On April 14, 2020, the Tax Court issued a Memorandum Opinion in the case of Williams v. Commissioner (T.C. Memo. 2020-48). The primary issue before the court in Williams v. Commissioner was whether the petitioners were entitled to deductions on Schedule C (Profit or Loss from Business) for the expenses of the petitioner-husband’s new business venture as he grew it and prior to the business’ actual operation.
The Basic Nature of Deductions in Williams v. Commissioner
As a starting point, taxpayers generally bear the burden of proving that they have met all requirements to be entitled to any deductions claimed. See Tax Court Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers must maintain sufficient records to enable the IRS to determine their correct tax liability. IRC § 6001.
The determination of whether an expenditure satisfies the requirements of IRC § 162 is a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). Business deductions are deductible if ordinary and necessary expenses, and such expenses were incurred in carrying on a trade or business. IRC § 162(a); Treas. Reg. § 1.162-1(a). Deductions are not permitted if the expense is personal, living, or family in nature, nor are deductions permitted for capital expenditures. See IRC § 262; IRC § 263.
Substantial Substantive Substantiation
The Cohan rule permits the Tax Court to estimate the deductible amount of the expense if the taxpayer presents sufficient evidence to establish a rational basis for making the estimate. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the amount allowable, the Tax Court bears heavily against the taxpayer who failed to maintain records and whose inexactitude is, therefore, of his own making. See Cohan, 39 F.2d at 544.
The Cohan rule, however, does not apply to estimating travel, gift, entertainment, and listed property (including passenger automobiles) expenses set forth in IRC § 274. See IRC § 274(d); Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969); Treas. Reg. § 1.274-5T(a). Under IRC § 274(d), the taxpayer’s self-serving testimony will not suffice. The Tax Court requires that the taxpayer corroborate his statement through adequate records or sufficient other evidence. Treas. Reg. § 1.274-5T(c)(3)(i).
Records are adequate and documents are sufficient if they set out each of the following elements. First, the evidence must show the precise amount of the expense, not just an estimate. Second, the evidence must set forth the time and place the expense was incurred. Third, the evidence must demonstrate the actual business purpose of the expense. Fourth (if it is an entertainment or gift expense), the evidence must show the business relationship to the taxpayer of each expense. See Treas. Reg. § 1.274-5T(b)(6)(i).
Records and “other sufficient evidence” are held to two different, but equally exacting, standards. Substantiation by adequate records requires the taxpayer to maintain an account book, a diary, a log, a statement of expense, trip sheets, or a similar record prepared contemporaneously with the expenditure and documentary evidence, such as receipts or bills. Treas. Reg. § 1.274-5(c)(2)(iii); Treas. Reg. § 1.274-5T(c)(2).
Substantiation by other sufficient evidence requires the production of corroborative evidence in support of the taxpayer’s statement specifically detailing the required elements. Treas. Reg. § 1.274-5T(c)(3). The latter standard may seem less stringent, but in practice, proof of either type of evidentiary category is exacting.
A business must be “functioning as a going concern” in order for expenses attributable to it to be deductible, meaning that the operations of the business must have actually commenced. Woody v. Commissioner, T.C. Memo. 2009-93, aff’d, 403 F. App’x 519 (D.C. Cir. 2010); Glotov v. Commissioner, T.C. Memo. 2007-147; Walsh v. Commissioner, T.C. Memo. 1988-242. Although a taxpayer may be committed to entering into a business and invest considerable time and money in preparing to do so, the activity does not constitute a trade or business for IRC § 162(a) purposes until the business is actually functioning and performing the activities for which it was organized. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965); Glotov, T.C. Memo. 2007-147.
Until such a time that the business is actually operating, expenses related to it are not considered ordinary or necessary expenses currently deductible under IRC § 162, nor are they deductible under IRC § 212 (as income producing activities); rather, they are start-up or pre-opening expenses as defined in IRC § 195. Woody, T.C. Memo. 2009-93 at *9-*10. Start-up expenses may be partially deducted, but their limit is low, and an election is required under IRC § 195(b)(1)(A) (election to deduct up to $5,000 of startup expenditures, reduced by the amount by which those expenditures exceed $50,000).
Thus, in the Williams case, the Tax Court found that because petitioner-husband’s new company’s only activity in 2010 was the pursuit of potential targets, pursuant to IRC § 195(c)(1), expenditures related to these activities were paid in connection with investigating the creation or acquisition of an active trade or business and not actually operating the business. Accordingly, for 2010 petitioners were not entitled to deductions for these client solicitation expenses. See IRC § 195(a).Add to favorites