Deductibility of Feasibility Studies

A taxpayer will pay about $75,000 to a consultant for a feasibility study concerning slot machines in state X (which currently has no legal gambling, but whose legislature is considering it) and, in particular, the effect such machines would have at the various hotels the taxpayer currently owns and operates. From a tax perspective, can the taxpayer deduct the costs of the feasibility study? 

Start-Up Costs

This issue centers on Sec. 195. Sec. 195(a) provides that “no deduction shall be allowed for start-up expenditures.” Sec. 195(c)(1) defines “start-up expenditures,” in part, as:

any amount…paid or incurred in connection with…investigating the creation or acquisition of an active trade or business…which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the [taxpayer’s current] trade or business…), would be allowable as a deduction for the taxable year in which paid or incurred.

The first $5,000 of such expenses can be deducted under Sec. 195(b) (1)(A). Generally, Sec. 195(b)(1)(B) allows the excess over $5,000 to be amortized over 180 months, beginning in the month in which the active trade or business begins. Sec. 195(d) details the time for making the election. Under Sec. 195(d)(1), an election to deduct start-up expenses must be made no later than the due date of the return (plus extensions) for the tax year in which the trade or business begins. The overall implication of Sec. 195 is that if the Sec. 195(c) requirements are not met, the costs are not deductible or amortizable.

To be able to take a current deduction, the taxpayer would have to prove that it is already engaged in a certain trade or business under Sec. 162 and is simply expanding said trade or business.

Application

The issue of start-up expenditures is clearly more factual than legal. In the facts described above, it would be difficult for the taxpayer to argue that it is expanding its hotel business. Even though the slot machines are part of the hotel/entertainment business in which the taxpayer is currently engaged, it is clearly something completely different from that activity.

Moreover, there is a risk that if the taxpayer currently deducts the costs as ordinary business expenses under Sec. 162, and the IRS subsequently disallows the deduction, it would then be too late to elect under Sec. 195(d). In other words, on the disallowance of the current deduction, the full amount would have to be capitalized and could not be written off until the hotel (or the slot machine business) were sold or abandoned. So, the risk is that by taking the full deduction currently, the taxpayer could completely lose it. However, by amortizing it, while there is no immediate deduction, at least a deduction is ensured. Moreover, to the extent the feasibility study is done and a decision is made not to enter the business, the cost becomes fully deductible at that time.

In light of the Supreme Court’s decision in INDOPCO, Inc., 503 US 79 (1992) (which stated that a separate or distinct asset does not have to be created to require capitalization), it will be even more difficult for the taxpayer to argue for current deductibility.

Recommendation

In Rev. Rul. 99-23, clarified by Ann. 99-89, the IRS discussed three fact situations dealing with investigatory costs for a new business. In each case, the ruling held that the costs were subject to Sec. 195 and not immediately deductible.

Thus, the taxpayer described above should elect under Sec. 195 to amortize the feasibility study costs over 180 months. If the project never goes through, the costs will become immediately deductible.

From Bernard Leibtag, CPA, MBA, Gorfine, Schiller & Gardyn, P.A., Owings Mills, MD