The Tax Court recently ruled in Kellett v. Commissioner (T.C. Memo. 2022-62) that certain costs paid by a taxpayer prior to the start of an active trade or business must be capitalized when incurred as start-up expenditures under Section 195. When incurred after the business began, the costs can instead be deductible under Section 162 as ordinary and necessary business expenses.
The taxpayer in Kellett was working on developing and designing an online financial website with the intent to earn revenues from subscription, advertising, personalized services and licensing fees. The taxpayer developed the core function of the website from 2013 to March 2015, resolved certain bugs and issues with the platform from March to September 2015, and finally opened the desktop and mobile applications to the public on Sept. 30, 2015. During this time, the taxpayer paid engineering costs, professional marketing costs, internet and phone provider costs—in addition to certain miscellaneous costs to develop the business.
In 2019, the taxpayer started to earn revenue from the business. The taxpayer deducted all costs incurred on the 2015 tax return, which the IRS subsequently disallowed and determined to be start-up expenditures under Section 195.
Under Section 162, a deduction is allowed for ordinary and necessary expenses paid or incurred during the taxable year in the carrying on of any trade or business. Alternatively, costs incurred prior to the active conduct of a trade or business are generally required to be capitalized under Section 195 and then generally recovered over 180 months beginning in the year in which the trade or business begins.
The determination of whether the expenses are properly deductible under Section 162 or capitalizable under Section 195 depends on when the website is considered an active trade or business. In this case, the IRS argued that the business was not active until 2019 when the taxpayer received revenue. However, the court determined the business likely became active in September 2015, when the website was open to the public. In making that determination, the court cited Richmond Television Corporation v. United States, 345 F.2d 901 (4th Cir. 1965), in which training costs were not deductible because a business did not begin until the television station went on the air. Similar to Richmond, the taxpayer in this case could have no users prior to the website going live and it begins broadcasting information.
In response to the lack of revenue, the court cited Cabintaxi Corporation v. Commissioner, 63 F.3d 614 (7th Cir. 1995), which stated, “a taxpayer’s effort to sell goods or services may qualify as an active trade or business even if the taxpayer makes no sales and therefore has zero gross receipts.” Although the taxpayer in this case did not have revenue until 2019, by the end of September 2015 the taxpayer had a plan to collect revenue, an active trade or business open to customers online, and prioritized creating web traffic and getting the website known online—all of which led the court to determine the company was an active trade or business. Because of this, the court held that expenses paid prior to Sept. 30, 2015, are capitalizable under Section 195, while those paid after that date are deductible under Section 162.
Discontent with the court’s determination that most of their expenses fell within Section 195, the taxpayer claimed that the engineering expenses should instead be treated as research or experimental expenditures under Section 174.
Prior to amendments by the Tax Cuts and Jobs Act, P.L. 115-97, taxpayers could either deduct or capitalize and amortize expenses paid for research or experimentation to resolve technical uncertainty in connection with an active trade or business. According to Treas. Reg. Sec. 1.174-2(a)(1), technical uncertainty exists “if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.” The court in this case quickly denied that argument after determining that the taxpayer had no “technical” uncertainty. The court cited United States v. Davenport, 807 F. Supp. 2d (N.D. Tex. 2012), in which the Tax Court held that a taxpayer’s software development lacked technical uncertainty because it relied on industry best practices and altered widely available software to create its desired product. Similarly, the taxpayer in this case used widely available software, knew the final product to be produced without any question about how to achieve that result, and worked with engineers to alter the initial software to its intended form. As such, no uncertainty can be present when the efforts are solely related to adaptation without any amount of innovation—and the court held that such expenses do not qualify under Section 174.
Lastly, the taxpayer attempted to assert a second alternative argument that the engineering expenses should fall under Rev. Proc. 2000-50. Per that revenue procedure, the IRS “will not disturb a taxpayer’s immediate deduction of certain costs for developing computer software that the taxpayer has not treated as Section 174 research or experimental expenditures.” The court found this assertion unsatisfactory as well—however, the reasoning behind the denial of this argument was unusual. The court denied the deductibility of the engineering costs under Rev. Proc. 2000-50 by stating that although the taxpayer referenced the revenue procedure, they failed to establish that the Code authorizes such a deduction. The court narrowly concluded that because there is no statutory authorization, the revenue procedure fails to create a right to a deduction. As such, both of the taxpayer’s arguments to deduct the engineering expenses as either Section 174 or under Rev. Proc. 2000-50 failed.
This case serves as a reminder that costs incurred prior to the active conduct of a trade or business are generally required to be capitalized under Section 195 and that taxpayers should carefully analyze both the determination of when an active trade or business begins, and the costs that are incurred prior to such date to properly compute taxable income.
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