Tax Court In Brief: Trade Or Business And Deductibility Of Expenses

Tax Court In Brief: Trade Or Business

Estate of Charles P. Morgan, Deceased, Roxanna L. Morgan, Personal Representative and Roxanna L. Morgan v. Comm’r, T.C. Memo 2021-104| August 23, 2021 | Pugh, J. | Dkt. No. 592-18

Short Summary:  The case analyzed whether activities carried to acquire a business rise to the level of a trade or business, and thus, whether related expenses are deductible. Additionally, the case discusses the framework applicable to establish reasonable cause based on reliance on a tax professional.

Mr. Morgan (the petitioner) was a real estate developer. During the 1983-2009 period he actively owned and was involved in various real estate companies. During the 2009 financial crisis, his real estate companies were severely impacted because of lack of liquidity and eventually, his creditors requested the appointment of a receiver. Upon the appointment, the receiver was in sole control of the petitioner’s companies, and he was prohibited from incurring expenses on behalf of the companies that were under the receiver’s control.

As consequence of the above, petitioner spent vacation time and later decided to start a new business, through a single-member LLC, Legacy. The purpose of his new venture was to acquire a business. Petitioner recorded his time spent working as “business search” and deducted various expenses related to the search of a possible target acquisition. Aside from Legacy, petitioner also owned another entity, Falcon, that was used to hold and operate an aircraft. Legacy paid consulting fees to Falcon, and Falcon’s expenses were related to the use and maintenance of the aircraft. Legacy deducted the consulting fee paid to Falcon. Finally, petitioner claimed Net Operating Losses (NOL) for both Legacy and Falcon, derived from previous years. The IRS disallowed the expenses and issued a notice of deficiency and imposed a penalty under section 6662 (underpayment due to negligence or substantial understatement of income tax).

The Tax Court determined that petitioner business of searching for target acquisition did not constitute a trade or business because no business had been started yet. Therefore the expenses were rejected. However, the Court rejected the imposition of the 6662 penalty because the petitioner showed reasonable cause based on reliance on a tax professional.

Key Issues: Whether the acquisition of a business constitutes itself a trade or business?

Primary HoldingsThe search of an active or existing trade or business is not a trade or business. Related expenses fall within Section 195(c)(1)(A)(i) as start-up expenses rather than expenses related to a trade or business.

Key Points of Law:

Section 162 allows taxpayers to deduct expenses paid or incurred on any trade or business. To determine the existence of a trade or business, three main factors are relevant: carrying the activity for profit, that the taxpayer is regularly and actively involved in the activity and that the activity has actually commenced. See Weaver v. Commissioner, T.C. Memo. 2004-108 , 2004 WL 938293 , at *6 ; McManus v. Commissioner, T.C. Memo 1987-457 , 1987 Tax Ct. [54 T.C.M. (CCH) 475], Memo LEXIS 454, at *20. To properly commence a business, the taxpayer must engage in such business. See Cabintaxi Corp. v. Commissioner, 63 F. 3d 614 , 620-621 (7th Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. Memo. 1994-316.

If there is no business yet, Section 195(a) provides that no deduction is allowed for start-up expenses. Legislative history includes as start-up expenses those incurred in the study and choose of potential business, and those to prepare to begin that business. See H. Rept. 96-1278 , at 10-11 (1980), 1980- 2 C.B. 709, 712; S. Rept. 96-1036, at 11-12 (1980), 1980 U.S.C. C.A.N. 7293, 7301. If taxpayer has yet not decided to enter into a business or which business to enter, any expenses is considered as an investigatory cost under Section 195(c). Once the business is chosen, and the business starts functioning as a going concern and performs the activities for which it was organized, any expense incurred falls within Section 162, because there is an existing trade or business.

In this particular case, petitioner argued that his expenses were deductible under Section 162 under two theories. First, petitioner argued that his homebuilding activities never ceased. The Court determined that this argument was without merit because the taxpayer considered himself as no longer carrying a homebuilding business (based on his testimony) and also, because the receivership terms clearly stated that the taxpayer could not be engaged in his previous business.

Second, taxpayer argued that the search for a new trade or business to acquire was itself an active trade or business. The Court rejected this argument for both entities, Legacy and Falcon. For Legacy, the Court ruled that the business investigation expenses that were claimed, fell within the start-up expenditures of Section 195(c)(1)(A)(i) as “amounts paid or incurred in connection with investigating the creation or acquisition of an active trade or business”. These included paid employees and outside consultants. This argument was supported by the fact that no business was acquired by petitioner. For Falcon, the Court concluded that such entity did not lease the aircraft and only income came from petitioner and Legacy, thereby no trade or business existed.

In sum, the Court concluded that no trade or business was carried by both Legacy and Falcon and rejected the related expenses.

The Court also ruled on NOLs related to the trade or business which were rejected based on the same conclusion that there was no trade or business for both Legacy and Falcon. A determination for partnership was also made and followed the same conclusion as above (no existence of trade or business).

Finally, as for the Section 6662(a) penalty, the Court determined that reasonable cause existed in this case because the taxpayer relied on professional advice, and the adviser was a competent professional with sufficient expertise to justify reliance, the taxpayer provided all necessary and accurate information to the adviser and the taxpayer actually relied in good faith on the adviser’s judgment. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225 , 246 (2018); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 , 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). In this case, the tax preparer, a CPA, was professionally licensed and knew the petitioners’ personal and business affairs. Secondly, petitioner provided necessary and accurate information to his tax adviser and third, petitioner relied on his tax adviser, because he had been preparing his returns for over a decade.

Insight This case is relevant specially in certain business ventures, for example SPACs (Special Purpose Acquisition Ventures), whose main purpose is to acquire an existing venture. Special consideration must be given to the determination as to whether a trade or business exists in those cases and if not, determine the most appropriate manner on how to characterize the expenses related.

This case is also relevant to understand the general framework of establishing reasonable cause, which usually applies in multiple settings around the Code.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

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Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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