Avoid This Common First-Year Business Mistake

Rookies make mistakes.

That’s true not only in sports but in taxes too.

That’s what happened to George M. Kellett.

As you will see in this article, there’s much to learn for the new business person from Kellett’s court experience.

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Facts

In 2013, while working for the Bloomberg Industry Group, Kellett started work on his commercial website, which he opened to the public in September 2015.

Kellett envisioned at least four ways to make money from his website:

• selling advertising space to third parties, 
• implementing a “paywall” and charging a monthly fee for access to certain features of the website, 
• selling personalized charts and reports of information from the website, and 
• licensing data from the website to other companies.

He did not pursue any of these monetization strategies in 2015, and his website did not begin to earn revenue until 2019.

Once he had the website online, Kellett and a marketing professional promoted the website to over a hundred universities and professional organizations, and about half these institutions added the website to their lists of research databases. This activity did not produce any revenue.

In Kellett’s view, the institutional and organization success would help him maximize long-term profit by cultivating confidence and dependence among users and advertisers.

On his 2015 Form 1040, Schedule C, Kellett deducted

• $20,509 paid to engineers,
• $2,410 paid to the marketing professional, and
• $1,856 for his cell phone and internet service at his home.

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IRS Audit

The IRS audited Kellett’s 2015 tax return and denied all business expenses. Per the IRS, the business had not started. Hence, no business—no business tax deductions.

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The Court

Kellett did not like the IRS denial. He took his case to court.

The court noted that Kellett’s website operation did not follow the fact pattern for a typical new business where it’s pretty easy to see when a business begins because it starts seeing revenue. For example, a new grocery store starts seeing grocery revenue as soon as it draws customers. An apartment building starts to see rent revenue when it admits tenants.

According to the court, even though Kellett did not attempt to earn revenue in 2015, his business began providing the services “for which it was organized,” with an eye to long-term profit once he opened the website. The court ruled that such activity, at least under these circumstances, constitutes an active trade or business that began on September 30, 2015.

Based on the dates Kellett paid his expenses, the court determined that Kellett could deduct about 32 percent as business expenses. He had to treat the remaining 68 percent as start-up expenses, of which $5,000 were deductible on September 30, and the remainder deducted ratable over 180 months.

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Verizon Trouble

The IRS argued that the court should deny the Verizon expenses because Kellett did not demonstrate their business purpose. Further, he had no record of business or personal use of his phone or the internet.

The court noted that under the Cohan rule, it may approximate a business expense if the taxpayer cannot substantiate its exact amount. The court said that it needs a basis for making an estimate, and that estimate, when made, should bear heavily against the taxpayer.

Kellett testified credibly (according to the court) that he used the Verizon services 80 to 90 percent for his website work, but he presented no records tracking his business and personal use.

The court found an alternative record. Kellett submitted a contemporaneously prepared Excel spreadsheet indicating that he averaged 49 hours per week working on the website during the last three months of 2015, which the court found helpful in approximating Kellett’s potential business use of the cell phone and internet services.

Remember the words “bear heavily against the taxpayer” from the Cohan rule. The court took the 168 hours in a week, subtracted 40 hours for the work at Bloomberg, then divided 49 hours by 128 hours (168 – 40) to arrive at a tax deduction of $159 (38 percent of the $415 in Verizon expenses paid after September 30).

Key point. The court counted sleep time as phone and internet time, ensuring that the calculation bore heavily against Kellett.

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Takeaways

Document your business and personal use of phone and internet or suffer a big loss in deductions. Kellett had $1,856 in such expenses. But the court allowed only $159. (None of the Verizon expenses made it into the start-up expenses.)

Make sure to document when the business starts. You want the IRS to believe your start date. Going to court is too costly and often leaves you short on deductions.

For sure, know what start-up expenses are and begin tracking them when you start thinking about starting a business.