Safaryan v. Commissioner
T.C. Memo. 2021-138

On December 13, 2021, the Tax Court issued a Memorandum Opinion in the case of Safaryan v. Commissioner (T.C. Memo. 2021-138). The primary issue presented in Safaryan was whether the petitioners were entitled to deduct certain Schedule C expenses for car and truck expenses, travel expenses, and “other” expenses.

Held: Not so much.

Background to Safaryan v. Commissioner

Safaryan trouble in paradise john krasinskiIn 2012 or 2013 the petitioner-husband purchased 10 acres of property in Newberry Springs, California. The property was in the middle of the Mojave Desert, approximately 1 mile away from any road and 120 miles away from petitioners’ residence. The petitioner-husband purchased the property with the intent of developing its natural resources, making it accessible by road, procuring a certification for organic farming, dividing it into parcels, and then renting the parcels to farmers. He called this venture “Paradise Acres.”

The petitioner-husband created a business plan, which first required him to construct a non-livable outdoor structure, similar to a barn, on the property. The business plan then required him to obtain a certification from the U.S. Department of Agriculture (USDA) certifying that the land complied with the standards set forth for organic farming. Finally, the business plan provided for the installation of an irrigation system on the property and the construction of an access road to the property.

Between the time that Paradise Acres was purchased and 2015 (the year at issue), the petitioner-husband partially installed a water tank and a rainwater collection system. He also explored the property and conducted a number of experiments, which included planting a small cactus garden, planting Mesquite trees, mapping the property, and determining the property’s topography. In addition to learning about the property for business purposes during this period, the petitioner-husband used the property for recreational activities, such as model rocket launches, archery, dry rock wall climbing, campfires, and camping. The petitioners did not claim any tax deductions relating to the Paradise Acres venture before 2015.

In 2015 the petitioner-husband, acting as the general contractor, began the construction of his non-livable outdoor structure on the property. He: (1) purchased building materials; (2) rented an industrial commercial truck to transport heavy loads of materials to the property; (3) rented a four-wheel tractor-trailer to transport the materials to the building site on the property; (4) established an unpaved vehicle access road to the property; and (5) hired day laborers to assist with the building of the non-livable outdoor structure. During 2015, the petitioner-husband worked full time as an engineer; therefore, he was available to work on the property only during weekends.

On the Schedule C of the petitioners 2015 Form 1040, the petitioners reported no gross income and claimed deductions for $12,700 of car and truck expenses, $5,580 of travel expenses, and $6,783 of other expenses, which consisted of $5,000 of startup costs and $1,783 of amortization. Petitioners reported on the Schedule C a total net loss of $25,063 for tax year 2015. In May 2018, the IRS issued the petitioners a notice of deficiency, determining a deficiency of $3,882. Attached to the notice of deficiency was a Form 886-A, Explanation of Items, explaining that the IRS had disallowed the deduction for (1) car and truck expenses and other expenses as not ordinary and necessary and (2) had disallowed the travel expenses for lack of substantiation.

Burden of Proof
Safaryan v. Commissioner
Indeed it does.

As a general rule, the IRS’s determinations are presumed correct, and the taxpayer bears the burden of proving otherwise.[1] Deductions are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed.[2] A taxpayer claiming a deduction must demonstrate that the deduction is allowable pursuant to some statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred.[3] A taxpayer is required to maintain and produce records sufficient to enable the IRS to determine the taxpayer’s correct tax liability.[4] Such records must substantiate both the amount and purpose of the claimed deductions.[5]

Under IRC § 7491(a)(1), the burden of proof may shift to the IRS if the taxpayer has introduced credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax. Under IRC § 7491(a)(2), the burden of proof, however, does not shift to the IRS unless the taxpayer complied with all substantiation requirements, maintained all required records, and cooperated with reasonable requests by the IRS.[6]

A taxpayer who provides only incredible testimony and inconclusive documentation is not considered to have provided credible evidence,[7] which is defined as evidence that, “after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted.”[8]

The Tax Court ultimately concluded that the petitioners did not introduce credible evidence with respect to the factual issues presented. The Tax Court noted that the petitioners provided only “incomplete and inconclusive” documentation, along with “incredible” (and entirely self-serving) testimony. Therefore, because the petitioners failed to introduce credible evidence with respect to the deductions, the burden did not shift to the IRS under IRC § 7491(a)(1); thus, the petitioners retained the burden of proof under Tax Court Rule 142(a), and they failed to carry the day.

Trade or Business Expense Deductions

IRC § 162(a) allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. For expenses to be deductible under IRC § 162, the expenses must actually relate to a trade or business functioning when the expenses were incurred.[9] Whether an expenditure satisfies the requirements of section 162 is a question of fact,[10] and determining whether a taxpayer’s activities constitute the carrying on of a trade or business requires an examination of the facts and circumstances of each case.[11]

Safaryan Carry OnIn order to be engaged in carrying on a trade or business under IRC § 162(a), the trade or business must actually have begun to function as a going concern, and the activities must have been performed in furtherance of the “going concern.”[12] Until that time, expenses related to that activity are not “ordinary and necessary” expenses currently deductible under IRC § 162 or IRC § 212; instead, they are classified as “start-up” or “pre-opening” expenses subject to IRC § 195.[13]

Whether a taxpayer is engaged in a trade or business is determined using a facts and circumstances test under which courts have focused on the following 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.[14] A taxpayer must demonstrate that his “predominant, primary or principal objective” in engaging in the activity was to realize a profit.[15]

The petitioners bore the burden of proving that the petitioner-husband’s activities with respect to the Paradise Acres venture constituted an active trade or business that commenced in 2015.[16] As noted above, the petitioners did not meet their burden. Although the petitioner-husband explored the property and conducted a number of experiments on it, those actions exemplify steps taken to set up a business; they do not indicate that a business has actually commenced and is presently operating as a going concern.[17] Other than the petitioner-husband’s “incredible” testimony, petitioners failed to produce any evidence to establish that petitioner husband was actively managing and engaging with potential customers to rent the property during 2015 or that he received any offers from potential customers.[18]

Because the petitioners failed to carry their evidentiary burden, the Tax Court sustained the IRS’s determination that the petitioners’ Schedule C deductions were not allowable.

  1. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  2. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
  3. IRC § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965); Treas. Reg. § 1.6001-1(a).
  4. IRC § 6001; Treas. Reg. § 1.6001-1(a).
  5. Higbee v. Commissioner, 116 T.C. 438, 440 (2001).
  6. Id. at 440-41.
  7. Id. at 445-46; see Blodgett v. Commissioner, 394 F.3d 1030 (8th Cir. 2005), aff’g T.C. Memo. 2003-212.
  8. Higbee, 116 T.C. at 442 (quoting H.R. Conf. Rept. No. 105-599, at 240 (1998)).
  9. Hardy v. Commissioner, 93 T.C. 684, 687 (1989).
  10. Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
  11. Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987); Higgins v. Commissioner, 312 U.S. 212, 217 (1941); O’Donnell v. Commissioner, 62 T.C. 781 (1974), aff’d without published opinion, 519 F.2d 1406 (7th Cir. 1975).
  12. 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).
  13. Hardy, 93 T.C. at 687-88, 691-92; see also McKelvey v. Commissioner, T.C. Memo. 2002-63, at *3 (observing that carrying on a trade or business requires a showing of more than initial research or investigation of business potential, and the business operations must have actually begun), aff’d, 76 F. App’x 806 (9th Cir. 2003).
  14. Woody v. Commissioner, T.C. Memo. 2009-93, *4, aff’d, 403 F. App’x 519 (D.C. Cir. 2010).
  15. See, e.g., Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993), aff’g T.C. Memo. 1991-212.
  16. See Tax Court Rule 142(a).
  17. See McKelvey, T.C. Memo. 202-63, at *3-*4 (concluding that, despite conducting economic and market feasibility studies of the property and test-planting trees, the taxpayer did not have an active trade or business because he had not planted any more trees, commercially harvested any trees, or even decided which trees to plant for commercial harvesting).
  18. See Charlton v. Commissioner, 114 T.C. 333, 338 (2000) (concluding that, despite incurring expenses to renovate several cabins, the taxpayer did not have an active cabin rental business until he began offering them for rent and renting them); see also Heinbockel v. Commissioner, T.C. Memo. 2013-125 (concluding that the taxpayers had not begun their vineyard business because they had not planted any vines).
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