The Internal Revenue Service as a stimulus to the entrepreneurial search process.

The 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. FIGURE 1 THE NEW VENTURE SEARCH PROCESS Conduct a macro-environmental analysis of the relevant environments to assess threats and opportunities Conduct a micro-environmental analysis to determine the prospective Entrepreneurial organization's strengths and weaknesses, focusing upon the prospective organization's competencies and capabilities Define the domain of the new venture in terms of markets served, segments served, products, technology, and competition Conduct an assessment of the relevant task environments that the new venture will compete within Assess the prospective organization's ability to create a sustainable competitive advantage within each task environments that the new venture will compete within Select the relevant task environments to function within Create a new venture

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).

Tax Planning Considerations

Expenses of expanding an existing trade or business are deductible in the tax period incurred. This is better treatment than the five year write-off offered by Section 195 and certainly better than the nondeductible situation faced by Zaida. If Zaida could have started a business with one or more local hospitality clients before incurring the travel and market survey expenses, the expenses would have been currently deductible since they would have been identified with expanding an existing business rather than investigating entering a new trade or business.

The Significance of the Search Organizations Business Form

Zaida chose to investigate a new business personally, thus making all expenses personal in nature. An individual may not deduct unsuccessful investigatory expenditures. These expenditures are considered to be nondeductible personal expenses (13). However, if Zaida had formed a corporation to investigate the new business, then the expenses would not have been personal expense but would have been corporate expenses. Corporate taxpayers are permitted to deduct any losses sustained that are not compensated for by insurance or otherwise (14). Thus, a corporation that makes expenditures in unsuccessfully searching for or investigating a new venture, may deduct the amount expended as a loss when it abandons the search or investigation (15). Figure 2 provides a summary of a more financially prudent process for investigating new venture opportunities. FIGURE 2 THE NEW VENTURE SEARCH PROCESS: A SEARCH COST PERSPECTIVE Form a corporation to conduct the entrepreneurial search and to incur the search costs Conduct a macro-environmental analysis of the relevant environments to assess threats and opportunities Conduct a micro-environmental analysis to determine the prospective Entrepreneurial organization's strengths and weaknesses, focusing upon the prospective organization's competencies and capabilities Define the domain of the new venture in terms of markets served, segments served, products, technology, and competition Conduct an assessment of the relevant task environments that the new venture will compete within Assess the prospective organization's ability to create a sustainable competitive advantage within each task environment Select the relevant task environments to function within Create the new venture and operate it within the corporate entity

Many factors of a tax, legal, and general business nature should be considered before a choice of the form of business is decided. The authors merely wish to point out that the deductibility of expenditures involved in unsuccessful business searches is one of the tax factors to consider.

Summary

The purpose of this manuscript is to alert prospective entrepreneurs to the tax law as it relates to the deductibility of expenditures to investigate and explore new business ventures. Search cost deductibility should enhance the entrepreneurial process by making new venture assessments more financially attractive. Successful searches are covered by Section 195 which allows a taxpayer to deduct expenditures over a five year period. This manuscript discusses the identification and classification of expenses, the required election by the taxpayer, and the significance of the choice of business forms. Tax planning opportunities designed to gain a current deduction for expenditures involved in unsuccessful searches are also explored. Table 1 Deductible Search and Start-up Costs

Type of Expense Example INVESTIGATORY EXPENSES Defined as those costs Expenses incurred during the new incurred seeking and reviewing venture analysis such as prospective businesses prior environmental assessments, market to reaching a decision to analysis, or competitive advantage acquire or enter any business analysis. (16). BUSINESS START-UP EXPENSES AND PRE-OPENING COSTS Defined as those costs Advertising and promotional incurred subsequent to a expenses, training of business and decision to acquire or prior to its actual expenses establish a particular incurred in developing distribution operation (17). channels, suppliers, and customers.

Legal and accounting service fees

to acquire employees, or proper

licenses, and expenses incurred in

the establishment of an accounting

system. Table 2 Sample Start-up Cost Election For Mary Park Mary Park SS# 112-22-3333 1993 - Form 1040 SECTION 195 ELECTION TO WRITE-OFF START-UP EXPENDITURES The taxpayer elects, under the provisions of Internal Revenue Code [section] 195, to amortize the start-up expenditures set forth below over a period of 60 months. The taxpayer commenced active trade or business in July 1993 for purposes of [section] 195. ITEM OF EXPENDITURE AMOUNT DATE INCURRED Market Survey $14,478 May 15, 1993 Travel Expenses 5,522 May 15 - June 30, 1993 Wages and Salaries 8,552 May 15 - June 30, 1993

(employees and instructors) Advertising (television) 12,000 June 12 - 20, 1993 Advertising (print media) 6,200 June 10 - 30, 1993 TOTAL $46,752

Endnotes

(1.) IRS Technical Advice Memorandum 9310001, 11-4-92, CCH IRS Letter Rulings eports

(2.) "Active trade or business test" imposed by IRC [section] 195 (c)(2)

(3.) Rev. Rul. 55-442, 1955 2 C.B. 529

(4.) Added by P.L. 96-605. Amended by P.L. 98-369

(5.) IRC [section] 195(c)(1)

(6.) IRC [section] 195 (c)(1)(B)

(7.) IRC [section] 195 (d)(1)

(8.) IRC [section] 195(d)(2)

(9.) IRC [section] 195(c)(2)

(10.) IRC [section] 195 (c)(2)(B)

(11.) Richmond Television Corp., CA-4, 66-1 USTC # 9133, 354 F 2d 410

(12.) See #1

(13.) IRC [section] 263

(14.) IRC [section] 165(a)

(15.) Rev. Rul. 73-580. 1973-2 C. B. 86

(16.) Committee Report on P.L. 96-605. (Miscellaneous Revenue Act of 1980).

(17.) See #16.

References

Burch, John G. (1986), Entrepreneurship, New York: John Wiley and Sons.

Day, George S. (1984) Strategic Market Planning, St. Paul: West Publishing Company.

Foxall, Gordon (1984) Corporate innovation: Marketing and Strategy, New York: St. Martins Press.

Medoff, James L. (19931 "Tall Order for Small Businesses," Business Week, (April 19), 114-116.

Miller, Danny and Peter H. Friesen, "The Correlates of Entrepreneurship in Three Types of Firms," Management Science, 29, 770-791.

Morris, Michael H. and Gordon W. Paul (1987), "The Relationship Between Entrepreneurship and Marketing in Established Firms," Journal of Business Venturing, 2, 247-259.

Prahalad, C.K. and Gary Hamel (1990) "The Core Competence of the Corporation," Harvard Business Review, (May-June), 79-91.

Stalk, George; Philip Evans; and Lawerance E. Shulman (1992) "Competing on Capabilities: The New Rules of Corporate Strategy," Harvard Business Review. (March-April), 57-69.

U.S. Department of Commerce, Bureau of the Census (1978) County Business Patterns, U.S. Government Printing Office: Washington, D.C.

U.S. Department of Commerce, Bureau of the Census (1984) County Business Patterns, U.S. Government Printing Office: Washington, D.C.

U.S. Department of Commerce, Small Business Adminstration, Office of Advocacy (1988) Handbook of Small Business Data. U.S. Government Printing Office: Washington, D.C.

A condensed and preliminary version of this manuscript has been submitted for presentation at the Southeastern Chapter of the Institute of Management Sciences 1993 Annual Meeting.

Spence L. Wise

Associate Professor of Accounting

Georgia Southern University

Statesboro, GA 30460-8141

Morgan P. Miles

Professor of Marketing

Georgia Southern University

Statesboro, GA 30460-8154