Start-up and Acquisition Costs after a Deal Falls Apart

Jim, an employee, decided he wanted to be in business.

He spent $15,000 examining the industry that included a company called ADG and then identified ADG as his acquisition target. He then entered into a purchase contract and spent $35,000 in legal, accounting, and other expenses. The purchase failed.

How does he treat, for federal income tax purposes, the $50,000 he spent?

Start-up Failure

Had Jim acquired ADG, he would have written off the $15,000 as a start-up expense.

It would work like this:

• Jim would deduct $5,000 in the year he closed on the ADG deal.

• Jim also would amortize the remaining $10,000 ratably over a 180-month period beginning with the month he closed on the deal.

Because Jim was attempting to acquire an existing business, the business would have started (for start-up purposes) on the date the deal closed, and Jim took ownership of the business.

Because Jim failed to acquire ADG, the business never started for Jim. He gets no write-off for the $15,000. It’s considered a personal non-deductible expense.

Although Jim cannot deduct the $15,000, that amount is not necessarily lost.

Dealing with the $15,000

Jim does not give up. He identifies another business, XYZ, that is similar to ADG. He spends another $5,000 on his investigation and start-up before identifying the target.

Odds are good that Jim has $20,000 in amortizable start-up costs.

Possible trouble. The tax code states that the start-up expense must be “in the same field as the trade or business” acquired. This raises the question: Is XYZ in the same field as ADG?

We could not find any private letter rulings, revenue rulings, court decisions, or other authorities that address the “same field” issue in the context of using much or all of the original investigation to acquire XYZ.

Now we know two things:

1. Because XYZ is similar to ADG, Jim has a good chance of treating the $20,000 as an amortizable start-up expense.

2. Jim gets no deduction for the $15,000 if XYZ is in a different field from ADG.

Dealing with the $35,000

Once Jim decided to buy ADG, he had to capitalize fees for legal, accounting, investment banking, and other expenses paid to facilitate the purchase.5 Jim then had to depreciate some costs, amortize some costs, or choose to recognize gain or loss when he sells the business.

But remember, Jim’s acquisition of ADG failed. Now what?

Good news. Jim treats the $35,000 as a capital loss. And it is a short-term capital loss because Jim’s failed acquisition agreement holding period was one year or less.

Jim may deduct his $35,000 against other capital gains and then (if excess losses remain) to the extent of $3,000. He can keep going until he realizes his entire $35,000 loss.

Takeaways

When Jim’s business acquisition fell through, the tax treatment of his related costs depended on the type of expenses Jim incurred and whether he ultimately entered a similar business.

Initial investigation costs ($15,000). Because Jim never acquired ADG, these original investigation/start-up expenses are personal and non-deductible—unless he later buys a business in the same field. If his later target (XYZ) is similar to ADG, he may be able to roll these costs into his new start-up and amortize them over 180 months.

Later investigation costs ($5,000). The costs related to exploring XYZ qualify as start-up expenses.

Acquisition-specific costs ($35,000). Once Jim committed to acquiring ADG, his legal and professional fees became capitalized transaction costs. Because the deal failed in one year or less, he gets to deduct those fees as short-term capital losses, usable against capital gains and up to $3,000 per year against ordinary income.