Your business clients can deduct the “ordinary and necessary” expenses of operating their business, but a new US Tax Court case involving exploratory research expenses shows that the operation must be “open for business” to qualify for write-offs.
In the case of Carrick v. Commissioner, TC Summary Opinion 2017-56 it was discovered that the determination of whether a business has actually commenced depends on the particular facts and circumstances.
To review, Samuel Carrick, who has a bachelor’s degree in electrical engineering, was employed in the oceanographic industry. At a time when his company was experiencing financial difficulty and he was granted more flexibility in his work schedule, Carrick began exploring a couple of business ventures with other individuals.
One activity involved creating a website, with features similar to Angie’s List, Yelp, and eBay that would allow people to bid on hiring contractors for products and repairs. He first had the idea in 2012 and went “full force” with it in the beginning of 2013, spending time accumulating data and developing software and the website. However, after certain key individuals left the project, it collapsed before the end of the year.
In 2014, Carrick began another activity based around the development of a device to prevent surfers and swimmers from being injured by stingrays. Initially, he noticed that sonar devices might affect the behavior of sharks and other species.
Carrick conducted research at California beaches where people often were stung and bitten by stingrays, but he did not fully develop any devices nor list any devices for sale in 2014. He had zero gross receipts during 2013 or 2014 from either activity.
When he claimed current deductions for ordinary and necessary business expenses, the IRS objected and the case went to the Tax Court. Carrying on a trade or business requires more than preparatory work, such as initial research or solicitation of potential customers.
A business must have actually commenced. Expenses paid after a decision has been made to start a business, but before the business begins, are generally not deductible as ordinary and necessary business expenses. These preparatory expenses are capital expenses.
Although Carrick may have been conducting research in 2013 with respect to the two activities, neither activity reached the point of actually commencing. There was neither sales activity nor any evidence of offering products or services to the public.
He was still in the very early stages of research and development in both activities. Accordingly, the Tax Court concluded that Carrick was not “carrying on” a trade or business in 2013 or 2014 when the expenditures were incurred. Result: No deduction was allowed.
If you have clients who are preparing to launch a new business venture, make sure they understand the tax rules. If they don’t ever get the business up and running, their prep work may go for naught.