February 28, 2019
If you are starting a new law firm, you may incur several different types of “pre-opening expenses.” By pre-opening expenses, we mean those that are incurred during the period before the new firm is actually up and running and earning revenue. Special federal income tax rules apply to such pre-opening costs. This article summarizes how to handle them under the current rules, which were altered in recent years by legislation and regulations.
How to Handle Expenses that Would Be Currently Deductible if a Firm Was Already Operating
Under Section 195 of the Internal Revenue Code, your firm can generally elect to immediately deduct up to $5,000 of “garden-variety” start‑up expenses in the year during which the active conduct of the firm’s business begins. However, this $5,000 instant write-off allowance is reduced dollar for dollar by cumulative Section 195 start‑up expenses in excess of $50,000.
Section 195 start-up expenses that cannot be immediately written off in the year when business commences must be capitalized and amortized over 180 months (i.e., over 15 years) using the straight-line method. This treatment is the rule for Section 195 start-up expenses that are paid or incurred after October 22, 2004.
Key Point: For some law firms, total Section 195 start-up expenses will be low enough to currently deduct the entire amount, under the $5,000 rule, in the year when the active conduct of business begins. A special tax return election is required to take advantage of the $5,000 instant deduction rule and the 180-month amortization rule.
The relatively favorable tax treatment afforded under the rules is limited to pre-opening expenses that would be currently deductible, under Section 162 of the Internal Revenue Code, if your firm was up and running. (Section 195(c)(1)(B) of the Internal Revenue Code and Revenue Ruling 99-23)
How to Handle Other Pre-Opening Expenses
Organizational expenses incurred to set up your law-firm entity (for example, state filing fees and so forth) fall under the same rules as for Section 195 start-up expenses. If your new firm is classified as a partnership for federal income tax purposes, organizational expenses that cannot be immediately deducted under the $5,000 rule must be capitalized and amortized over 180 months under Section 709 of the Internal Revenue Code. If your firm is classified as a C or S corporation for federal income tax purposes, organizational expenses that cannot be immediately deducted under the $5,000 rule must be capitalized and amortized over 180 months under Section 248 of the Internal Revenue Code. A special tax return election is required to take advantage of the $5,000 instant deduction rule and the 180-month amortization rule. This treatment is the rule for organizational expenses that are paid or incurred after 10/22/04.
Of course, not all pre-opening costs fit into the Section 195 start-up expense or organizational expense categories. For instance, regulations under Section 263(a) of the Internal Revenue Code mandate that certain types of pre-opening expenditures generally must be capitalized rather than currently deducted. Such capitalized expenses may or may not be eligible for amortization or depreciation under other tax rules. In addition, the Section 263(a) regulations have some taxpayer-friendly loopholes that may allow your firm to claim current deductions.
Let’s say you and some associates are opening up a new law firm that will be operated as a partnership. Before your new firm begins earning revenue, you incur the following expenses:
- Pre-opening expenditures to recruit and train employees for the new firm. These qualify as Section 195 start-up expenses and are subject to the relatively favorable tax treatment explained earlier in this article.
- Pre-opening expenses to develop and roll out marketing strategies for the new firm. These also qualify as Section 195 start-up expenses.
- Expenses to properly establish the partnership under applicable state law. These qualify as organizational expenses and are subject to the relatively favorable tax treatment explained earlier in this article.
However, under the Section 263(a) regulations, the firm is generally required to capitalize the following pre-opening expenditures.
- Amounts paid to acquire or create a lease agreement for the new firm’s offices, including related transaction costs. These amounts can then be amortized over the life of the lease.
- Prepaid expense items, such as prepayments for liability and casualty insurance coverage. These amounts can generally be deducted in the periods to which the insurance coverage relates.
Your firm may incur various other pre-opening expenditures that also must be capitalized under the Section 263(a) regulations. Depending on the nature of the expenses, the tax treatment may be relatively favorable, or not.
Bottom line: A new law firm may incur a wide variety of pre-opening costs. Different tax rules apply to different types of costs, and special tax return elections may be necessary to get the best treatment for your firm’s expenditures. Contact your tax adviser if you have questions or want more information.