Case Study: Avoid common mistakes as a new business startup  

Starting a new business can be an exciting and challenging experience. There are many things to consider when launching a new venture and making mistakes can be costly. There will be a lot we will be learning in this article, starting with some highlighted facts based on George M. Kellett’s court experience.  

Facts  

Kellett began working on his commercial website in 2013 while still working for Bloomberg Industry Group, in September of 2015 he opened his website to the public. 

Kellett planned four ways to make money through his website: 

• Selling space for advertising to third parties 
• Giving access to premium features and charging for them 
• Selling personalized charts and reports of information from the website   
• Licensing data to other companies 

Unfortunately, he did not earn any income in 2015 from his website, the site didn’t start to generate revenue until 2019 when he started to implement his strategy. 

 After publishing and affiliating his website to various universities and organizations, only about half of them added the website to their list of research databases. This did not earn him any revenue.  

But from Kellett’s point of view, his website cultivated long-term clients and maximized profit by earning their confidence. On his Form 1040 in 2015 Schedule C, He deducted: 

• Approx. $20,000, which was paid to engineers 
• Approx. $2500, which was paid to marketing professionals 
• Approx. $1800, which was for internet and cell phone services  

IRS Audit 

An IRS audit is a review and examination of your information and facts so that you comply with the tax laws. The IRS is merely double-checking your numbers to ensure there are no discrepancies in your return.  

The IRS audited Kellett’s 2015 tax return and denied all his business expenses. Per the IRS, his business had not started because there was no revenue. 

Taking his case to court 

 Kellett challenged the IRS’s denial in court. 

The court found that Kellett’s company operation did not follow the typical new business pattern where you start to see revenue when a business begins. For example, a new grocery store starts seeing revenue as soon as it starts having customers. An apartment building starts seeing rent revenue after accepting tenants. 

 According to the court, even though Kellett did not make any revenue in 2015, his business began to provide services for which his business was intended. The court ruled that such activity, at least in these circumstances, is an active trade or business that began in September of 2015. 

 Based on when Kellett paid his expenses, the court reduced the amount he could deduct by 32 percent. Kellett had to treat the remaining 68 percent of the expenses as business startup costs, of which $5,000 were deductible in 2015 and the rest could be deducted over 180 months. 

 The IRS argued that Kellett should be denied his Verizon expenses because Kellett failed to provide their business purpose. Kellett credibly testified that he used 80 to 90 percent of his Verizon services for his website; he did not present any records tracking his personal and business use.  

The court estimated that based on Kellett’s contemporaneously prepared Excel spreadsheet that he averaged 49 hours per week working on the site during the last three months of 2015, that helped the court approximate that Kellett’s business use of the cellular and internet services. They did this by taking the 168 hours a week and subtracted 40 hours for his Bloomberg work, then divided 49 hours (168-40) to arrive at a tax deduction of $159 (38 percent of the Verizon expenses paid after September 30). 

Takeaway notes:  

Document any and business expenses you incur as well as phone and internet expenses.  Kellett incurred $1,856 on such expenses, but the court only deducted $159. (None of the Verizon expenses were considered into his start-up costs). 

Keeping records is very important as proof in Kellett’s case and having to go to court to prove your case is very expensive and may leave you short of expenses.