opening of additional boutiques as an expansion of the new retail business. Note carefully the dimensions of the barrier the IRS is erecting. First, the costs of opening all the boutiques except the first one will not qualify for amortization under section 195 because that rule does not apply to expenditures in connection with an existing business. Second, the additional boutiques may not be currently deductible under the IRS’ use of Indopco ’s significant future benefit rationale. Thus, all expansion costs except those associated with the first boutique may be permanently capitalized. Scaling the new market barrier. Briarcliff Candy (475 F.2d 775 [CA-2, 1973]) was the seminal case allowing a taxpayer to deduct the costs of expanding into a new market. An urban candy manufacturer, seeking a way to expand its market, decided to use its sales personnel to solicit drugstores as retail sellers of its candy. The result was franchise contracts with druggists that provided the company a suburban market. The Second Circuit Court of Appeals allowed the taxpayer to deduct the costs of expanding into this new market. However, the bad news is that in Indopco the U.S. Supreme Court rejected the appeals court’s rationale that the new distribution network was not a separate and distinct asset. The good news is that in Briarcliff the court would not distinguish between expanding and protecting a business. Taxpayers may still be able to use Briarcliff to scale the new market barrier if they can make a reasonable argument that the company is acting to protect its existing business rather than expanding to, say, increase its market share. Deduction barrier: New products/services of same generic type. The IRS and the Tax Court recently required taxpayers in the insurance and mutual fund industries to capitalize expenditures to develop products similar to existing product lines. In one instance an insurance company incurred substantial costs to develop and introduce a variable life insurance product. The company argued it was so similar to its old universal life policy that the change amounted to revamping an existing product. But the IRS said the new policy had different attributes and was relatively new in the insurance industry and thus the company should capitalize the development costs. (See FSA 9999-9999-65.) In F MR Corp. and Subsidiaries v. Commissioner (110 TC 30 [1998]), the Tax Court required mutual fund giant Fidelity to capitalize the costs of launching a group of new funds. These costs included developing the initial marketing plan, forming the required regulated investment company (RIC) and registering it with the SEC and the required states. Although these costs are pre-opening costs for the new RIC, in reality they represent new product development costs in an industry that must use an RIC to develop a new product. In any event, the Tax Court said the classification of these costs was beside the point, which was that the move created a significant future benefit. Scaling the new product barrier. If a taxpayer could demonstrate that the purpose behind developing a new product was not to create or improve a capital asset or long-term benefit but to remain competitive, would it improve the chances of avoiding capitalization? There is some support for a business purpose test in the courts, but the IRS position is that an expansion expenditure is capital if a significant long-term benefit results—regardless of the taxpayer’s business purpose. For more insight, CPAs can compare Frederick Weisman Co. (97 TC 563 [1991]) with Five Star Manufacturing Co. (F.2d 724 [CA-5, 1966], rev’g 40 TC 379 [1963]). Deduction barrier: Entirely different products/services. There is little doubt the IRS will require capitalization of costs to introduce entirely different services or products. This conclusion applies regardless of whether the company introduces the new product into new or existing markets. For example, if a cosmetics manufacturer decides to introduce a line of dietary supplements, the IRS will doubtless require capitalization—whether the company uses the existing cosmetics distribution system or devises a new one. Scaling the different product barrier. The fact that an entirely different product is the most clear-cut case for capitalization is not all bad news. An entirely different product should also be a more likely candidate for amortization under section 195, since the taxpayer can argue that a new business has been created. Probably the cleanest way to provide for this result, although not required, is to set up a new subsidiary and have the subsidiary file a section 195 election. FINANCIAL REPORTING DEVELOPMENTS The treatment of start-up and organizational costs is completely different for financial reporting purposes, which may require some companies to maintain two sets of accounting records for book and tax purposes. SOP no. 98-5, Reporting on the Costs of Start-up Activities, requires companies to expense start-up and organizational costs as they incur them. It defines start-up activities as one-time actions related to opening a new facility, conducting business in a new territory or with a different class of customer, introducing a new service or product, introducing a process in a current facility, starting new operations or organizing a new entity. The AICPA issued SOP 98-5 to bring about uniformity and enhance comparability. It says start-up costs meet all of the conditions of APB Opinion no. 17, Intangible Assets, for being deducted from income when incurred. Thus, the costs of developing, maintaining or restoring intangible assets that are not specifically identifiable, have indeterminate lives and are inherent in a continuing business and related to an enterprise as a whole should be expensed when they are incurred. Financial accounting standards are not controlling for tax purposes, but the IRS finds them useful in determining whether the current deduction of an item clearly reflects income. For this reason, it appears certain the IRS will ignore SOP 98-5, choosing instead to wield the mighty sword of Indopco to slash current deductions for pre-opening and expansion costs. MORE LITIGATION TO COME Deducting the costs of starting new activities may cause trouble not only for companies expanding existing businesses but also for those starting new ones. IRS aggressiveness in capitalizing expansion costs is understandable in light of Indopco ’s significant future benefit standard. But recent IRS attempts to deny amortization of pre-opening costs of new businesses is puzzling. Section 195 clearly allows amortization of investigation and creation costs in start-up situations. However, the IRS is seeking to deny amortization by narrowly defining investigation and creation expenses. These definitions are provoking litigation. Stay tuned. | |||||||||||||||||||||||||
he 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. 
