Section 195 Tax Code: What You Need to Know

Dear Client, 

Formation of a business starts by raising capital, purchasing equipments, manufacturing, and selling products with the main intention of generating revenue. Therefore, accomplishing the aforementioned steps in a relatively short period is significant when pursuing a profit, as well as committing to commencing a business as of the date of the formation of the entity (Castellon, 2015). After formation, the business will usually incur start-up expenses prior to starting operating actively. The expenses will include the costs incurred when training workers, employee wages, utilities, rent, or marketing costs. By and large, Section 162 stipulates that businesses can deduct necessary and ordinary costs that are incurred or paid during the year of taxation to enable business operate. 

However, the business must capitalize start-up costs and make them part of its tax basis, unless it chooses to deduct an amount of up to five thousand dollars of its start-up costs during the year of taxation in which, the business’ active trade starts. It also has to amortize the outstanding costs within a period of a hundred and eighty months by starting with the month that the business’ active operations commence. Sections 195 (a) and (b) stipulates that the amount of five thousand dollars deduction reduces as per the amount that the total start-up costs of the business exceed fifty thousand dollars (Castellon, 2015). For the start-up costs that are incurred or paid after the 16 th of August, 2011, a business is considered to have completed such a selection, unless a taxpayer positively chooses to benefit from the costs on its well-timed filed tax returns in the year that the business starts as stipulated in Regs. Sec. 1.195-1(b). Additionally, Sec. 174 provides that a business can deduct the expenses that relate to experimentation and research. However, such costs are not included in the description of start-up costs, as are the state taxes in Sec. 164 and interest costs in Sec. 163(a). 

Section 195(c)(1) provides that start-up expenses are the amounts otherwise deductible as business expenses or trade that are incurred or paid in relation to: 

Developing a business or an active trade; 

Investigating the acquisition or development of an active business or trade; or 

Any doings involved in for income or profit generation prior to the commencement of an active business, and in expectation of the doings becoming an active business. 

In theory, Section 195 intends to match operations of a commercial trade from the generated revenues with the costs that are incurred when preparing a trade for commercialization. Though Section 195(c)(2)(a) permits IRS to provide regulations that prescribe when a business should commence, the IRS does not state so (Castellon, 2015). As such, the stakeholders of the business, as well as the IRS always differ on the period a business should begin its active operations, or trade for taxation purposes. To shade light on the ambiguity, stakeholders of a business should review the case law below to determine the point at which their business is deemed to have started active operations, or trade for the reasons provided under Section 195. Drawing guidance from the case law below, it is easy to comprehend when a business should commence under Section 195. 

Richmond Television Corporation , 345 F.2d 901 (The 4 th Circuit 1965) 

The firm was created in 1952 to manage a television station. It applied for a license that permitted it to operate in the same year. However, it got the license and commenced broadcasting in 1956. The business incurred the costs to acquire the broadcast license, as well as training costs between 1952 when it was created and 1956 when it got the license (Castellon, 2015). The firm’s argument was that the deductions were necessary and ordinary expenses that were associated with its operations. It also argued that the costs could be deducted as stipulated in Section 162 during the periods they got incurred. The 4 th Circuit differed with the firm’s argument, stating that there is no engagement of a taxpayer in conducting any business as contained in the intendment of Sec. 162 (a) till such a period when the business begins to operate as a going concern, and engage in the operations that it was formed to conduct. As such, the court made its ruling that the costs were not deductible since the taxpayer was not assured that it would get a license, or operate before the license was received. In effect, the firm did not prove that it had commenced operating as a going concern, or that it could plausibly predict becoming an active business at the time of incurring its costs. 

Yours Faithfully, 

Business Expert. 

References  

Castellon, M. C. (2015). Tax treatment of drug development company startup costs. Journal of Accountancy. Retrieved from http://www.journalofaccountancy.com/issues/2015/aug/sec-195-drug-development-company-costs.html