BUSINESS STRATEGY
You’ve quit your crummy job. You’ve developed your website. You’ve discovered a unique niche and you’re proudly anticipating your forthcoming traffic.BUSINESS STRATEGY
You’ve quit your crummy job. You’ve developed your website. You’ve discovered a unique niche and you’re proudly anticipating your forthcoming traffic. Being an astute businessperson, you’re also thinking of the ancillary benefits of owning your own business: i.e. tax deductions. Your head is awash in advertising expenses, website development expenses, travel expenses to Internext, content expenses, and home-office expenses. Come April, you figure you’re due a huge refund. Beyond that, you figure you’re never going to have to pay taxes again!
Well, maybe not. It’s true that owning your own business will entitle you to certain tax benefits. However, there are more than a few rules you’ll have to follow and obstacles you’ll have to overcome. You may have to be patient to fully realize the tax benefits of owning your own business. Nevertheless, arming yourself with the following tax basics should help your business planning for your start-up as well as your next few years.
Background – Ordinary and Necessary Business Expenses
Internal Revenue Code Section 162 allows a current year deduction for all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. This is the type of deduction most people refer to when talking about “business deductions.” To qualify for this deduction, an expense must be: (a) “paid or incurred during the taxable year,” (b) for “carrying on any trade or business,” and (c) an “expense” that is “necessary” and “ordinary.” Over the course of your business, this is the type of deduction you will most often utilize. However, in your first year of business, there are a number of hurdles that may prevent you from currently deducting expenses you would otherwise be allowed.
Hurdle #1: Is Your Website Just a Hobby?
First, you must pursue and develop your website as a “business” that you are engaged in for the purpose of making a profit. Otherwise, your site may be treated as a “hobby,” the losses of which may only be deducted against hobby-related gains. This can be a real problem if (as is common with any start-up) your site-related losses outweigh your site-related gains. In that case, if your website is treated as a hobby, you won’t be able to use the excess losses to offset other income items. This can be a common problem if you started your site in your spare time while maintaining an unrelated “day job.”
IRS Publication 535 lists nine factors that the government will scrutinize when determining whether or not an activity is a hobby or a business. While no one factor will be determinative, you should organize your website-related activity so that you can answer as many of the following questions with a “yes.”
1. Do you conduct your website-related activity in a businesslike manner?
2. Does your time and effort indicate your intent to make a profit?
3. Do you depend on your website for your livelihood?
4. Are your losses due to circumstances beyond your control or are they normal in the start-up phase of your business?
5. Do you monitor and change your operations to improve profitability?
6. Do you have the knowledge required to turn your website into a successful business?
7. Do you have any past success in making a profit in a similar activity?
8. Is your website profitable in some years?
9. Do you expect to make a future profit from the appreciation of your site-related assets?
Further discussion of each of the above factors could merit nine separate articles. However, it is worth mentioning that for start-ups, factor Number One is the most important (conducting your website in a businesslike manner) because it is the one factor of which you have complete control.
To conduct your website in a businesslike manner, you should, at the very least, maintain a complete and accurate set of books for your website. Make sure you have a separate checking account for your website. You should also obtain an Employer Identification Number from the IRS and look into submitting a fictitious business name statement to the appropriate agency in your state. Obtain a local business license from the city within which you operate. Finally, you should organize a business entity (i.e. a corporation, partnership, or limited liability company) for your website. Each of the above facts will suggest to the IRS that you are conducting a serious business and not just pursuing a desktop hobby.
Hurdle #2 – Are Your Costs Otherwise Required to be Capitalized?
Assume that you’ve established the fact that your website is a business and not a hobby. Your expenses may still not be currently deductible if they are treated as “capital expenditures” under Section 263. Section 263 provides that a capital expenditure is any “amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.” This includes “amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use.”
Under this rule, expenditures that result in the acquisition or enhancement of a separate and distinct asset generally must be capitalized and corresponding deductions may only be taken as the asset depreciates over the course of its useful life. This rule can pose great difficulties when trying to determine whether the components of your website constitute separate and distinct assets. Is your site’s visual content a separate and distinct asset? What about its audio content? Text? The site’s overall design? What is the useful life of any of these assets?
Each of these issues pose tough questions that go beyond the scope of the basics presented in this article and will ultimately depend on the facts of each individual case. One of the most often-litigated issues in tax cases is whether or not an expense was in the ordinary course of business or created a separate and distinct asset. For Newbie purposes, it will be important to remember two things: 1) if you’ve created or purchased content that may constitute a separate asset, the related expenditure must be capitalized and depreciated; 2) if you’re unclear whether or not you’ve created an asset that must be capitalized, contact a qualified tax preparer for guidance.
Also, remember that for certain expenditures common to traditional businesses as well as adult websites, the “deductible vs. capitalization” debate has already been decided by history. For example, expenses relating to minor upkeep of your site will not likely be treated as creating a separate asset and will be deductible. Similarly, ongoing charges for renting office space or server space or renewal fees for domain registration will generally not be treated as capitalized expenses under Section 263. Business travel and entertainment expenses will still be deductible (to the extent those costs are subject to other rules as well).
Hurdle #3 – Are Your Costs Properly Classified as “Start-up Expenses”?
Even if you’re sure that your website-related expenses are not required to be capitalized, you’re not yet ready to start taking deductions.
If you have incurred currently deductible expenses related to your website prior to the time when you have begun “carrying on a business,” those expenses will not be currently deductible under Section 162. Instead, these expenditures will be deferred and amortized under Section 195. This section deals specifically with “start-up” expenditures, and will therefore apply to most businesses developing websites. Under Section 195, you can realize a delayed tax benefit for these expenses by making an affirmative election to amortize the expense over a period of not less than 60 months.
If you’re a Newbie, most of your start-up costs will generally be subject to Section 195 until you begin active operations and your website is publicly available on the Internet and open for online transactions.
If you have an existing business and have developed a new website, it is more difficult to determine whether or not Section 195 will restrict your ability to use current year deductions. Generally speaking, if an existing business creates a new website to expand an existing business, Section 195 will not apply and the expenses related thereto will be currently deductible in the year of development. This more favorable treatment is something you should keep in mind once you’ve shed your “Newbie” status and are looking to expand your already-existing business.
Conclusion
As noted, your tax position will vary with the facts of your particular business. Nevertheless, keep the following questions in mind before deducting certain expenses in the current year:
1. Is my website merely a hobby?
2. Did I create a new asset with my expenditure?
3. Did I make the expenditure before I started doing business?
If the answer to any of these is “yes,” you may not be entitled to a deduction in the current year.
The reader should be reminded that this article only touches on the basics of how to properly treat your website development expenses for tax purposes. For instance, if you develop software as part of your website, the expenses related to that software may be deductible under other rules not discussed in this article. As with any legal article, the above summary is NOT a substitute for informed advice from an attorney or other tax professional. Please contact a qualified tax professional before relying on any conclusions described herein.
Jake Lager has been practicing transactional business and tax law since 1998. He attended the University of Pennsylvania Law School after graduating with distinction from the UC Berkeley. After spending the first four years of his practice working in the Los Angeles offices of two large international law firms, Mr. Lager now counsels individuals and businesses who require first-rate business and tax planning, transactional guidance and estate planning. His office is located in Santa Monica, California.
This article is for informational purposes only and is not intended to and does not create an attorney-client relationship, does not constitute legal advice, and is not a substitute for legal advice from qualified legal counsel.
Mr. Lager can be reached at hjl@adultnetlaw.com or jake@lagerlaw.com.
