Question

A partnership may elect to amortize the cost of organizational expenses. IRC 709(a), (b)(1) However, to be an organizational expense, the expense must meet a three-part test. Please discuss and provide examples.

Answer 1

Organizational expenses. Section 709(b)(2) of the Internal Revenue Code defines organizational expenses as expenses which:

(1) Are incident to the creation of the partnership;

(2) Are chargeable to capital account; and

(3) Are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would (but for section 709(a)) be amortized over such life.

An expenditure which fails to meet one or more of these three tests does not qualify as an organizational expense.The following are examples of organizational expenses : Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement; accounting fees for services incident to the organization of the partnership; and filing fees.

The election either to amortize organizational expenditures or to capitalize organizational expenditures is irrevocable and applies to all organizational expenditures of the corporation.

Example 1. Expenditures of $5,000 or less. Corporation X, a calendar year taxpayer, incurs $3,000 of organizational expenditures after October 22, 2009, and begins business on July 1, 2016. Corporation X is deemed to have elected to amortize organizational expenditures. Therefore, Corporation X may deduct the entire amount of the organizational expenditures in 2016, the taxable year in which Corporation X begins business.

Example 2. Expenditures of more than $5,000 but less than or equal to $50,000. The facts are the same as in Example 1 except that Corporation X incurs organizational expenditures of $41,000. , Corporation X is deemed to have elected to amortize organizational expenditures . Therefore, Corporation X may deduct $5,000 and the portion of the remaining $36,000 that is allocable to July through December of 2016 ($36,000/180 x 6 = $1,200) in 2016, the taxable year in which Corporation X begins business. Corporation X may amortize the remaining $34,800 ($36,000 - $1,200 = $34,800) ratably over the remaining 174 months.

Example 3. Subsequent change in the characterization of an item. The facts are the same as in Example 2 except that Corporation X determines in 2018 that Corporation X incurred $10,000 for an additional organizational expenditure erroneously deducted in 2016 as a business expense. Corporation X is deemed to have elected to amortize organizational expenditures in 2016, including the additional $10,000 of organizational expenditures. Corporation X is using an impermissible method of accounting for the additional $10,000 of organizational expenditures and must change its method .

Example 4. Subsequent redetermination of year in which business begins. The facts are the same as in Example 2 except that, in 2017, Corporation X deducted the organizational expenditures allocable to January through December of 2017 ($36,000/180 x 12 = $2,400). In addition, in 2018 it is determined that Corporation X actually began business in 2017. Corporation X is deemed to have elected to amortize organizational expenditures in 2017. Corporation X impermissibly deducted organizational expenditures in 2016, and incorrectly determined the amount of organizational expenditures deducted in 2017. Therefore, Corporation X is using an impermissible method of accounting for the organizational expenditures and must change its method.

Example 5. Expenditures of more than $50,000 but less than or equal to $55,000. The facts are the same as in Example 1 except that Corporation X incurs organizational expenditures of $54,500. Corporation X is deemed to have elected to amortize organizational expenditures in 2016. Therefore, Corporation X may deduct $500 ($5,000 - $4,500) and the portion of the remaining $54,000 that is allocable to July through December of 2016 ($54,000/180 x 6 = $1,800) in 2016, the taxable year in which Corporation X begins business. Corporation X may amortize the remaining $52,200 ($54,000 - $1,800 = $52,200) ratably over the remaining 174 months.

Example 6. Expenditures of more than $55,000. The facts are the same as in Example 1 except that Corporation X incurs organizational expenditures of $450,000. Corporation X is deemed to have elected to amortize organizational expenditures in 2016. Therefore, Corporation X may deduct the amounts allocable to July through December of 2016 ($450,000/180 x 6 = $15,000) in 2016, the taxable year in which Corporation X begins business. Corporation X may amortize the remaining $435,000 ($450,000 - $15,000 = $435,000) ratably over the remaining 174 months.