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The proper timing of income tax deductions for expenses incurred by developers while researching projects can prove tricky. One developer recently learned the hard way that the costs of marketing materials aren’t necessarily immediately deductible — and may not be deductible at all if you don’t sufficiently document the outcome of the bidding process for a project.

Disputed Deductions

The taxpayer pursued real estate development projects under the name “Hisham Ashkouri Architects.” He also was the sole shareholder and officer of ARCADD Inc., which provided architectural and design services.

ARCADD was hired to assist him in the pursuit of development projects by preparing what the taxpayer referred to as “marketing materials” — for example, building designs, brochures and 3-D drawings. Ultimately, though, he didn’t end up developing any of the target projects. If any of them had resulted in a deal, he would have had a 20% ownership interest.

Each of his federal tax returns for 2009 to 2011 included a Schedule C for his business. The schedules listed deductible expenses for payments to ARCADD for “architectural” and “contract” services. The IRS disallowed the deductions, asserting they should have been capitalized under Internal Revenue Code Section 263A.

Good News, Bad News

Sec. 263A requires the capitalization of direct and indirect costs of property produced by the taxpayer or acquired by the taxpayer for resale. In Ashkouri, the taxpayer argued that the deductions at issue couldn’t be capitalized because they were used for marketing and promotion with no real estate transaction resulting.

The U.S. Tax Court agreed that Sec. 263A doesn’t require the capitalization of “marketing, selling, advertising, and distribution costs.” It also, however, cited a tax regulation that convinced it that his payments to ARCADD weren’t such costs.

That regulation requires a taxpayer to defer all bidding costs paid or incurred in the solicitation of a particular contract until the contract is awarded. The timing of the deduction depends on whether the taxpayer wins the contract. If so, the costs become part of the indirect costs allocated to the contract’s subject matter.

If the contract isn’t awarded to the taxpayer, as here, bidding costs are deductible in the earliest of the tax year that:

  • The contract is awarded to another party,
  • The taxpayer is notified in writing that no contract will be awarded and the contract won’t be rebid, or
  • The taxpayer abandons its bid.

Sec. 263A would apply to the taxpayer’s pursuit of development projects only if they would have resulted in his acquisition of property. That’s because a taxpayer generally isn’t considered to be “producing” property unless the taxpayer is considered an owner of the produced property.

The court, therefore, accepted the taxpayer’s claim that he wasn’t required to capitalize his expenses from pursuing projects that didn’t lead to acquisition of a property interest. But it didn’t find the expenses immediately deductible.

Instead, their deductibility was deferred pending the outcome of the bidding process. And, the court found, the taxpayer had failed to meet his burden of proving those initially deferred costs became deductible during any of the years in question. He didn’t establish when, if ever, the contracts he sought were awarded to others; when he received written notice that no contract would be awarded; or when he abandoned his bid for each project.

The evidence as to the proper timing of the deduction wasn’t the only critical information missing. The court also faulted the taxpayer for failing to adequately substantiate the expenses underlying the deductions.

Don’t Lose Out

When it comes to business expense deductions, the rules aren’t always as straightforward as you might think. And, due to the economic consequences of the novel coronavirus (COVID-19) pandemic, every dollar counts. Your CPA can help ensure you claim and document your deductions appropriately.

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Deduction Documentation Falls Short

Even if the deductions at issue in the Ashkouri case were immediately deductible (see main article), the U.S. Tax Court said, it would have upheld the IRS’s disallowance of the deductions because the taxpayer didn’t adequately substantiate the related expenses. As the court noted, taxpayers must substantiate both the amount and purpose of business expense deductions.

The documentation here (primarily spreadsheets listing deposits into the vendor’s bank accounts) established only the making of deposits. Nothing linked the deposits to specific work done to generate the payment, an invoice or similar documentation. Moreover, the taxpayer provided no documentation showing that he was the source of the funds for the deposits.

The court acknowledged that it’s allowed to estimate the amount of deductions when there’s evidence the taxpayer incurred deductible expenses — if it has some basis on which to make such an estimate. Here, though, the court concluded it didn’t have enough evidence to make even a rough estimate.