Digital Businesses And Analog Dilemmas: The US Tax Deductibility Of Expenses Incurred By Web-Based Startups

• Published date: 17 June 2022
• Subject Matter: Corporate/Commercial Law, Tax, Technology, Corporate and Company Law, Income Tax, Tax Authorities, Fin Tech
• Law Firm: Mayer Brown
• Author: Mr Mark Leeds

"The [decentralized finance] DeFi boom is a very near equivalent of an apocalyptic event for the traditional financial institutions," wrote digital entrepreneur Mohith Agadi. Given the current meltdown in the cryptocurrency markets, however, I'm thankful that traditional banks didn't close up shop when bitcoin hit $60,000. There has been another recent collision of the digital world with traditional finance, but this time it's in the realm of tax. In Kellett v. Commissioner,¹ released on June 14, 2022, the US Tax Court addressed an age-old question for a digital-age business: When are expenses incurred in web development deductible for federal income tax purposes? And, not least of all, the court knocked out a taxpayer-friendly revenue procedure that allowed taxpayers to deduct software development costs.

In Kellett, supra, the taxpayer launched a retail website in 2002, which he operated until 2007. He then accepted a couple of jobs with internet research firms. While working full-time, the taxpayer began work on a website called "Vizala" that collated demographic, social and economic data that would be useful to any number of companies. He hired remote engineers to develop the website and develop user interfaces using open code software. The website was functional by March 2015, the bugs were worked out, and the website launched in September 2015. Vizala did not earn any revenue until 2019.

The taxpayer claimed deductions for the amount paid to the software engineers, to marketing companies, and for home internet access and other miscellaneous expenses on his 2015 federal income tax return. The expenses were claimed on Schedule C as trade or business expenses. The Internal Revenue Service (the "IRS") challenged the deductibility of these expenses. The Schedule C must have looked suspicious to the IRS because the expenses were claimed, but no revenue was reported. The IRS asserted that the expenses were start-up expenses that were required to be amortized ratably over 180 months beginning in September 2015.²

A taxpayer may deduct ordinary and necessary expenses incurred in a trade or business.³ If the taxpayer has not begun its trade or business, the expenses are referred to as start-up expenses. Start-up expenses are not currently deductible. Instead, these expenses must be capitalized or amortized over 180 months. The Tax Court used the test enunciated by the Fourth Circuit (the Circuit that would hear an appeal of the Kellett case) to determine...