Martin H. Fishman v. Commissioner of Internal Revenue
Docket: 87-1570
Court: Court of Appeals for the Seventh Circuit; January 12, 1988; Federal Appellate Court
The case concerns an appeal by the Internal Revenue Service (IRS) regarding the deductibility of business start-up costs incurred by a partnership that was developing a shopping center. The taxpayers formed a partnership to develop the center on land they did not own, incurring several expenses in 1976, including a $9,000 fee for a permanent mortgage commitment, $9,000 for a construction mortgage fee (partially paid in 1976 and 1977), and various other costs totaling nearly $8,000 for professional fees, advertising, and other operational expenses.
The IRS disallowed these deductions, labeling the mortgage commitment fee as a capital expenditure requiring amortization and deeming the professional fees as nondeductible organizational expenses. Conversely, the Tax Court permitted deductions for the remaining expenses under section 212(2) of the Internal Revenue Code, which allows for the deduction of ordinary and necessary expenses incurred for income-producing property, even before the property was operational.
The Tax Court's decision referenced previous cases, notably differing opinions from various circuits regarding the treatment of start-up costs. The IRS's challenge hinges on aligning with the Ninth Circuit's affirmation of the Tax Court's view or the Sixth Circuit's contrary ruling. An amendment to section 195 requires capitalization of start-up costs incurred after July 1, 1984, but numerous disputes regarding pre-amendment costs persist, potentially necessitating intervention from the Supreme Court to resolve conflicting circuit interpretations.
The legal framework regarding deductions for expenses in profit-making activities evolved significantly after 1942, when Congress enacted the predecessor to section 212 to address the unequal treatment of business versus nonbusiness income. Prior to this change, only expenses related to a trade or business were deductible under section 162, leaving individuals with expenses for passive income without relief. Section 212 allowed for some deductions related to nonbusiness income but maintained the restrictions applicable under section 162.
Court precedents have established that "pre-opening" expenses—those incurred before a business begins operations—are not deductible but must be capitalized, as they provide benefits over the life of the business. Examples include incorporation fees, which do not yield immediate benefits and thus cannot be fully deducted in the year incurred.
The inability of taxpayers to deduct certain expenses arises not from the language of section 162 but from the fundamental tax principle that income and expenses should be matched in time to avoid resource misallocations. This principle is codified in section 263(a), which prohibits the immediate deduction of capital expenditures, regardless of their ordinary and necessary nature. The timing of deductions is crucial due to the time value of money, as immediate deductions are more beneficial than deferred ones. Tax law aims to minimize interference with natural expenditure patterns while balancing revenue and distribution goals.
Richmond Television Corp. v. United States establishes the principle of temporal matching as crucial in determining the nondeductibility of pre-opening expenses under section 162. This principle requires that income and expenses be aligned in timing, impacting the deductibility of start-up costs for both individuals (under section 212) and corporations (under section 162). Congress intended for section 212 to reflect section 162's limitations, except for its restriction to trades and businesses. For instance, while individuals can deduct costs related to securing income, they must capitalize expenses related to creating capital assets, such as purchasing a safe, contrasting with renting a safe-deposit box. The IRS's contention focuses on expenses incurred before the shopping center began operations, which are viewed as capital expenditures necessary for its creation rather than current operational costs. Although section 212 does not explicitly differentiate between current and capital expenses, the language suggests a preference for current expenses. Furthermore, section 195 previously allowed for the amortization of start-up costs, reinforcing the understanding that such costs could not be deducted as current expenses. The 1984 amendment clarified that individuals also could not deduct these costs as current expenses.
Taxpayers argued that ground-lease rentals paid before the completion of a shopping center should be treated as current expenses, aligning with the premise that rental costs generate current revenue once operational. The Internal Revenue Service (IRS) acknowledged that post-operation, these rental payments become costs for generating income. Prior to income generation, however, these rentals were classified as start-up costs, akin to expenses incurred during lease negotiations, viewed as "advance payments in contemplation of future benefits." The document references case law to illustrate that such expenses, including the purchase or rental of equipment for future projects, are capital expenditures and not deductible as current expenses.
Additionally, the taxpayers claimed that the IRS conceded mortgage-commitment fees were deductible under section 212, which was incorrect. The IRS only conceded that if those fees were deductible, it would not challenge their amortization, not that start-up costs were inherently deductible under section 212. The court found that the Tax Court erred in allowing deductions for ground lease rentals and other start-up costs. Two unresolved issues were identified: the determination of when the start-up period ended and whether the partnership's start-up costs could be amortized over the shopping center's life. Section 195, which would have allowed for amortization, was not effective until 1980, thus not applicable to these taxpayers. The court concluded that the Tax Court's decision was erroneous and reversed it.
