In a recent case, the United States Tax Court addressed an increasingly hot topic: the deductibility of business expenses. More specifically, the Tax Court addressed the substantiation requirement (i.e. the extent of support that a taxpayer must provide to support a business expense deduction).
Summary of Facts:
Taxpayer was employed as a mortgage banker by a company called Quick Loan Funding and Homefield Financial Inc. He was paid wages reported on Forms W-2, Wage and Tax Statement, of $ 127,319.47 and $ 79,052.24, respec-tively.
Taxpayer included three Schedules C with his individual tax return for three separate businesses in 2007. First, tax-payer reported gross receipts of $ 2,309 and claimed deductions for car and truck expenses of $ 10,242 in connection with his business as a mortgage banker. Respondent disallowed this expense. Second, taxpayer reported no gross re-ceipts or sales but claimed total expenses of $ 69,893 ($11,922 of which was for car and truck expenses) in connection with an advertising business. Respondent disallowed all of the ZE Advertising Co. claimed expenses. Finally, taxpayer reported gross receipts of $ 43,218, claimed costs of goods sold of $ 22,587, and claimed miscellaneous advertising expenses of $ 25,560 in connection with a search engine optimization business. The IRS disallowed all deductions.
The Tax Court upheld the IRS' disallowance of taxpayer's claimed business expenses. Consequently, taxpayer was liable for taxes on the claimed deductions. Furthermore, taxpayer was liable for accuracy-related penalties for improperly claiming unsubstantiated business expense deductions.
Deductibility of Business Expenses
I.R.C. § 162(a) allows a deduction for "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." In this respect, a business expense is "ordinary" if it is normal, usual, or customary within the taxpayer's particular trade, business, or industry. Commissioner v. Heininger, 320 U.S. 467, 471 (1943); Deputy v. du Pont, 308 U.S. 488, 495 (1940). Similarly, a business expense is "necessary" if it is appropriate and helpful for the development of the business. Id.
When is an Expense a "Business Expense"?
In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the United States Supreme Court held that to be considered to be carrying on a trade or business within the meaning of section 162, "the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer's primary purpose for engaging in the activity must be for income or profit." In determining whether a taxpayer's involvement with the alleged business was sufficiently continuous and regular, it is not controlling that the taxpayer intended to operate a business, because a business may not exist or yet have commenced without a single customer. There is no business in active operation where there are no customers and no evidence of any sales efforts that could lead to customers. Goodwin v. Commissioner, 75 T.C. 424, 433 (1980), affd. 691 F.2d 490 (3d Cir. 1982); Wolfgram v. Commissioner, T.C. Memo. 2010-69.
In Baacel Roumi v. Commissioner, the taxpayer failed to establish that his claimed advertising business was in fact an ongoing business for profit as required by Section 162(a). Taxpayer presented no evidence that the business was in operation in 2007. Indeed, taxpayer testified at trial that his advertising business was "in development" in 2007. Moreover, the advertising company's taxpayer identification number was not established until January 2008. Furthermore, taxpayer did not present evidence that the business had ever generated revenue or that he had claimed expense deductions relating to it in prior tax years. On this basis, the Tax Court held that the taxpayer failed to persuasively explain why an active business generated no gross receipts or sales yet managed to generate $ 69,893 in expenses.
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