Tax Deductions: The Bright Side Of Failure

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Not every project or business activity succeeds. Savvy business owners know that failures can be instructive and eventually lead to success. Thomas Edison once noted that “I have not failed. I’ve just found 10,000 ways that don’t work.” But what happens to the costs put into these failed endeavors? Fortunately, the tax law provides some relief.

Aborted Business Ventures

What happens if you spend time and money investigating a business or start a venture that never takes off? Say you hire an architect to build a factory but never get city approval or financing to build it? The good news: The costs of an aborted business venture are immediately deductible under the right circumstances. The tax treatment depends on whether you are or are not already in business.

Startups that Never Start

If you are not yet in business, then the key for deducting expenses related to a business that never got off the ground is proving that you have gone beyond a general search and have focused on a specific business. Once you have focused on a particular business but the deal falls through, you can write off your expenses.

Mere investigatory costs are not deductible. For example, you travel to check out various business opportunities, but none seem promising. None of your travel costs are deductible.

But say you like one of the business opportunities you see, and you begin drawing up contracts. Then, the deal falls apart and you walk away. In this case, your travel costs to check out this business opportunity, as well as your legal fees for the contracts, become deductible. In one case, a would-be business owner paid $25,000 to buy a franchise but then learned that the area he was assigned was saturated with businesses that were losing money; he walked away and wrote off his investment.

Projects that Never Prosper

If you are already in business and a particular activity, such as construction of a new facility or launch of a new product, fails, the costs can be immediately deducted as an ordinary and necessary business expense.

Years in the Red

If your revenues for the year are less than your expenses, which can easily happen when you invest in a new idea, such as expansion into a new line of business, you may have a net operating loss (NOL) for your company. If so, you can carry back the loss for two years (or five years for federal disasters) and offset income in those years to generate an immediate tax refund. Refunds from NOL carrybacks can be made in two ways.

• By filing amended returns for the carryback years. C corporations use Form 1120X, Amended U.S. Corporation Income Tax Return; other business owners use Form 1040X, Amended U.S. Individual Income Tax Return.
• By filing for a “quick refund.” C corporations use Form 1139, Corporation Application for Tentative Refund; other business owners use Form 1045, Application for Tentative Refund. Forms can be found at the IRS website. Refunds usually are issued within 45 days.

If you can’t use up your NOL in the prior two years (or if you elect not to use the carryback), you can carry the NOL forward for up to 20 years, offsetting your profits and lowering your taxes for years to come.

Final Word

Failure is part of an entrepreneur’s business life. Work with your tax advisor to make sure that your business losses generate tax gains to the greatest extent possible.