Tax treatment of due diligence and start-up costs remains uncertain.

• Author: Jorgensen, Dean

Under Sec. 162, ordinary and necessary expenses paid or incurred in carrying on an existing trade or business are deductible. Since 1980, however, if a taxpayer acquires or creates a new business, expenses incurred prior to beginning the business are not immediately deductible, but are eligible to be amortized over a 60-month period under Sec. 195. Expenses eligible for the 60-month amortization include start-up and investigatory expenses, such as due diligence.

Recent developments, however, have raised several questions.

1980 Legislation

Prior to 1980, investigatory and start-up costs incurred to expand an existing trade or business were immediately deductible. These same costs, however, if incurred to acquire or create a new business, were required to be capitalized without amortization. Controversies inevitably arose as to whether the costs were incurred in connection with an existing (rather than a new) trade or business.

To decrease these controversies and to encourage the formation of businesses, Congress enacted Sec. 195, which allowed costs incurred to acquire or create a new business to be amortized over a period of not less than 60 months. The following costs were eligible for the 60-month amortization:

* Investigatory expenses (including due diligence costs) incurred in reviewing a prospective business, as well as expenses incurred to analyze or survey potential markets, products, labor supply, transportation facilities, etc.

* Start-up costs, including costs incurred after a decision to establish a particular business, but prior to the time the business began. These costs include advertising, salaries and wages paid to employees who are being trained, travel and other expenses incurred in lining up prospective distributors, suppliers or customers.

According to the legislative history, investigatory and start-up expenses are to be treated as follows:

* Expenses incurred to acquire or create a new business qualify for amortization if incurred prior to the final decision to acquire or create that business. On the other hand, expenses do not qualify for amortization if incurred as part of the acquisition cost of the trade or business. Whether expenses are considered as part of the acquisition cost depends on the facts and circumstances.

* Expenses incurred by an existing business do not qualify for amortization, as "these expenses will continue to be currently deductible."

Acquiring or Creating a New Business

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