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At last I could work on an invention. I took early retirement from Westinghouse in 1989, and began to look for an idea to turn into an invention. I decided that trailerable pontoon boats were limited in size and expensive to operate and needed more side-to-side stability than could be obtained while limited to a maximum of eight feet.
I encountered a lot of technical challenges that I was able to solve. However, doing so cost plenty of money over several years. I kept excellent records of my expenses and, following the directions of my accountant, I wrote them off each year on my income tax report.
It turned out that the technical problems were only the beginning of my problems. I got a rude shock during the second year of the R&D phase of development. I was nowhere nearly ready to go into production and had plenty of work ahead to optimize efficiency and handling.
The return address on the envelope displayed the dreaded words, Internal Revenue Service, and sure enough notified me that I was to appear for an audit of my last years' tax return. I calmed myself with the thought that thousands of people get audited each year, and I had good records with original invoices for every expense that I had claimed. My return had just been selected by the computer.
I showed up on the prescribed morning with my records, check stubs, and receipts under my arm. The examiner seemed friendly and we exchanged cordial greetings in what I took for a friendly atmosphere of trust.
In this environment, I eagerly explained the intent of my project to him. I laid out the list of expenditures involved. My approach was to write off all the expenses each year as deductions and pay the taxes at the time that I sold either hardware or intellectual property. I pointed out that sales taxes has been paid on all of the material since the actual sale of the prototype almost never occurs.
The examiner informed me that he would consult with his superior (who worked in a different city) and would get back to me in a few weeks. Before leaving, I inquired why I had been chosen for an audit.
The reply was that any significant change in data from prior years causes the computer to automatically select a file. Once selected, the audit must be accomplished in full no matter what the findings are at the onset of the investigation.
The second meeting started with clarification of some expense items brought up during the first meeting, which caused me some additional work. I was then informed that an unincorporated entity cannot deduct R&D expenses. Several years prior to starting the project, I had consulted a tax preparer on the point and his findings were that it is ok to deduct as you go, but he did not mention a need to incorporate.
In the meantime, I had changed accounting firms. I asked the new firm about this practice and they could not find the code. On their advice, I consulted an attorney specializing in tax code problems.
I got an attorney who cited sections of the tax code (showing silence on any need for incorporation) indicating that you can, in fact, deduct your expenses as you go.
When the examiner was confronted with these codes and asked for an explanation for his charges, he explained that what he meant was that the computer wouldn't have selected me for audit as quickly had I been incorporated.
The other code argument is that, when starting a business, you can write off your startup expenses from your profits over the first 5 years of doing business. In this case, R&D and starting a business are not quite the same.
Once again the examiner was not able to make a decision on our findings but had to consult with his supervisor in another city. Thus we had to schedule yet another meeting. The time between meetings began to stretch out for some reason.
The next meeting, some months later, granted me use of the codes that are in my favor. But this was followed by a "fishing trip" into my expense claims.
Eventually none were denied, but this became expensive because by now I was not comfortable meeting with them without my attorney present. At one time, I invited the examiner to come visit my project site so he could get a feel for the scope of the project and the materials used. This would not have been difficult since the project site was less than a mile from the examiner's office.
The examiner declined on the basis that the rules don't allow them to leave their office. Once again the examiner had to consult with his supervisor and no decision in my favor had been made.
Months laters, we requested action on their part so that the project could proceed without the threat of back taxes and penalty. They claimed we had not properly responded on some paperwork. Fortunately, my attorney had registered all of the correspondence and the documents were produced.
More expense — more delay.
At the next meeting, the issue raised was the challenge of taxes on patents. There had been a considerable amount deducted on patent development and their interpretation was that I must pay taxes on the patents. No particular code was cited by the IRS.
The attorney and I asked to see the code supporting their claim. The code states that the sale of patents can be taxed and nothing more. At this time, no sales had been made. Again the meeting ended without a decision to stop the audit.
Finally, the attorney informed the examiner that the time limit of 2 years had passed and that I would like for the audit to end and continue without the threat of debt and penalties.
After a further period of time, I called my local state senator's office and presented my complaint. About 10 days after that, the case was closed. At last I could concentrate on solving the technical problems that still plagued me in getting the performance I wanted from the pontoon boat.
I wasted a lot of time and money and a lot of my mental energy was diverted. I have talked to my accountant and my lawyer and here are some impressions that may be useful to you: