Tax considerations can play a key role in how well a new business gets off the ground. Anyone contemplating a start-up venture should realize that major decisions -- such as how to treat preopening expenses -- ought to be made at the very outset in order to minimize taxable income during a company's early years.
Two kinds of situations must be examined: starting np a totally new venture and buying or expanding an existing company. Each has distinctive tax consequences. Expansion of an already going business, for example, can bring immiediate tax relief, since the related costs are deductible on a current basis. But for most types of new businesses, preopening expenses aren't deductible. They must be capitalized and written off over a period not to exceed five years.
Right away, however, there is an important exception. Let's say you decide to form a business that involves a considerable amount of risk, such as one that is developing a new product. Before going too far, consider organizing the enterprise as a corporation. In that case, if you abandon the venture, you and any other shareholders can take deductions -- only as much as has been paid for the stock -- for ordinary losses associated with the startup, provided the company qualifies as a small business corporation. If you don't form a corporation, you'll have a difficult time deducting preoperating expenses as ordinary losses.
Preopening expenses fall into three general categories, which are treated in different ways for tax purposes:
Investigator expenses are incurred while you are examining and evaluating a venture but before you decide to go ahead. You might decide to do market surveys or analyze possible plant locations, cost and availability of raw materials, labor, and transportation facilities. Travel, salaries, and professional fees paid during yonr feasibility studies and investigations would also fall under this heading. The type of venture you are contemplating determines how the expenses are treated. If you are looking at an investment as opposed to a business you would actively manage, you will probably have to capitalize the costs as part of the investment; they cannot be amortized. On the other hand, the rules for a business you plan to manage actively are more complex, as explained below.
Organization expenses are another type of expenditure normally incurred in setting up a new corporation or partnership. These expenses are, typically, legal fees for professional services used in setting up a new business. There are other expenses in this category, such as the cost of organizationnl meetings of stockholders and directors, state incorporation fees, and the legal fees to prepare a charter, bylaws, minutes, and stock certificates. All these expenses can be amortized over a period of not less than five years, beginning on the date your business starts operations. It is important to note that certain organizational costs can be neither deducted nor amortized. They include underwriting fees, prospectus printing, and other expenses of issuing and selling stock or partnership interests.
Start-up costs are the expenses incurred after a go-ahead decision has been made but before business operation begins. They can include the cost of hiring and training employees, product design, salaries, travel, telephone calls, and other expenses of executives and employees who are working on the start-up. However, start-up costs do not include costs for items that would normally be capitalized in the operation of a business, such as the cost of acquiring depreciable property. But remember that any expenses incurred in selling stock or issuing partnership interests, also part of starting up the business, aren't deductible. They must be capitalized and generally can't be recovered until you liquidate your company.
Once the business is going, as long as you are actively managing it, you will be able to deduct ordinary business expenses. But before you have taken in even your first dollar, several decisions must be made. While it may be possible to deduct some of the expenses when you incur them, others may have to be amortized. One strategy that any tax expert knows is not foolproof is to deduct right away such items as rent, utilities, and secretarial expenses and to capitalize over five years expenses such as legal and accounting services. The right to amortize preopening expenses is not automatic, however. You must elect to do this when you file the tax return for the year in which the business is begun. The election is irrevocable and applies to expenses incurred before you begin operations.
A key issue in any tax decision for a new venture is pinpointing when your trade or business actually begins. Frequently, it is a controversial matter for tax lawyers and the Internal Revenue Service. The IRS generally takes the stand that a business does not begin until revenue is produced, and deductions are therefore not allowed until then. A widely held dissenting view is that a business begins when its activities are sufficiently in place to produce income, even if no such income has yet been produced. This would cover a business that attempts to sell its product but has difficulty lining up its early sales.
A recent Tax Court decision challenges the IRS position and backs this view, holding that the fundamental question is whether the business expenses are capital or ordinary expenses -- not whether operations have begun. So long as there is a business or profit-making motive, the Court maintains that ordinary expenses are business-related and, therefore, deductible. But the IRS will probably contest future cases in this area.
As a prospective new business owner, you should take care in planning your strategy for establishing a company. There are many pitfalls. Following is a checklist to keep in mind:
* Analyze your business idea to determine whether the new venture can qualify as an expansion of an existing enterprise or whether it must be an unrelated new company. Investigatory and start-up costs of a business expansion can be deducted currently rather than over five years. When in doubt about whether the expenses are expansion costs, you should probably elect to amortize the expenses rather than run the risk of losing any type of tax advantage.
* Determine when your business began operations. If there is uncertainty about this, and if it is difficult to distinguish between preopening expenses and currently deductible operating expenses, you will have to make a decision. If you take the more aggressive view and deduct expenses on a current-year basis (beginning with the start of your business or profit-motivated activities" even though you have not earned any money yet) the IRS may go after you. If you don't prevail, you may have lost the opportunity to amortize the costs.
A more conservative choice, of course, is to elect to amortize expenses up to the date when it becomes clear that the business has begun operations and to expense costs only after that point.
* Prepare for the chance that you may abandon your new business before it begins operations. If this is a possibility, consider setting it up as a corporation. This will ensure an ordinary loss deduction for preopening expenses if the project never materializes. An individual entrepreneur deducting expenses from an aborted venture may be questioned by the IRS, and you might not win. However, if a specific investment has been targeted, and the venture aborted, an ordinary loss may be allowable.
* Consider the effects of abandonment even after operations have begun. If it is within five years after the start-up, the remaining unamortized expenses can be written off as a loss or carried over into reorganization if necessary.
These planning considerations should help you weigh the benefits of starting up a new business or expanding an existing one. Remember that the rules, regulations, and case law are complicated, so you should consult a tax professional as your plans take shape.