In Brief
The community-supported business (CSB) model has enabled many people to preserve the economic vitality of their small business or start new business ventures. “Community” usually implies people in a specific location, but it could equally apply to individuals with a common interest. Organizations are looking for new and innovative funding models, and the CSB provides entrepreneurs with an alternative funding structure. CSBs offer many advantages to businesses, their owners, and their communities. The number of organizations using this type of business model is growing substantially, increasing the demand for CPAs who can provide guidance.
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An increasing number of businesses are pursuing new ways to market their products and connect to customers. And today’s consumers are increasingly interested in buying local and knowing more about what they’re buying, who made it, and where it came from. Direct producer-to-consumer businesses offer opportunities for financial professionals to advise community-supported businesses (CSB) on the unique tax issues they face. Note that this article does not discuss financial accounting (U.S. GAAP) issues because most CSBs are smaller organizations that typically use the tax basis of accounting.
CSB Operations
The CSB model is based on building closer relationships with customers than in a typical commercial transaction. The phrase “community-supported” implies that CSBs have a financial connection with the communities in which they operate. A familiar example of a CSB is a community-supported agriculture (CSA) arrangement, where a farmer sells memberships to the public ahead of the growing season, then produces the crop and provides a weekly bundle of fruits or vegetables to consumers for a specified period of time. The advantages to farmers include the ability to conduct marketing activities before the busy farming season, increased cash flow for production costs prior to harvest, elimination of the middleman and thus increased profit potential, and the opportunity to meet and connect to the people consuming their produce. Advantages to consumers include fresh food with enhanced taste and nutrition, additional varieties of goods, greater transparency in the food production process, and the ability to support the local economy. This connection between producers and consumers typically increases customer satisfaction and loyalty.
Many CSAs also provide value-added activities, such as food processing, packaging and delivery services, education, and farm tours. Some CSAs allow members to provide labor in exchange for reduced membership fees. Restaurants are also embracing the community-supported approach, but instead of receiving boxes of produce, those members are entitled to meals worth a specific dollar amount. An important concept woven into the CSB model is shared risk. With a CSA, for example, members typically pay up front and the farmers try to provide an abundant selection of produce each week; however, if the harvest is poor, members are typically not reimbursed.
The CSB model is emerging in many business fields. It has been used to start new companies and turn struggling ones around when neither would have been possible using a traditional approach. CPAs with knowledge in this area can find additional ways to utilize the CSB strategy.
Is a CSB a business?
Because CSBs often provide personal pleasure to their owners, the first question that tax professionals must address is whether a CSB is a business. Under Internal Revenue Code (IRC) section 183, deductions of business expenses for an activity not engaged in for profit (i.e., a hobby) are limited to the income from that activity. Deductions allowed regardless whether the activity is a business, such as property taxes and qualified mortgage interest, must be deducted first, so that the remaining expenses are deductible only to the extent of the remaining income, according to Treasury Regulations section 1.183-1(b)(1). Hobby expenses are deductible from adjusted gross income as itemized deductions subject to the 2% floor [Treasury Regulations section 1.67-1T(a)(1)(iv)]. However, it should be noted that, for tax years beginning after 2017, the Tax Cuts and Jobs Act repeals the deduction for hobby expenses and other miscellaneous itemized deductions subject to the 2% floor.
A key feature of a business is the intent to make a profit. Treasury Regulations section 1.183-2(b) lists nine factors that the IRS considers in order to determine whether a taxpayer has a profit objective. In general, the IRS looks at how the taxpayer operates the CSB: Is it in a business-like manner? Are books and records maintained? Are experts consulted as necessary? IRC section 183(d) provides a rebuttable presumption that an activity is profit-seeking if it shows a profit in at least three of the previous five tax years. The profit-motive decision is subjective, and CPAs are well equipped to help CSBs maintain records and other documentation necessary to support a for-profit-business intent.
Method of Accounting
Most small CSBs use the cash method of accounting for tax and accounting purposes, even though they’re not required to use the same method for both. Regardless of accounting method, per Treasury Regulation section 1.61-1(a), gross income includes not only amounts received in cash but also anything of value received in lieu of cash, to the extent of its market value. If the CSB provides goods, services, or use of facilities in exchange for other goods or services, it is considered a barter transaction, and the recipient must include in its income the market value of what is received [Treasury Regulations section 1.61-2(d)(1); Revenue Ruling 79-24]. In such cases, tax professionals should make the business and service providers aware of the tax consequences of bartering (discussed in greater detail below).
As previously mentioned in the CSA example, the CSB model typically requires the receipt of cash before goods or services are provided to members. A cash-basis taxpayer must include as income advance payments for goods or services to be delivered in the future when the payment is actually or constructively received—that is, when received without restriction as to use and without obligation to refund [Treasury Regulations section 1.451-1(a); Farrara v. Comm’r, 44 TC 189 (1965)]. In most CSB arrangements, the receipt of funds is not subject to restrictions and there is no refund obligation, so the amount received is included in taxable income in the year of receipt. It should be noted that the cash method is not available for large C Corporations (IRC section 448).
Though the cash method is simple and may be beneficial from a liquidity standpoint (because it enables the CSB to pay taxes when it has the cash), the accrual method typically more clearly reflects income and may provide a more accurate picture of the CSB’s financial status for purpose of obtaining credit, business partners, or investors. (CPAs can assist cash-basis CSBs in the preparation of accrual-basis financial statements if necessary.) An accrual-method taxpayer includes an item in gross income for the year in which it is earned; the income is earned when all events have occurred that the amount of income is fixed and determinable [Treasury Regulations section 1.451-1(a)]. The “all events test” has been understood by the IRS to require recognition of income upon the earliest of the following: the completion of required performance, the date when payment for the performance becomes due, or the date when payment is received. For financial reporting purposes, advance payments received from customers are reflected as an unearned revenue liability of the seller. For tax purposes, however, prepaid income is generally taxed in the year of receipt [Revenue Ruling 74-607; Treasury Regulations section 1.451-1(a)]; therefore, accrual-basis CSBs will also recognize gross income in the year cash is received from its members, notwithstanding the deferred revenue liability. Under certain circumstances, an accrual-method taxpayer may recognize advance payments received for services (and specific nonservices) as income over the period in which the income is earned, but no longer than the year following the year of receipt [Revenue Procedure 71-21, Revenue Procedure 2004-34, and Treasury Regulations section 1.451-5].
If the CSB provides goods, services, or use of facilities in exchange for other goods or services, it is considered a barter transaction, and the recipient must include in its income the market value of what is received.
The Tax Cuts and Jobs Act (TCJA) codifies the deferral for certain advance payments provided by Revenue Procedure 2004-34 for tax years beginning after 2017. The TCJA also requires accrual-method taxpayers subject to the all-events test to recognize items of income not yet received no later than the year the income is reported in their applicable financial statement. An exception is provided for taxpayers without an applicable financial statement [IRC section 451(b) as amended by TCJA section 13221(a)]. Because most CSBs will use the cash method, any further discussion of income reporting by accrual-method taxpayers is beyond the scope of this article.
Tax professionals should keep the following in mind when advising CSBs:
- CSBs should refrain from reporting the advances of cash received from members as a gift rather than gross income: the amount is not a gift because the member pays the CSB with the incentive of anticipated benefit (IRC section 102; Revenue Ruling 99-44; Comm’r v. Duberstein, 363 U.S. 278).
- The personal consumption of the CSB’s product by the owner’s family members is not income. In the earlier CSA example, the value of farm produce consumed by a farmer and his family need not be reported as income, but expenses incurred to produce the food consumed cannot be deducted [Homer P. Morris v. Comm’r, 9 BTA 1273 (1928); IRS Publication 225, “Farmer’s Tax Guide,” p. 25].
CSB Deductions
A cash-method taxpayer’s expenses are deductible only when they are actually paid with cash or other property. In many cases, a cash-basis CSB can choose the year to claim the deduction by postponing or accelerating payment of the expense; however, Treasury Regulations section 1.263(a)-4(f) has established the one-year rule for prepaid expenses, which permits a taxpayer to deduct expenditures for rights that do not extend beyond the end of the following tax year. Both cash- and accrual-basis taxpayers may use the one-year rule [Treasury Regulations section 1.466-1(a)(4)(i)]. Prepaid expenditures extending beyond the following tax year must be prorated. To take advantage of the one-year rule, the payment must be required (i.e., not a voluntary prepayment) and the current deduction should not materially distort income. Generally, a CSB can take the current deduction if the item is recurring and made for a business purpose other than to manipulate income (Zaninovich v. Comm’r,80-1 USTC 9342; Keller v. Comm’r, 84-1 USTC 9194). In addition, CSBs may be required to maintain inventories for the production, purchase, or sale of merchandise held for sale to customers, as well as to use the accrual method to account for purchases and sales [Treasury Regulations section 1.471-1].
Inventory
Certain taxpayers are not permitted to use the cash method. Under IRC section 448(a), for example, C corporations, partnerships with a corporate partner, and tax shelters must use the accrual method. Another exception applies to taxpayers that maintain inventory. Treasury Regulations section 1.471-1 requires inventories if the purchase or sale of merchandise is an income-producing factor in the taxpayer’s business. Many small businesses choose to use a hybrid method: accrual for inventory and cash for all other items. The hybrid method may be used by a CSB that does not qualify for the small-business exceptions for accounting for inventory discussed below.
Under the hybrid method, the accrual method is used for inventory purchases and sales, while the cash method is used for all other income and expenses [Treasury Regulations section 1.446-1(c)(1)(iv)(a)]. For these non-inventory-related items, however, the same accounting method must be used to report both income and expenses (e.g., if the cash method is used for reporting income, then it must also be used for reporting expenses). Thus, the accrual of expenses (e.g., real estate taxes, salaries) is not permitted under the hybrid method. Different accounting methods may be used for two or more businesses as long as the businesses are distinct and separate books are maintained [Treasury Regulations section. 1.446-1(d)]. The hybrid method may be used for businesses that provide a mix of services and merchandise, provided the taxpayer can appropriately segregate its revenue and expenses attributable to the services and merchandise, based on the Hospital Corporation of America (HCA) case in Tax Court Memo 1996-105.
In order to reduce compliance burdens on small businesses and minimize disputes with the IRS, there are several small-business exceptions to the accrual method’s requirement for inventories that are likely to apply to CSBs. The first is a small-business exception for taxpayers with average annual gross receipts not exceeding $1 million for the three-year period preceding the current tax year (Revenue Procedure 2001-10). Second, the gross receipts ceiling is extended to $10 million for taxpayers in certain eligible businesses, primarily those providing services (Revenue Procedure 2002-28). Gross receipts include net sales; service income; and investment income, such as dividends and interest. It should be noted that when a CSB has existed for fewer than three years, the applicable period is the number of years in existence with short years being annualized [Treasury Regulations section 1.448-1T(f)(2)(iv)]. For tax years beginning after 2017, the TCJA expands the list of taxpayers eligible to use the cash method of accounting by raising the average annual gross receipts test to $25 million [IRC section 471 as amended by TCJA section 13102].
CSBs qualifying for these exceptions must treat their inventory items as nonincidental material and supplies under Treasury Regulations section 1.162-3. For cash-method taxpayers, these nonincidental inventory items are deducted in the later of the year paid or sold. These small-business exceptions simplify the accounting for many CSBs and allow them to defer sales recognition until actual or constructive collection of cash. Moreover, the uniform capitalization rules of IRC section 263A, which prescribe which costs must be capitalized and included in the basis of inventory, do not apply to inventory items treated as nonincidental material and supplies.
Inventory for Farming
A CSB in the business of farming has the option to use the cash method for inventory, regardless of the amount of gross receipts. The method selected must be used consistently in subsequent years, unless the IRS authorizes a change of method (Treasury Regulations section 1.471-6).
Valuation of inventory.
Two simplifying methods are available for farmers valuing inventories: the farm-price method and the unit-livestock-price method. The former may be applied to both crops and livestock, while the latter is only for livestock. Under the farm-price method, each inventory item is valued at its market price, less the direct cost of disposition. If this method is used, it must be used for all farm products produced, except livestock for which the farmer elected to use the unit-livestock-price method [Treasury Regulations section 1.471-6(d)]. Under this method, market price is the current bid price on the inventory date for the volume typically sold by or purchased from the farmer. If the current bid price is not available, the best available evidence of market value in local markets may be used [E.T. Bamert, 8 BTA 1099 (1927)]. Cost of disposition includes broker’s commissions, freight to the nearest market, and other handling expenses [Treasury Regulations section 1.471-3(c)].
There are several small-business exceptions to the accrual method’s requirement for inventories that are likely to apply to CSBs.
Taxpayers using the farm-price method may have more fluctuating taxable income, because income tends to follow the market in which the farmer sells. The advantage of this method is its simplicity; the disadvantage is that taxable income will be higher in the year preceding sale because the unit prices of ending inventory are higher than actual costs. The product is typically valued at more than cost, so the higher ending inventory (smaller cost of goods sold) may not be fully offset by the cost of the product—potentially resulting in a higher taxable income.
The second valuation method available is the unit-livestock-price method, which farmers producing livestock are permitted to use to value their inventories of animals. A farmer using this method estimates the cost of raising the different types of livestock to various stages of development and determines a standard unit price for each age level of a particular class of livestock [Treasury Regulations section 1.471-6(e)]. The objective is to allocate current period costs to the proper class of livestock. For example, consider that a farmer determines it requires $20 to raise a calf and $8 for each additional year it takes to raise the animal to maturity. The farmer’s classifications and unit prices are—
- calves: $20,
- yearlings: $28,
- two-year-olds: $36, and
- mature animals: $44.
At the end of the year, if the farmer has 50 calves, 60 yearlings, 50 two-year-olds, and 90 mature animals, the total inventory would be $8,440.
The market price of the animal is irrelevant in this method; rather, it is the cost of producing the livestock that determine unit prices. The unit prices should be reevaluated annually and adjusted if necessary, according to Treasury Regulations sections 1.471-6(f) and 1.263A-4(c). A farmer who elects to use the unit-livestock-price method must apply it to all livestock raised, whether for sale or for draft, breeding, or dairy purposes. But the farmer may make an election to treat the livestock purchased or raised for draft, breeding, or dairy purposes as property used in a trade or business, subject to depreciation [Treasury Regulations sections 1.471-6(f) and 1.471-6(g)]. This election is binding for future years, unless the IRS consents to a method change (Tee Bar Ranch Co. v. U.S. 63-2 USTC 9663; Urbanovsky v. Comm’r, 24 TCM 1518, Tax Court Memo 1965-276; Revenue Ruling 1960-1 CB 190). A later sale of depreciable livestock would be subject to depreciation recapture under IRC section 1245 and gain or loss rules under IRC section 1231.
If a CSB member receives less than what was expected, the tax consequences hinge upon the nature of the initial investment and the terms of the CSB agreement.
Crop method.
If the CSB does not harvest and dispose of its crop in the same tax year that it is planted, then it can, with IRS approval, use the crop method of accounting. Under this method, the entire cost of producing the crop, including seeds or young plants, is deferred and deducted in the year the crop is sold [Treasury Regulations section 1.126-12(a)]. IRS Publication 225 provides a useful reference for tax professionals to learn more about specialized farm tax issues beyond the scope of this article.
Retail CSBs
CSBs engaged in a retail business may benefit from the following simplifying conventions for inventory: IRC section 263A generally requires resellers to include in inventory costs direct costs and an allocable portion of indirect costs of inventory produced or acquired for resale; however, resellers with gross receipts of $10 million or less and producers with $200,000 or less of indirect costs are not required to capitalize these costs under IRC section 263A [Treasury Regulations section 1.263A-2(b)(3)(iv)(A)]. Retail CSBs using the accrual basis for inventory may use the retail method, which provides that, for the purpose of valuing inventory at year-end, the cost of items is the retail selling price less the average percentage markup. The formula to convert retail to cost is the cost-to-retail ratio, defined under Treasury Regulations section 1.471-8 as the ratio of the value of the beginning inventory, plus the cost of purchases to the retail selling price of the beginning inventory, plus the initial retail selling price of purchases. The taxpayer computes the value of ending inventory under the retail method by multiplying the cost ratio by the retail selling prices of goods on hand at year-end.
For example, assume a new CSB has a $0 beginning inventory. During the year, purchases are $2,880 at cost and $4,800 at retail. The cost complement is 60% ($4,800 × 0.60 = $2,880). Sales for the year are $2,600 and permanent markdowns are $300, resulting in ending inventory at retail of $1,900. The ending inventory using the retail method would be $1,140 ($1,900 × 0.60). This method is typically used by large retailers or specialty stores that may have no practical way of ascertaining the cost of each item of merchandise in stock at the end of the year. Taxpayers using this method must maintain accurate records and disclose the method used on the tax return. A retail CSB maintaining inventories but not using the retail method must use cost or the lower-of-cost-or-market method to value its ending inventory under IRC section 471 and accompanying regulations. (See IRS Publication 538, “Accounting Periods and Methods,” for additional information.)
Education Expenses
CSB operators are often mid-career or changing-career individuals likely to continue their education and training for additional CSB-related skills. They may be able to deduct certain education expenses for courses that are related to the CSB’s business but do not qualify the individual to enter a new business [Treasury Regulations section 1.162-5(a) and (b)]. For example, an individual operating a brewery may enroll in fermentation-science classes at a local university. If the course is taken at an educational institution, the tuition may qualify for the lifetime learning credit [IRC section 25A(c)].
Barter Transactions
A CSB may pay for goods and services by trading them for other goods or services. For example, a CSB operating a winery may receive legal services and pay for those services by providing an agreed-upon amount of wine. In this case, the fair market value of the legal services received is gross income to the CSB, and the fair market value of the wine is taxable to the attorney [Treasury Regulations section 1.61-1(a)]. The CSB must report the income from the wine exchanged, as well as a “legal fees” (or other type of business) deduction for the fair market value of the wine provided to the attorney [IRC sections 1001(a) and (b); Treasury Regulations section 1.61-6]. Bartering or trading is often useful when cash flow problems would otherwise prevent the CSB from securing the goods or services. CSBs may pay for labor by transferring property (e.g., inventory, such as farm products) or services (e.g., free restaurant meal or gym dues) to a labor provider. In this case, the deduction for wages paid, as well as the income reported, is the fair market value of the property or service transferred. The CSB may have a gain or loss to recognize on the transfer of the property if the fair market value of the property differs from its adjusted basis [IRC sections 83(h) and 1001(a)].
Recordkeeping for bartering transactions should be treated similarly to any other financial exchange transaction. The original cost of goods traded, fair market value of the goods or services that are exchanged, transaction date, purpose, and other relevant details should be recorded to assist with income tax reporting and information returns. To this point, any CSB making payments (including non-cash ones) to another person for rent, compensation, or other remuneration aggregating $600 or more in the tax year must file an information return under IRC section 6041. Because CSBs frequently make payments to third parties in non-cash forms, accountants might need to assist with these information-reporting obligations.
The Inability to Provide Goods
If a CSB member receives less than what was expected, the tax consequences hinge upon the nature of the initial investment and the terms of the CSB agreement. For example, assuming it is a typical farm CSA and the farmer is unable to provide the weekly produce or provides significantly less than expected, the member will have a nondeductible personal loss. If the situation involves a fraudulent CSB, the individual may be eligible for a theft loss deduction under IRC section 165(e) in the year of discovery [Treasury Regulations section 1.165-1(d)(2)]. For CSB members who joined as part of their business, such as a restaurant seeking a local food source, the loss should qualify as a deductible business loss under IRC section 165(c)(1), a theft loss, or an IRC section 162 business expense, depending upon the circumstances. CPAs can assist these taxpayers in structuring the financial arrangements in a way that produces the desired business and tax outcome to the involved parties in the event of a loss.
It should be noted that the CSB member would not be eligible for an IRC section 166 bad debt deduction because the amount the member pays in the typical CSB model does not qualify as a loan. A bona fide debt arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a determinable amount. The CSB has no absolute liability to repay the amount. CSBs may receive loans from members or nonmembers, but the agreement between the parties must be structured as a loan.
CSBs and Charitable Organizations
Many CSBs partner with charitable organizations. In doing so, the CSB receives additional visibility in the community, an enhanced reputation, and increased consumer loyalty. But partnering with charitable organizations may have tax implications that CSBs should remain aware of.
Donating inventory.
The CSB’s deduction for inventory donated to a charitable organization is limited to the lesser of the inventory’s basis or value under IRC section 170(e). CSBs may claim a deduction for donations of “apparently wholesome food,” defined as food that meets all the quality and labeling standards imposed by federal, state, and local laws, even though the food may not be readily marketable due to appearance, age, freshness, grade, or other conditions [42 USC 1791(b)(2)]. The food’s pull date or sell date is therefore not relevant in determining fair market value. In addition, the fair market value of such food is determined without regard to the taxpayer’s internal standards, a lack of market, or by reason of being produced by the taxpayer exclusively for the purpose of transferring the food to a qualified charity [IRC Section 170(e)(3)(C)(v)]. The determination does consider the price at which the taxpayer sells food items of the same type and quality at the time of the contribution or in the recent past [IRC Section 170(e)(3)(C)(v)(1)].
Partnering with charitable organizations may have tax implications that CSBs should remain aware of.
For zero-basis inventory of a cash-method taxpayer not required to maintain inventory (such as a cash-basis farmer), the charitable deduction is 50% of the fair market value under IRC section 170(e)(3)(B). The charity must use the donated food to further its mission and solely for the care of the ill, needy, or infants. No goods or services may be received in exchange for the donation, and the taxpayer must receive a written statement saying its use of the property will be in accordance with these provisions.
For example, consider a cash-basis CSB that operates a vegetable farm. Throughout the growing season, unsold vegetables are delivered to the local charitable food bank at the end of each week. During the current week, vegetables that normally would have sold for $150 are delivered to the food bank. Assuming the business meets the documentation requirements, the charitable donation deduction is $75 (half the normal sale price).
The above explanation of food donations applies for tax years beginning after 2015. Tax professionals should encourage CSBs to take advantage of this rule. Before this special provision, cash-basis taxpayers holding zero-basis food inventory received no deduction for the contribution of the food.
CSBs operated by charitable organizations.
A charitable organization may also operate a CSB. For example, a nonprofit day school for children with special needs might also operate a CSB restaurant that serves breakfast, lunch, and dinner to the general public and also prepares meals for the schoolchildren. Among other requirements, nonprofit organizations must be operated exclusively for exempt purposes in order to qualify for and maintain their tax exemption. An organization will be regarded as such if it engages primarily in activities that accomplish one or more of its exempt purposes under IRC section 501(c)(3). An organization will not satisfy the operational test if more than an insubstantial part of its activities is not in the furtherance of an exempt purpose [Treasury Regulations section 1.501(c)(3)-1(c)(1)]. There is no bright line defining “substantial”—it must be determined by looking at the facts, including the dollar amounts of the receipts, disbursements, assets, and overhead structure devoted to the business versus the exempt activities. The fact that an organization engages in a business does not result in denial of tax-exempt status if the business furthers the organization’s exempt purposes [Treasury Regulations section 1.501(c)(3)-1(e)(1)].
The fact that an organization engages in a business does not result in denial of tax-exempt status if the business furthers the organization’s exempt purposes.
In this example, the meals for the schoolchildren would relate to the exempt purpose of the school; however, the meals sold to the general public would not, unless the restaurant was also used to train the schoolchildren or provide them with other educational skills. Thus, if the unrelated activities are substantial and conducted like a business, the school might lose its exempt status; if the unrelated activities are not substantial in relation to the school’s activities, the income generated by the restaurant from serving the general public would still be subject to the unrelated business income tax (IRC sections 511 and 512). Too much unrelated business-activity income could jeopardize the charity’s tax exemption (IRS Publication 598, “Tax on Unrelated Business Income of Exempt Organizations”).
One way a charitable organization may operate a business without jeopardizing its exempt status is by establishing a for-profit subsidiary. The relationship between the charity and the business subsidiary must be managed and structured carefully, and tax professionals can aid in this endeavor.
CSB Formation and Organization
CSBs have several options and considerations when deciding how to organize. Sole owners may form as a sole proprietorship, which requires a Schedule C on Form 1040, U.S. Individual Income Tax Return. Unless the business is a corporation, individuals owning and operating it jointly with their spouse are operating a partnership, and thus a Form 1065, U.S. Return of Partnership Income, might be required. (For farming operations, an election can be made to be a qualified joint venture and file two schedule Fs or Cs instead; see IRC section 761 and IRS Publication 225, p. 73, for more information.) Moreover, CSBs may choose to incorporate either as a C corporation or S corporation. (For a discussion of business entity choice, see “Making the Right Choice of Business Entity” by James F. Hopson and Patricia D. Hopson” The CPA Journal, October 2014.)
Organizational costs.
IRC section 248 allows corporations to deduct up to $5,000 of organizational costs in the year business begins and amortize the remainder over 180 months, beginning the month business begins. If costs exceed $50,000, the deduction is reduced [IRC section 248(a)]. The corporation may elect to forgo the deduction and capitalize the expenses instead [Treasury Regulations section 1.248-1(c)]. The tax treatment for partnership organizational expenses is similar to corporations. Organizational costs may be paid for the formation of a disregarded entity [a single-member limited liability company (SMLLC) or qualified sub-chapter S subsidiary (QSub)]; such costs are not amortizable and must be capitalized [Treasury Regulations section 1.263(a)-5(a)(6)]. A de minimis rule, however, does not require disregarded entity-related organizational costs less than or equal to $5,000 to be capitalized [Treasury Regulations section 1.263(a)-5(d)(1) and (3)].
Startup costs.
IRC section 195 defines startup costs as those incurred to investigate the potential of creating or acquiring an active business or to create an active business. To qualify as startup costs, they must be deductible as business expenses if incurred by an existing active business and must be incurred before it begins [IRC section 195(c)(1)]. Common examples of preopening startup costs include advertising, wages paid to train employees, salaries or fees paid to managers and consultants, travel, and rent. Startup costs do not include costs for interest and taxes, which are deductible regardless of business activity [IRC sections 163, 164, and 195(c)(1)].
The tax treatment of startup costs is similar to organization costs: a taxpayer may deduct up to $5,000 of startup costs under IRC section 195(b)(1)(A) and amortize any startup costs over the deduction limit for 180 months, beginning in the month the active conduct of the business begins [IRC section 195(b)(1)(B)].
Planning Suggestions
Tax professionals should advise CSB clients about documentation—namely, that it is important for persons providing services in connection with the organization of the entity to provide invoices that describe and set forth charges for expenditures that qualify as organizational expenses separately from those that do not qualify.
Date business begins.
The deduction for or amortization of organizational expenses and startup costs is allowed in the taxable year in which business begins [IRC section 709(b)(1)(A); IRC section 248(a)(1); IRC section 195(b)]. Ordinarily, business begins when an entity starts the business operations for which it was organized [Treasury Regulations section 1.248-1(a)(3)]. Mere organizational activities, such as obtaining a corporate charter, are not sufficient to show the beginning of business.
It is important to document the month and year in which the new business actually begins, since this is when the deductions under IRC section 195 become available. Because costs that qualify as startup costs will be deductible as ordinary and necessary business expenses when the business becomes active, a taxpayer should consider beginning the active conduct of the business before startup costs exceed $5,000; this will help the taxpayer avoid having to amortize any startup costs. Furthermore, under IRC section 195(b), if conduct never amounts to an active trade or business, startup expenditures are not subject to the IRC Section 195 election, and cannot be deducted or amortized. Tax professionals may assist CSBs in the identification and tracking of organizational and startup costs and advise them as to the proper tax treatment.
Membership agreement.
Tax professionals should advise a CSB to have a written membership agreement—an important tool the business may use to communicate clearly with its members—signed by both the operator and the member. The agreement can identify the legal issues that could present themselves throughout the CSB’s development and operation and could help the business understand what needs to be communicated to others involved in the process. If these issues are addressed, all individuals involved will benefit, and the true community feeling of the CSB will be fostered. Examples of items to be addressed in the membership agreement include premises liability, food safety and labeling (if relevant), membership structures, payment methods, distribution, missed pickups, item availability, shared risks, refunds, end of agreement, and the process for settling disputes. At a minimum, this document should disclose the potential risks to the consumer and should list the items the CSB will provide, along with a pricing structure, delivery period, and delivery method. Because this agreement is essentially a contract, it is prudent to consult an attorney before finalizing the document. For tips on writing a membership agreement, and to view sample agreements, visit http://www.memberassembler.com/hub/your-csa-needs-a-membership-agreement.
CSBs have a financial responsibility to their members beyond that of a traditional business to the consumer. Although CSB members do not own the business in the same way that corporate shareholders or partners own such businesses, they do share the CSB’s risks and rewards. Communication between the business and its members is essential to the success of the CSB. Because the members have invested in the CSB, there is an additional need for transparency, and CSB operators may not have the ability or time to devote to appropriate member communication. CPAs are well equipped to help manage this responsibility and recommend any necessary consultants.
