On August 23, 2021, the Tax Court issued a Memorandum Opinion in the case of Estate of Morgan v. Commissioner (T.C. Memo. 2021-104). The primary issues presented in Estate of Morgan were whether the petitioners (1) are entitled to deductions claimed on Schedule C for expenses incurred by Falcon, LLC (Falcon), and Falcon Legacy, LLC (Legacy); (2) are entitled to a net operating loss deduction attributable to an alleged NOL carryover from tax years 2010 and 2011; and (3) are liable for an accuracy-related penalty under IRC § 6662(a).

Background to Estate of Morgan v. Commissioner

The decedent-taxpayer was a homebuilder, which was not the best field to be in around 2008, during the recession. In 2009, a receiver was appointed for the petitioners’ homebuilding entities. The decedent formed a company in 2008 (Legacy) to search for new business opportunities. The decedent-taxpayer also continued to fly aircraft that he owned through an entity (Falcon).

For 2010 and 2011 Falcon was taxed as a partnership, and its partners included the decedent and an S corporation. For 2012, the decedent was Falcon’s sole owner, resulting in the partnership’s termination and Falcon’s taxation as a disregarded entity. The petitioners’ returns were prepared by their long-time CPA. The decedent provided all appropriate documentation to the CPA and provided all requested information promptly.

In the notice of deficiency, the IRS disallowed the $819,956 Schedule C deduction for Falcon’s expenses, the $648,118 Schedule E deduction for Legacy’s loss due to unreimbursed expenses, and the $966,121 NOL deduction. As a result of these adjustments the IRS determined that the correct amount of tax due from petitioners for 2012 is $407,214. The petitioners reported $38,555 of tax on their 2012 Form 1040, leaving the $368,659 deficiency.

Legal Background: Carrying on a Trade or Business

A taxpayer must prove entitlement to any deductions and credits claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

IRC § 162(a) allows as a deduction all the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Neither the Code nor the regulations provide a generally applicable definition of the term “trade or business”. Commissioner v. Groetzinger, 480 U.S. 23, 27 (1987); McManus v. Commissioner, T.C. Memo. 1987-457, aff’d without published opinion, 865 F.2d 255 (4th Cir. 1988). Determining the existence of a trade or business “requires an examination of the facts in each case.” Groetzinger, 480 U.S. at 36 (quoting Higgins v. Commissioner, 312 U.S. 212, 217 (1941)).

In examining the facts of each case to determine the existence of a trade or business the Tax Court has focused on three factors: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer’s activity has actually commenced. See, e.g., Weaver v. Commissioner, T.C. Memo. 2004-108 at *6; McManus, T.C. Memo. 1987-457.

With respect to the third test, even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not “engaged in carrying on any trade or business” within the intendment of IRC § 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965).

Stated otherwise, a taxpayer must show “more than initial research into or investigation of business potential” to cross the threshold into “carrying on a trade or business.” Glotov v. Commissioner, T.C. Memo. 2007-147 (citing Dean v. Commissioner, 56 T.C. 895, 902 (1971); McKelvey v. Commissioner, T.C. Memo. 2002-63, aff’d, 76 F. App’x 806 (9th Cir. 2003)). Crossing that threshold does not require that the business succeed, but it must engage in business. Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620-21 (7th Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. Memo. 1994-316. Before crossing the threshold of carrying on a trade or business, the taxpayer is in the province of IRC § 195.[1]

Start-Up Expenditures

IRC § 195(a) provides the general rule that no current deduction is allowed for start-up expenditures.[2] Although not deductible “before the day on which the active trade or business begins,” IRC § 195(c)(1)(A)(iii), start-up expenditures may be deducted, or capitalized and deducted over time, upon a taxpayer’s becoming actively engaged in a trade or business. See IRC § 195(b); Treas. Reg. § 1.195-1; see also Cabintaxi Corp., 63 F.3d at 619; T.C. Memo. 2018-147, at *13.

IRC § 195(c)(1)(A)-(B) defines “start-up expenditure” to include any amount paid or incurred in connection with

1. investigating the creation or acquisition of an active trade or business;
2. creating an active trade or business, or
3. any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and which, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred.

The legislative history of IRC § 195 states that start-up expenditures are those incurred to study and choose a potential business, and, once a business is chosen, to prepare to begin that business by compensating employees and consultants and traveling as needed. See H. Rept. 96-1278, at 10-11 (1980); H. Rept. 96-1278, at 10-11 (1980); S. Rept. 96-1036, at 11-12 (1980).

The taxpayer must make the preliminary choices of whether to enter into business and which business to enter. If the taxpayer has not made these choices, at the most he is still incurring investigatory costs.[3] If the taxpayer has made these choices, the next step is getting that business to “function as a going concern and perform those activities for which it was organized.” Richmond Television Corp., 345 F.2d at 907. This is the step that allows the taxpayer to deduct expenses under IRC § 162.

The taxpayer does not have to succeed, even so far as to have a single penny of income, in order to be engaged in a trade or business. Cabintaxi Corp., 63 F.3d at 620. But it must intend to engage in a business (make the “whether” and “which” choices) and perform activities for which it was organized.

Short of taking that step and performing the functions for which a business was organized, the taxpayer cannot deduct expenses. Cabintaxi Corp., 63 F.3d at 620, directs the Tax Court to compare Jackson v. Commissioner, 864 F.2d 1521, 1526 n.7 (10th Cir. 1989), aff’g on this issue 86 T.C. 492 (1986). In Jackson, the taxpayers organized a business to sell audio players/recorders and obtained a license to do so.

However, the taxpayers made no “legitimate efforts” to locate potential buyers for the players/recorders, a finding which was fatal to their case. Id. at 1526. The court held that merely possessing the legal capability to sell player/recorders by obtaining a license from the inventor, without actual efforts to sell the products, is insufficient to constitute carrying on a trade or business for purposes of IRC § 162.

Further, in Richmond Television Corp., 345 F.2d at 907—the case that gave the oft-quoted “function[ing] as a going concern” test—the taxpayer could not currently deduct training costs incurred before and after issuance of a construction permit for a television station because the television station was not in business until it obtained its license and began broadcasting.[4] In each of these cases the taxpayer was still investigating or creating a trade or business, or the business had not yet begun. See IRC § 195(c)(1)(A).

Acquisition can be the means of beginning a trade or business: If a trade or business is acquired, it is deemed to begin when the taxpayer acquires it. IRC § 195(c)(2)(B). If a prior trade or business never ceased, the taxpayer need not begin a new trade or business; business investigation expenses are deductible if they are incident to an existing trade or business. See O’Donnell v. Commissioner, 62 T.C. 781, 785 (1974), aff’d without published opinion, 519 F.2d 1406 (7th Cir. 1975); Frank v. Commissioner, 20 T.C. 511, 513 (1953).

The Tax Court’s Conclusion

The Tax Court ultimately concluded that the decedent was no longer carrying on a trade or business within the meaning of IRC § 162 after the homebuilding entities were placed in receivership in 2009. The Tax Court, therefore, sustained the IRS’s disallowance of the Schedule C and Schedule E deductions in issue.

The receivership spelled the end of the decedent’s homebuilding trade or business, and his continued activities in the aftermath of the recession and receivership–namely, the use of Legacy to search for a new trade or business and the continued existence of Falcon—did not constitute an active trade or business in 2010, 2011, or 2012.

Because the decedent was not engaged in a trade or business, the NOL carryover was disallowed. However, the petitioners reasonably relied on the advice of a competent tax professional. As such they were not liable for the IRC § 6662(a) accuracy related penalties.

(T.C. Memo. 2021-104) Estate of Morgan v. Commissioner

Footnotes:

[1] See Weaver, T.C. Memo. 2004-108 at *5 (observing that implicit in the foregoing definitions is the concept that a taxpayer must in fact be ‘carrying on’ a trade or business for expenditures to be deductible under IRC § 162, and that such limitation is made explicit in IRC § 195).

[2] See Yapp v. Commissioner, T.C. Memo. 2018-147, at *13, aff’d, 818 F. App’x 743 (9th Cir. 2020); see also Fishman v. Commissioner, 837 F.2d 309, 312 (7th Cir. 1988) (noting “in a long line of decisions under IRC § 162, the courts (including the Tax Court) have held that ‘pre-opening’ expenses, that is, expenses incurred before the taxpayer’s trade or business begins to operate (what the Tax Court is calling ‘start-up-costs’), are not deductible”), rev’g T.C. Memo. 1986-127.

[3] See IRC § 195(c)(1)(A)(i); Rev. Rul. 99-23 (concluding that amounts spent hiring an investment banker to conduct research on several industries and evaluate publicly available financial information related to several businesses are “typical of the costs related to a general investigation” because they are “expenditures paid or incurred in order to determine whether to enter a new business and which new business to enter” and are therefore start-up expenditures under IRC § 195).

[4] Madison Gas & Elec. Co. v. Commissioner, 72 T.C. 521, 566-567 (1979) (rejecting the taxpayer’s argument that the date of issuance of a provisional construction permit should be considered the date of commencement of the partnership business and holding that the expenses the taxpayer sought to deduct were preoperational costs of the partnership’s initial activity and therefore must be capitalized), aff’d, 633 F.2d 512 (7th Cir. 1980); McKelvey v. Commissioner, 2002 WL 341044, at *3; Provitola v. Commissioner, 2021 WL 2390370, at *4 (11th Cir. 2021).

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