195 and 199A

Technical topics regarding tax preparation.
#1
JAD  
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The way I learned it, we could not deduct start-up costs for real estate undertakings because rental real estate did not rise to the level of an active trade or business. 195(b)(1)(a) refers to an active trade or business.

It seems to me that if we take the position that an undertaking is a trade/business for 199A, then 195 should be available.

Do you agree, disagree?

Thanks.
 

#2
WEISSEA  
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Agree, not only 195 but home office with no commute miles, all the bene's of being a 162.
 

#3
Coddington  
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This comes up quite often. Section 195 applies to both 162 and 212 activities. The best discussion of this is a case is called Hardy v. Commissioner, 93 T.C. 684, 687 (1989), aff’d in part, remanded in part, 1990 U.S. App. Lexis 19670 (10th Cir. Oct. 29, 1990).
-Brian

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#4
WEISSEA  
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"This comes up quite often. Section 195 applies to both 162 and 212 activities."

RIA prior to 199A
The capitalization and amortization rules of IRC Sec. 195 apply to an activity that constitutes an active trade or business under IRC Sec. 162 . An activity is not an active trade or business for IRC Sec. 195 merely because the corporation engages in it for the production of income and deductions are allowed under IRC Sec. 212 . If, however, the corporation anticipates that the investment activity will eventually become an active trade or business, the rules of IRC Sec. 195 apply to the "preopening" expenses paid or incurred in connection with that activity.
Rental Activities. A rental activity constitutes an active trade or business only if significant services are furnished incident to the rentals. In general, apartment complex, office building, and shopping center operations constitute an active trade or business. [See H. Rep. 96-1248 (P.L. 96-605), 1980-2 CB 709, at 713.]
 

#5
JAD  
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Brian, I dunno. I read the case. Hardy clarifies that “pre-opening” expenses are capital items whether they relate to a 162 or a 212 activity. The court discussed that it made no sense to treat these expenses as nondeductible under section 162 (which was not in dispute) but deductible under section 212, which apparently some cases had concluded. The court discussed the need for parity between expenses incurred in the different activities (again, treated as capital items, not deductible). The case did not address the amortization of these capitalized expenses.

195(a) is the general rule:

(a) Capitalization of expenditures

Except as otherwise provided in this section, no deduction shall be allowed for start-up expenditures.



195(b) provides the conditions for deducting the capitalized costs:

(b) Election to deduct

(1) Allowance of deduction

If a taxpayer elects the application of this subsection with respect to any start-up expenditures -

(A) the taxpayer shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the lesser of –


1.195-1(c ) Ex 1 specifies that the start-up expenditures relate to an active trade or business.


Parker discussion addresses active trade/business requirements and does not discuss 212 activities in relation to 195 amortization.

I did find one Tax Adviser article dated 9/1/2017, “Deducting Startup and Expansion Costs”. It includes this paragraph:

Startup expenses of an investment activity

The capitalization and deduction rules for startup activities also apply to Sec. 212 activities. Sec. 212 activities are those conducted for the production of income as opposed to trade or business activities. Thus, Sec. 212 activities include what are ordinarily considered investment activities.

This paragraph could be clearer. Is the author saying that a section 212 activity may claim 195 amortization? If so, what is the basis for that conclusion?
 

#6
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The Tax Adviser author bases that on the Toth case. Toth is an interesting case, because, nowadays, most of us would look at the regular and continuous involvement and intent to make a profit and call it a trade or business. Nonetheless, the parties agreed that this was a section 212 activity. Since this was a section 212 activity, the Service contended that because the taxpayer intended to have a section 162 trade or business later, all of her 2004 costs would be capitalized under section 195. In other words, they read, "(iii) any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business," quite literally. And the Service lost.

The Tax Court explained:

Once her section 212 activity has begun, the deduction of ordinary and necessary expenses paid or incurred in that activity is not precluded by section 195 regardless of whether that activity is subsequently transformed into a trade or business. This interpretation is consistent with section 195 and its legislative history.


What it comes down to is that the courts have repeatedly said that section 212 and section 162 activities are on equal footing. The full Tax Court in Toth said it best: "The purpose of the 1984 amendment to section 195 was to bring sections 212 and 162 into parity when determining whether an expenditure has been incurred in a startup activity." If they are on equal footing, expenses related to section 212 activities get capitalized under section 195 during the start-up phase. Expenses after the section 212 activity commences are deductible. This is Toth's holding.

(It is important to note that section 195(c)(1)(B) applies only to costs that would otherwise be deductible. We can't use section 195 to get around the suspended miscellaneous itemized deductions, except to the extent that section 62(a)(4) permits.)
-Brian

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#7
JAD  
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I will look at Toth now, but in the meantime....

If they are on equal footing, expenses related to section 212 activities get capitalized under section 195 during the start-up phase. Expenses after the section 212 activity commences are deductible. This is Toth's holding.

I have no problem with that. My issue is whether the expenses capitalized under section 195 may be amortized once the section 212 activity commences. I think that the plain, clear language of 195 leads to a conclusion of NO.
 

#8
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I had already read this case because it cited Hardy. Funny, right? I had already forgotten the name.

I stand by my position. The issue is the amortization of the capitalized costs incurred before the 162 or 212 undertaking began. If the undertaking is a 162 trade/business, then we can elect to amortize start-up costs when business begins. If the undertaking is a 212 investment activity, then amortization of the capitalized costs is not available.
 

#9
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Section 195 applies only to startup expenditures. There is nowhere in the statute for them to be capitalized that doesn’t permit expensing/amortization. If Toth and Hardy stopped at repudiating Hoopengarner and applied a common law preopening expenditure rule to section 212 activities, I would agree. But they held that section 212 startup activities, after the 1984 amendments to section 195, fall into the section 195(c)(1)(A)(iii) bucket. Even though I wouldn’t read the plain language of the statute that way, the Tax Court did.
-Brian

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#10
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Brian, where do you see in either case that 195(b) is available to a 212 undertaking?
 

#11
Coddington  
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In Toth, when it says,"This Court construes the term "startup expenditure" to denote an expenditure that is capital rather than ordinary. This Court will not interpret section 195 to override the deductibility of ordinary and necessary expenses petitioner incurred in an ongoing section 212 activity any more than it would do so for an ongoing section 162 activity." If something is a start-up expenditure within the meaning of section 195, the amortization provisions will be available.

One of the problems here, I think, is that the legislative history is not visible. Toth and Hardy talk about it, but they don't quote it. (Harry will love this part.) The Senate Report provided that a passive business is an active trade or business for section 195 purposes. (This was 1984, so before the PAL rules. This is more along the lines of passive within the meaning of section 179.) The Senate Report specifically identifies a "net lease" as an example of an active trade or business for section 195 purposes. As we've seen with section 199A, "net lease" meant what we now call a triple net lease. See, e.g.Rev. Rul. 73-522. This is one of those Through the Looking Glass moments where the Tax Court, supported by the Senate Report, chose that the words mean something other than what is plain.
-Brian

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#12
JAD  
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You said

If something is a start-up expenditure within the meaning of section 195, the amortization provisions will be available.

I disagree. There is a difference between 195(a) and 195(b). The former is the general rule. The latter is the election that is available, if you qualify for it. If all start-up costs qualified for the election, then why have 195(a) and 195(b)? If amortization of start-up costs are allowed for 212 activities, then the language of 195(b) is meaningless.

If 212 activities were eligible for 195 amortization, then Parker and RIA would not have extensive discussion about what it means to be an active trade/business.

You have cited cases as support that 195(b) is available for 212 activities, but those cases don’t address 195(b). You link to a Senate Report, but again, we have the plain language of the law. I have to make a decision now, and I cannot justify amortizing start-up costs for this 212 activity. That conclusion is based upon (1) the code 195(b), (2) the regulations 1.195-1(c ) Ex 1, (3) RIA and Parker explanations. If I made the election, and an agent asked me to justify my decision, and he held up the language of the law, what would I hold up?
 

#13
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There’s another Senate Report, relating to the Miscellaneous Revenue Act of 1980, which says this:

Further, in the case of rental activities, there must be significant furnishing of services incident to the rentals to constitute an active business (within the meaning of Code sec. 162) rather than an investment. Thus, a rental activity is not considered to be an active trade or business solely because deductions attributable to it are allowable in computing adjusted gross income (Code sec. 62(5)). In general, the operation of an apartment complex, an office building, or a shopping center would constitute an active trade or business.

And there was a case, involving tax year 1983 (Active Lipid Development Partners), where the aforementioned Senate Report was cited:

The next issue we must decide is whether petitioner is entitled to amortize start-up costs of $17. Section 195 permits a taxpayer to amortize start-up expenditures under certain circumstances. One requirement for amortizing start-up expenditures is that they must be incurred in connection with an active trade or business. Sec. 195(c)(1)(A). The legislative history of section 195 emphasizes that section 162 controls for purposes of the active trade or business requirement in section 195. S. Rept. 96-1036 (1980), 1980-2 C.B. 723.

…but I think where Coddington is going is to more recent stuff. Yes, it is only in the Senate Report Coddington identifies, and Sec 195(b) still says “active” in it…but I think his point is that the definition of “active,” when we look behind the scenes, should now be construed to mean “active or passive.” Basically a law change wherein the text of the law wasn’t changed, but we are instructed to now read it differently. Reminds me of that lengthy thread about an “Investment Partnership” we had a while ago…
 

#14
JAD  
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I agree with all that. 195 amortization is allowed for a rental activity if it is a 162 trade/business. It does not matter if it is active or passive. In other words, it can be a 162 activity even if no one materially participates. Maybe that is the source of the confusion in this thread. My issue is not 162. The activity is investment, 212. It does not rise to the level of a trade/business.
 

#15
Coddington  
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Sorry I can't address everything with the attention it deserves.

"Active" and "passive" in the 1984 Senate report refer generally to the distinction between section 212 and 162, since 1984 pre-dates section 469. Section 195(c)(1)(A)(iii) was added to section 195 by the DRA '84. It was the section that added section 212 activities to the definition of "start up expenditures", based on the 1984 Senate report and confirmed by the Tax Court in Hardy. In Toth, the full Tax Court addressed the question head on: If a section 212 activity is undertaken with a plan to turn it into a section 162 activity, are all of the section 212 expenses considered startup expenditures?

This is the Hoopengarner situation and what the literal language of (iii) seems to encompass. The Tax Court denied that approach based on the 1984 Senate report and the equivalency standard announced in Hardy. None of that, however, directly addresses the issue of section 195(b). Is the "active trade or business" requirement in (b) different from the one in (c)(1)(A)(iii)? Saying "yes" will violate the equivalency standard and doesn't seem like it would get much traction in the Tax Court. Saying "no" violates basic norms of construction, but might work in a non-Tax Court setting.

What it really comes down to is that Congress, if they intended to address something beyond the facts of Hoopengarner, botched the statutory language. The Tax Court bailed them out by setting up section 195 with an esoteric meaning of "active trade or business".
-Brian

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SourceAdvisors.com

Opinions my own.
 


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