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Weekly UpdatesThe importance of the entrepreneurial process to the health and well being of the U.S. economy cannot be overstated. During the period from 1988 until 1990 small business with nineteen employees or less created approximately four million new jobs, while larger firmssuffered a net loss of over one million jobs (Medoff, 1993), suggesting that much of our nation's net job creation is in the new venture / small business sector.
U.S. Department of Commerce (1978; 1984) County Business Patterns data indicates that from 1978 until 1984 employment in the small business sector, defined as firms with less than 500 employees, grew at a annual rate of 2.14 percent, while employment in firms with over 500 employees grew at an annual rate of only 0.55 percent. The U.S. Small Business Administration (1988) Small Business Data base supports the proposition that the most significant potential for growth in employment is in the small business sector, with employment in the small business sector growing at approximately a 67.2 percent greater rate on an annual basis than employment growth in firms with more than 500 employees during the period from 1978 until 1984. The implications derived from the data clearly suggest that most of the net new job creation and growth in work opportunities have occurred in the small business sector.
The job creation stimulus of new venture creation is critical to the success of the current efforts in local, regional, and national economic development. Foxall (1984) suggests that entrepreneurship is the "mainspring ... of innovative success." Entrepreneurial organizations are responsible for both the development and commercialization of innovations such as the personal computer, PC software, and fast food that have created entirely new industries, opportunities, and most saliently jobs.
The New Venture Creation Process
The search for exploitable business opportunities is the initial step in the entrepreneurial process (Butch, 1986). An entrepreneur pro-actively seeks risky but financially attractive business opportunities that can be exploited (Miller & Friesen, 1983; Foxall, 1984; Ginsberg, 1985; Morris & Paul, 1987) by the application of Day's (1984) concept of superior skills or superior resources, with the goal of creating a sustainable competitive advantage.
Burch (1986) suggests that this search process typically consists of: (1) product / service idea generation, (2) product / service idea evaluation, (3) definition of business, (4) development of a business plan, and (5) the creation of the new venture. However, Butch's entrepreneurial process omits the critical marketing oriented assessments of the macro-environment, the task environment, and the prospective entrepreneurial organization's core competencies (Prahalad & Hamel, 199f and corporate capacities (Stalk, Evans Shulman, 1992). All of these search activities will typically generate considerable pecuniary and non-pecuniary search costs. Hence, search costs for the purposes of the present study are those pecuniary costs, incurred by the prospective entrepreneur when conducting preliminary opportunity assessments. Figure 1 provides a summary of the steps typically taken during the new venture search process.
Purpose
The National Office of the Internal Revenue Service ruled in 1992 that an individual taxpayer could not deduct the cost of searching for or investigating either the acquisition of an existing business or the start-up of a new consulting business (1). The individual taxpayer had failed to meet a specific requirement (2) pertaining to the "active trade or business test" contained in Section 195, "Start-Up Expenditures," of the Internal Revenue Code. Unless individual taxpayers are careful to meet the tests and conditions imposed by the tax law, expenses incurred while searching for a new business to acquire or create will be nondeductible and thus yield no tax benefit. The purpose of the present study is to encourage the entrepreneurial process by proposing a tax effects oriented search framework for the prospective entrepreneur to follow in the new venture search process. A case example is provided to illustrate how requirements of the federal tax code impact the financial dimensions of the search and start-up process. In addition the present study offers the prospective small business owner a framework though the required tests and conditions to allow the deductibility of these exploratory and start-up expenses. This proposed framework is designed to allow the deductibility of new venture search costs and should financially encourage critically needed entrepreneurial activities.
History
Prior to 1981, the Internal Revenue Code did not allow a current deduction for investigatory or start-up business expenses incurred prior to the establishment of an active business. The tax law called for an initial capitalization of these expenses with a later deduction if and when the business was sold (3). Congress sought to give relief to taxpayers through the adoption in 1981 of Code Section 195 (4). Under this section, taxpayers can elect to deduct these expenses, once the entrepreneurial organization is established, over a period of not less than 60 months. Although not the ideal situation of a 100% current year deduction, this five year write-off of search and start-up expenses is significantly better for the active entrepreneur than the capitalization provided for by the old law.
Covered Expenditures
Section 195 provides this electable five year write-off period for three types of start-up costs. These three types are: (1) investigator search expenses, (2) business start-up expenses, and (3) pre-opening expenses (5). In addition to qualifying under one of these three categories, expenses also must be of a type that would be deductible if incurred in an active trade or business (6). For example, expenses involved with training of employees would qualify while expenses of selling common stock in a corporation would not be deductible, and therefore, would not qualify. Table 1 offers a summary of expenses classified by category.
Making Start-up Costs Deductible
The prospective entrepreneur must make an election to deduct start-up costs. The election must be made no later than the extended due date of the taxpayer's federal income tax return for the taxable year in which the new business begins (7). The amortization or write-off period once elected by the taxpayer is binding for the current and all future tax years. Thus, the write-off period cannot be changed or amended by the taxpayer (8). The period is stated in months since write-off of the elected expenses begins the month that the new business begins. Remember that sixty months or five years are the minimum write-off period that may be elected. Table 2 provides a sample tax election for Mary Park, a recent entrant into the entrepreneurial sector.
Like all conceptual frameworks, we have simplified such that we avoided any tax problems for at least some of the readers. If the search results in the acquisition of an existing business or the establishment of a new business, the above discussion of Code Section 195 is all that is required. Proper classification of expenses and election of the write- off period at the proper time and in the proper manner is all that is involved. However, what happens if the prospective entrepreneur is not sure the search will be successful? Then they should consider the following tax planning measures.
The Possibility of an Unsuccessful Search: The Need for Tax Planning
It is very prudent for the prospective entrepreneur to consider the possibility that the business search may be unsuccessful and not result in the acquisition of an existing business or the establishment of a new venture. Code Section 195 is only applicable to successful searches and does not cover investigatory or start-up expenses incurred in unsuccessful searches. However, with proper tax planning, a prospective entrepreneur can comply with other sections of the tax law that may allow a current deduction for these unsuccessful search expenditures. The prospective entrepreneur will then be in the best tax position possible regardless of the outcome of the business search. To understand the tax problems associated with an unsuccessful search, let us consider the "Case of Zaida."
The Case of Zaida
Zaida Doe is the Vice President of a Los Angeles based corporation that is currently involved in consulting to the hospitality industry. She is not satisfied with her current professional situation and decides to investigate either the acquisition of an existing consulting practice or the establishment of a new practice. She incurs travel expenses to various Southern California locations in efforts to determine an ideal location. In addition she contracts with a market research firm for an environmental analysis and new venture feasibility study. After incurring approximately $20,000 in travel and consulting expenses, Zaida analyzes her professional situation and abandons her plans to leave her current employment. The IRS rules that these expenses are nondeductible on Zaida's individual income tax return.
When Does the Business Begin?
The IRS ruled that Section 195 could not apply because Zaida never began the "active trade or business" of consulting (9). When a business is acquired by the taxpayer, it is treated as beginning on the date the taxpayer acquires it (10). When a business is established by the taxpayer, the IRS applies a "going concern" test (11), under which a trade or business does not begin until it starts to perform those activities for which it was organized. Since Zaida, as an individual, had no clients and offered no consulting services to anyone, no trade or business had begun.
The IRS ruled that Zaida did not qualify as being in the trade or business of consulting by virtue of her executive position in a corporation engaged in the same sector. The corporation and Zaida were distinct entities and therefore the consulting activities of the corporation could not be attributed to Zaida (12).
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