Start Up Capitalized Costs or Deductible Business Expenses?

When starting a new business, an important consideration to is to determine at what point expenses become deductible as a business expense under §162[1] as opposed to being classified as startup expenditures which must be amortized over 15 years under §195[2]? In general, expenses eligible to be deducted as an ordinary and necessary expense of carrying on a trade or business may be immediately deducted in the year incurred, while the deducting for startup expenses must be deducted ratably over a 180-month period, or 15 years. Our firm previously wrote several articles about the importance of activities rising to the level of carrying on a trade or business[3], but not in the context discussed here. In a recent Tax Court case, Mr. Costello and his wife, Ms. Legarcie, deducted their costs associated with farming activities as ordinary and necessary business expenses. However, the Court denied the deductions, holding that the Costello’s farming activities did not rise to the level of carrying on a trade or business, but rather were start up costs which are non-deductible under §195(a) but may be amortized over 15 years under 195(b).[4]

It is important to note that the case did not discuss the hobby loss rules under §183, other than the profit motive issue mentioned below. Ms. Legarcie’s farming activities may very well have been classified as a hobby subject to such hobby loss rules but it does not appear the IRS made such an argument. We previously wrote about these hobby loss rules and the issue of determining whether expenses were incurred in carrying on a trade or business, or alternatively, in carrying on a hobby.[5]

Facts

Mr. Costello and Ms. Legarcie resided in California, but Ms. Legarcie carried on farming activities on a 6,500 acre piece of land in Mexico known as Oasis del Eden. She began these activities in 2007 and at least through January of 2014, carried on the farming activities in one form or another. In January 2014, Ms. Legarcie’s farming ventures seemingly concluded following an attack by wild dogs which wiped out her chicken flock.

From 2007 through 2011, Ms. Legarcie raised meat chickens on the property. The chickens were purportedly raised as meat chickens rather than as egg producing chickens. During these 5 years, Ms. Legarcie provided no evidence that any of the chickens were sold, other than the reported sale of livestock at a loss in 2011. The sales price was $264.

From 2007 to 2011, she had been selling and bartering eggs even though the focus of her flock was for meat production.  At some point in 2011, Ms. Legarcie switched her focus from raising meat chickens to raising chickens for egg production. This did not last long, and in 2012, Ms. Legarcie decided there was no money to be made in selling eggs due to the cost of chicken feed, so she converted her flock back to meat chickens. It is unclear how many chickens were in her flock, but in May of 2012, she bought 69 more chickens to add to her flock. She did not sell any chickens in 2012 or 2013.

Chickens were not the only livestock Ms. Legarcie attempted to raise. In 2012, she bought three cows and three calves. However, shequickly abandoned the cattle business because, according to Mr. Costello, the cattle could not find enough to eat on the 6,500 acre property. The cows were sold in 2013 for $4,800, the only farm activity income reported in 2013.

In addition to livestock, Ms. Legarcie also tried her hand growing crops. From 2007 to 2011, she grew a variety of fruits and vegetables including watermelons, squash, apples, bananas, and asparagus. She deducted these expenses on their tax returns, but never reported any revenue related to these activities. Due to the property’s location adjacent to an evaporative salt plant, crops grown on the property were apparently not commercially acceptable. In 2012, Ms. Legarcie grew a test crop of peppers, but those were destroyed by insects.

Mr. Costello and Ms. Legarcie deducted all of their farming related expenses and reported losses from farming activities every year from 2007 to 2013. Their 2012 and 2013 returns were both audited. The deductions for the farming activities were denied on the basis that the farming activities were not a trade or business on the grounds that she lacked a profit motive, or alternatively, that in the years at issue, 2012 and 2013, her business had not yet commenced.[6]

Analysis

The Court began its analysis with §162(a) which provides for the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.” Generally, a profit motive is required for deduction under §162 since §183 generally disallows deductions for activities which are not engaged in for profit to the extent such deductions exceed the income generated from such activities. The IRS argued that Ms. Legarcie lacked a profit motive in all of her farming activities. However, as to profit motive, the Court was convinced that “notwithstanding seven fallow years…[Ms. Legarcie] was determinedly seeking during the years in issue to earn a profit from farming.”

Next, the analysis turned to the IRS’ second argument, Ms. Legarcie’s trade or business had not yet commenced and all of the expenses should have been classified as start-up expenses rather than business expenses. For expenses to be deductible under §162, the expenses must be incurred by a functioning trade or business.[7] For the trade or business to have commenced, the activity must “function as a going concern”[8], that is, the activity must be an ongoing activity with the ability and resources to continue its operations and meet financial obligations. The business operations must have actually commenced at the time the expenses were incurred.[9] Expenses incurred prior to the day of which the active trade or business begins are not deductible under §162, but rather are start-up expenses that must be amortized over 15 years.[10] However, under §195, unlike §183, the amortized expenses may be used against income from other activities whereas §183 limits the deductions to the income generated by the activity for which the deductible expense was incurred.

The Court focused its analysis on two prior cases with similar fact patterns. First, in the McKelvey  case[11], Mr. Mckelvey sought to deduct expenses from a tree farming business. He conducted several unsuccessful pilot tests for various varieties of pine trees but never ultimately decided what species to plant. By the 8th year of having the property, he had not planted any new trees, had not harvested any tress, and had not ultimately decided what species of trees he would plant. Based on these facts, the Court concluded he did not have a functioning business, and as such, all his expenses were determined to be start-up expenditures which were not deductible under §162.

Next, the Court discussed the Reems case.[12]Mr. Reems purchased some property to raise and harvest timber and proceeded to spend $30,000 as the first step in starting a commercial timber business. Nevertheless, for the year at issue, the Court determined that Reems had not commenced an active business but rather was in the process of doing so, and thus classified the expenses as start-up expenses.

Both of the cases had similarities to the current facts in the Court’s mind. Ms. Legarcie’s various farming activities never moved past the initial experimentation and/or investigation phases and into the active conduct of a trade or business. Any eggs sold from 2007 to 2011 were determined to be merely by-products of raising chickens for meat. The Court did note there was the possibility of the cattle operations being considered a business but concluded that it made no difference as the expenses of the cattle, poultry, and crops were not segregated by the taxpayer. While it appears the Court had some sympathy for Ms. Legarcie and all of her attempts to make some profit, ultimately the Court concluded that the farming activities did not constitute an active trade or business and thus the costs associated with them were start-up expenses governed under §195.

Additionally, the IRS assessed Mr. Costello and Ms. Legarcie with a substantial understatement penalty under §6662(a). The Court did not discuss this issue at length and sustained the imposition of the penalty on the grounds that Mr. Costello and Ms. Legarcie did not address the issue and, based on the evidence, the Court was not able to conclude that they acted with reasonable cause or good faith.

Conclusion

One has to admire the effort and attempts at starting a farming business that Ms. Legarcie made. As Mr. Costello put it, “when you have something in a business that is not making money, you change it, and you figure out why it’s not making money. You evaluate to see if you could make it make money. If it does not, you stop doing that and you start doing something else.” One also has to admire Mr. Costello’s optimism, as he concluded that they do fully expect to make a profit at some point.

Notwithstanding that effort, grit, and optimism are great attributes, they will not get you to the level of a trade or business. As seen in this case, and as outlined in our previous articles written on the importance of an activity meeting the trade or business threshold, whether an activity meets the threshold of a trade or business can have some pretty significant consequences, including lost deductions for those activities that do not meet such threshold. Taxpayers who are looking to start a business should pay careful attention to the interplay of §162, §183, and §195, and structure their affairs to avoid the application of §183 or §195 to the extent possible.

While only briefly mentioned in the opinion, perhaps not all hope is lost for Mr. Costello and Ms. Legarcie. While their expenses are not deductible presently, start-up expenses for an unsuccessful business may nevertheless be deductible under §165(c)(2) which provides for the deduction of losses incurred in any transaction entered into for profit which is not connected with a trade or business.[13]

[1] All references to a § or a Section are to Sections of the Internal Revenue Code unless otherwise noted.

[2] Note that under §195(b), the taxpayer is allowed an immediate deduction of start-up expenses of $5,000, reduced dollar for dollar when expenses exceed $50,000. The excess is then deducted ratably over 15 years. For purposes of this article, I have ignored the $5,000 deduction amount.

[3] https://esapllc.com/the-importance-of-being-a-trade-or-business/; https://www.esapllc.com/keefe-2020/.

[4] Costello v. Commissioner, TC Memo 2021-9.

[5] https://esapllc.com/side-hustle-business-or-hobby/ .

[6] Note that the IRS also sought to deny some rental related losses on the grounds that they were passive losses. While not discussed in this article, we have previously written about material participation for rental activities: https://esapllc.com/eger-pal2020/.

[7] Hardy v. Commissioner, 93 TC 684 (1989).

[8] Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965).

[9] McKelvey v. Commissioner, T.C. Memo 2002-63.

[10] IRC §195.

[11] McKelvey v. Commissioner, T.C. Memo 2002-63.

[12] Reems v. Commissioner T.C. Memo 1194-253.

[13] Seed v. Commissioner, 52 TC 880 (1969); Rev. Rul. 77-254, 1977-2 C.B. 63.