Taxes in Your Practice: Tax court denies deductions for new business search
Vol. 77, No. 5 / Sept. - Oct. 2021
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
The Tax Court recently denied deductions for costs to search for a new trade or business. In Estate of Charles P. Morgan, Deceased and Roxanna L. Morgan v. Commissioner, T.C. Memo. 2021-104, the Tax Court upheld the Internal Revenue Service disallowance of deductions and net operating loss (NOL) carryovers but rejected the IRS imposition of penalties.
The court found that Charles Morgan was no longer carrying on a trade or business after prior businesses were placed in receivership, and the entities he used to search for a new trade or business or a continuation of prior activity did not qualify for trade or business deductions during the years in question.
Morgan was a residential real estate developer, with a variety of business entities in the home building business, Morgan entities. From 1983-2009, the Morgan entities built thousands of homes in Indiana and North Carolina. Morgan owned the entities and was involved in the operations and management. Leading into 2009, the real estate and financial markets declined, as did the Morgan entities’ homebuilding business. By 2009, the Morgan entities had millions of dollars of debt in default, and by March 2009 their creditors successfully obtained an order appointing a third-party receiver for all five Morgan entities.
During the receivership, including the 2010-2012 tax years, the receiver was in sole control of the Morgan entities, subject to court supervision. Pursuant to the receivership terms, Morgan was prohibited from infringing on the receiver’s authority or incurring expenses on behalf of the Morgan entities. After the receiver took over the Morgan entities, Morgan began searching for a new trade or business through a single-member limited liability company called Legacy, which was taxed as a disregarded entity for 2010-2012.
The Legacy search was not limited to any one business or industry and was actively engaged. Legacy employed some former employees of the Morgan entities, who logged time on Legacy’s business search as well as the Morgan’s other activities. Morgan also tracked his time working for Legacy and labeled it “business search/forward looking.” Legacy identified potential new business opportunities during these time periods and entered into nondisclosure agreements, but Legacy made no purchase offers or acquisitions before the end of 2012.
Morgan also had an entity called Falcon that had owned, operated, and maintained aircraft for many years, including significant use by the Morgan entities when they were under Morgan’s control. During the time periods in question, Morgan continued to fly aircraft owned by Falcon in his search for new business opportunities. Falcon did not lease aircraft or provide services to any unrelated third parties. Falcon filed partnership returns for 2010 and 2011, including Morgan and another entity as partners; Falcon was reported as a disregarded entity for 2012, with Morgan as sole owner.
Legacy and Falcon both reported significant losses for 2012. Legacy reported no gross receipts, and its expenses included consulting fees paid to Falcon, business investigation expenses and other expenses related to the former Morgan entity employees’ searches for business opportunities, provision of personal services to the petitioners, and management of Falcon. Falcon had total expenses for the use and maintenance of Falcon’s aircraft well in excess of the fees paid to Falcon by Legacy for consulting and use of the aircraft in 2012.
The petitioners also claimed a significant net operating loss deduction on their 2012 return. This deduction included NOL carryforwards from the 2010 and 2011 tax years generated primarily by similar Legacy and Falcon losses and expenses.
On audit of the 2012 tax return, the IRS disallowed deductions for Legacy and Falcon losses and expenses, as well as disallowed the NOL carryforward deduction. The IRS also determined that the petitioners were liable for a § 6662 accuracy-related penalty for negligence or substantial underpayment.
Tax Court Opinion – Business Expense Deductions
The court framed the deductibility question for Legacy and Falcon deductions with a simple question: “Were they carrying on a trade or business in that year?”
Section 162(a) allows a deduction for all ordinary and necessary expenses in carrying on any trade or business. Citing prior cases, the court identified three factors to make this factual determination: “(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.” With respect to the third factor, the court stated that “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.”
The court also noted that start-up expenditures are not deductible under the general rule of § 195(a). Section 195(c)(1) defines “start-up expenditure” to include amounts paid or incurred to investigate creation or acquisition of an active trade or business; to create an active trade or business; or any activity engaged in for profit or 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. These start-up expenditures are not deductible until an active trade or business begins, but they may be deducted or capitalized once a taxpayer becomes actively engaged in the trade or business.
The IRS argued that Morgan was no longer carrying on a trade or business once the Morgan entities were placed into receivership in 2009. The petitioners argued that Morgan’s continued engagement with the homebuilding industry after the receiver was appointed constituted an ongoing trade or business and that Morgan’s search for a new business acquisition was related to this trade or business.
The court observed that the cessation of homebuilding activity by the Morgan entities and the order appointing the receiver confirm that Morgan’s prior homebuilding trade or business ceased in 2009. All homebuilding employees were terminated in February 2009 and the Morgan entities did not continue building homes, which the court viewed as a practical shut down of the business. The court also rejected the argument that Morgan’s loan to a former colleague and friend for development opportunities demonstrated regular and continuous activity in the homebuilding business.
Despite arguments that he made efforts between 2009-2012 to continue his trade or business and had genuine intent, the court found that this did not overcome evidence that Morgan neither built nor sold homes during this period and that he was unsure whether he would return to the homebuilding industry.
Based on this analysis, the court found that Morgan did not carry on a homebuilding trade or business after the appointment of a receiver for the Morgan entities. As a result, the court rejected the petitioners’ argument that there was an active trade or business relating to Falcon’s aircraft maintenance expenses and Legacy’s business search expenses.
The court then turned to the Legacy and Falcon activities during the years in question. The petitioners argued that Legacy was formed, hired employees, and engaged outside consultants to establish its trade or business, and further argued that Falcon supported Legacy in its search activities by providing the same services it previously provided to the Morgan entities. With respect to Legacy, the court concluded that its general business search was not “carrying on any trade or business” under § 162, and the Legacy “business investigation expenses” fit the definition of start-up expenditures under § 195. Since a new business was not acquired by the end of 2012, the court found that Morgan was not carrying on a trade or business through his search for a new acquisition through Legacy.
With respect to Falcon, the court noted that its activities had never been an independent trade or business relative to the Morgan entities. After the Morgan entities receivership, Falcon listed its principal business as consulting, but the court stated that the petitioners never established Falcon’s consulting was anything more than transporting the Morgans and related individuals. Falcon did not lease an aircraft or provide services to unrelated third parties at any time, and its only gross receipts came from the petitioners and Legacy. As a result, the court also rejected the petitioners’ argument that Legacy carried on a trade or business during the years in question.
Tax Court Opinion - Net Operating Losses
The court next addressed whether the petitioners were entitled to an NOL deduction in 2012 for NOL carryovers from 2010 and 2011. Section 172 allows an NOL deduction for a taxable year, by aggregating NOL carryforwards and NOL carrybacks to the taxable year. In this case, the IRS argued that the petitioners’ 2010 and 2011 expenses were not allowable for an NOL deduction because they were the same type as the expenses Legacy and Falcon claimed in 2012, and petitioners were not carrying on a trade or business in 2010 or 2011. The court agreed and found that Legacy’s 2010 and 2011 expenses could not carry over to 2012 under § 172.
With respect to Falcon, the petitioners successfully argued that the IRS had not initiated an audit of the Falcon partnership returns for 2010 and 2011, resulting in those returns being final under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). This precluded the IRS from disallowing claimed deductions on the Falcon partnership returns. However, the court further concluded that the petitioners’ outside basis in Falcon was not a TEFRA partnership item, resulting in a partner-level determination of outside basis and flow through of losses from Falcon to the petitioners. The court, finding that the petitioners failed to substantiate outside basis in Falcon, concluded that the petitioners failed to prove adequate basis to establish the NOLs for 2010 and 2011.
Tac Court Opinion - Accuracy-Related Penalty
The IRS imposed a § 6662(a) accuracy-related penalty for negligence or disregard of rules or regulations and/or a substantial understatement of income tax. The court notes the IRS initially presented sufficient evidence to support imposition of this penalty and properly obtained internal supervisory approval. The court then addressed whether the petitioners could avoid the penalty by showing they acted with reasonable cause and in good faith with respect to the underpayment.
The petitioners argued they had reasonable cause for the tax return reporting positions because they reasonably relied on tax advisers when reporting the Legacy and Falcon expenses. The court noted that reasonable reliance on professional advice may meet the reasonable cause and good faith requirements if a taxpayer proves by a preponderance of the evidence that “(1) the adviser was a competent professional with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.” The court found that the petitioners’ advisers were competent and that the petitioners provided necessary and accurate information to the advisers. With respect to the third requirement, the court found that the petitioners received advice and relied on it in good faith, given testimony that Morgan actively worked with the advisers to determine how to report key items and the advisers had been preparing the petitioners’ returns for over a decade. Based on these conclusions, the court held that the petitioners were not liable for the § 6662 accuracy-related penalty.
Estate of Charles P. Morgan is a reminder that start-up expenses may not be deductible, even if a taxpayer has previously been in business. The court’s analysis also highlights the difficulty in navigating these issues through receivership and restarting of activities. Importantly, the case also shows that engaging competent tax professionals, providing them with necessary and accurate information, and being aware of tax issues can help establish reasonable cause to avoid penalties on issues later challenged by the IRS.
1 Scott E. Vincent is the founding member of Vincent Law, LLC, in Kansas City.