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Tax Deduction Regulations for New Businesses

When running your own business, it can be easy to forget that not every expense counts. The critical tax law provision for deducting “ordinary and necessary” trade or professional expenses includes travel costs. These claims may also be subject to special rules that could limit how much can qualify as claimed vs. what’s been spent during your trip(s).

Another tax deduction available to entrepreneurs is Section 195. This law allows you up to $5,000 in start-up expenses if your business has been “open for business” since its inception.

A trade or business is generally considered carried on if it’s done to make a profit. A thorough determination will entail assessing your level in both activities and income-producing abilities, but you don’t need any profits for this finding; just demonstrating an active drive towards increasing revenue streams should suffice.

An Example Case

Taxpayers must effectively conduct trade or business to deduct their expenses incurred while doing so. In one case, Costello, TC Memo 2021-9, 1/25/21, a married couple residing in California decided to make a living on the 6,500 acres of land in Mexico owned by the wife. 

Her first venture into chicken-keeping was not successful. In 2007, she decided to raise chickens on the property. In 2011, she went into egg production, which proved unsuccessful after a profit of just $1000. She added chickens and went back to meat production, but unfortunately, her chickens were eaten by wild dogs.

The taxpayer tried to grow various crops during these four years, including watermelons and bananas. They all failed due to the region’s conditions, making it impossible to cultivate these items successfully. In their last-ditch effort, the taxpayers turned to raise cows, but the land couldn’t produce enough for them to eat, and they sold the cows for less than $5000.

The couple’s expenses were deducted on their tax returns for the four years in question. The IRS has denied taxpayers’ deductions for expenses related to their businesses, claiming that they were either hobby or pre-operational start-up costs. The Tax Court followed suit, denying deductions for these expenses because the court couldn’t find any evidence that they were carrying out a trade or running a functional business.

What Can We Learn From This?

The profit motive is an essential element in establishing business activity, and the IRS is unlikely to challenge deductions for business expenses if there’s an income motive.

 If you don’t have any income, then the IRS will challenge your deductions and may even become subject to challenge or cancellation if they’re not supported with proper evidence that can demonstrate how these costs were incurred.

When establishing your business, it’s essential to think through the IRS’s rigorous standards for expenses deduction. More evidence shows you have an income-producing undertaking and conduct any relevant activities concerning this venture.