Deducting Losses from a Startup Business

Dear Tax Talk:

Q. Three years ago, we opened a retail store. This year our rental contract expires and we decided to let go of our business. Unfortunately, the $90,000 that we used to open this business did not materialize. What are the business losses that I can apply?
-- Mildred

Dear Mildred,

While you may have started your business with $90,000, your tax deduction for this initial capital depends on how it was put to work.

Let's assume your original $90,000 was used for the following purposes.

Example business costs

Inventory: $30,000
Rent/utility deposits $10,000
Displays/racks $40,000
Cash in bank $10,000

The initial inventory has probably been sold and replaced over the three years, so that it is no longer carried at a cost of $30,000. When you close the store, the current cost of your ending inventory needs to be measured against its value to determine your loss or gain. If you sell your ending inventory, the difference between its cost and selling price will be an ordinary loss (or gain) to the business. If you throw it away, the ending cost is an ordinary loss as well.

If your deposits are returned, you have no further tax deduction, as they were converted into cash. If they are applied to final bills, then you would write off the deposits in accordance with their application, such as rent or utilities.

The displays and racks should have been depreciated over seven years. Because you have an unrecovered basis in the original cost, the most likely loss on their disposal will result in a section 1231 loss to the business. Use Form 4797 to report a section 1231 loss, which is also an ordinary deduction.

The original cash in the bank has either been used in the business and accordingly deducted or is available for withdrawal when the store is closed. Either way, there is no gain or loss on this original capital.

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