Freeman Law | The Tax Court in Brief

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Freeman Law | The Tax Court in Brief

The Tax Court in Brief

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

Tax Litigation: The Week of December 13 – December 18, 2021

Antonyan, et. al. v. Comm’r, TC Memo. 2021-138 | December 13, 2021 | Nega, J. | Dkt. No. 13741-18

Opinion

Short Summary: In 2012 or 2013, Mr. Antonyan purchased 10 acres in the middle of the Mojave Desert, around 1 mile away from any road. Mr. Antonyan intended to develop the property’s natural resources and, ultimately, rent parcels of the property to farmers for organic farming.  He called this venture “Paradise Acres.” Mr. Antonyan devised a business plan for Paradise Acres, according to which he would undertake the following steps: 1) build a barn-like structure on the property; 2) obtain USDA certification that the property complied with organic farming standards; 3) install an irrigation system on the property; and 4) build an access road to the property.

Prior to 2015, Mr. Antonyan had partially installed a water tank and rainwater collection system on the property, explored and mapped the property, and experimented with growing certain plants on the property. He also used the property for recreational activities.

In 2015 Mr. Antonyan began construction on the barn-like structure. He purchased building materials, rented a commercial truck and tractor-trailer to transport materials to the property, created an unpaved road to access the property, and hired workers to assist in building the structure. During this time, Mr. Antonyan could only work on the property on weekends because of his full-time job as an engineer.

Mr. Antonyan and Ms. Safaryan (the “Petitioners”) filed a joint income tax return for 2015. Attached to this return was a Schedule C for Paradise Acres.  The Schedule C reported no gross income and claimed deductions for car and truck expenses, travel expenses, start-up costs, and amortization. The Petitioners had not attempted to claim deductions in connection with Paradise Acres in previous years.

On May 11, 2018, the Internal Revenue Service issued a notice of deficiency for 2015 to the Petitioners disallowing the Petitioners’ Schedule C deductions.

Key Issues:

  • (1) Were the Petitioners entitled to deduct expenses relating to Paradise Acres as ordinary and necessary trade or business expenses under Section 162 in 2015?
  • (2) Were the Petitioners entitled to deduct start-up costs and amortization expenses relating to Paradise Acres as start-up expenses for an active trade or business under Section 195 in 2015?

Primary Holdings:

  • The Petitioners were not entitled to deduct expenses relating to Paradise Acres as ordinary and necessary trade or business expenses under Section 162. Mr. Antonyan’s activities in connection with Paradise Acres in 2015 did not amount to a trade or business but were, instead, merely activities taken to set up a trade or business. Mr. Antonyan had not completed any of the steps set forth in his business plan by the end of 2015, which indicated that the Paradise Acres venture was not an active trade or business in that year. Even assuming that none of the steps in the business plan were necessary to rent the property, the Petitioners still failed to produce any credible evidence that Mr. Antonyan was actively engaging with potential customers to rent the property during 2015.
  • The Petitioners were not entitled to deduct start-up costs and amortization expenses relating to Paradise Acres as start-up expenses for an active trade or business under Section 195 in 2015. Per the reasoning set out above, the Paradise Acres venture was not an active trade or business in 2015.

Key Points of Law:

  • A taxpayer may deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business during the taxable year. I.R.C. § 162(a).
  • To be deductible under Section 162, expenses must relate to a trade or business functioning when the expenses were incurred. See Hardy v. Commissioner, 93 T.C. 684, 687 (1989). Until then, expenses are not “ordinary and necessary” expenses deductible under Section 162 but rather start-up expenses subject to the requirements of Section 195. Id. at 687-88.
  • Whether a taxpayer is presently engaged in a trade or business is determined by examining the facts and circumstances, including: (1) whether the taxpayer intends to earn a profit from the activity; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer has begun the activity. See Woody v. Commissioner, T.C. Memo. 2009-93, aff’d, 403 F. App’x 519 (D.C. Cir. 2010).
  • Activities taken to set up a business (such as exploration and experimentation) do not indicate that a business has commenced and is presently a going concern. See McKelvey v. Commissioner, T.C. Memo. 2002-63.
  • A taxpayer is allowed to deduct certain start-up expenses in the taxable year in which the taxpayer begins an active trade or business in an amount equal to the lesser of the amount of start-up expenses or $5,000, reduced (but not below zero) by the amount by which such expenses exceed $50,000. I.R.C. § 195(b)(1)(A). Any remaining start-up expenses are deducted ratably over the 15-year period beginning with the month in which the active trade or business begins. Id. § 195(b)(1)(B).

Insight: Antonyan highlights the basic requirements for being able to deduct expenses under Section 162 and Section 195. It also demonstrates the importance of keeping records relating to trade or business activities in order to prove up the existence of a trade or business within a given year and the possible consequences of failing to adhere to a business plan.


Mitchel Skolnick and Leslie Skolnick, et al., v. Comm’r, T.C. Memorandum 2021-139| December 16, 2021 | Lauber, J. | Dkt. Nos. 24649-19, 24650-16, 24980-16.

Short SummaryThe main issue in this case is whether the taxpayers’ horse breeding activity was operated with the intent to make a profit under section I.R.C. 183 during the 2010-2013 period (the tax years). Additionally, the case discussed if the losses generated in the horse activity of the taxpayers were deductible as carryforwards to the tax years.

Mitchel Skolnick and Eric Freeman (the taxpayers) were co-owners of Bluestone Farms, an LLC taxed as a partnership for federal tax purposes. Bluestone Farms was engaged in the breeding of Standardbred horses. Since its incorporation, Bluestone incurred in considerable losses despite the various business plans prepared by Mr. Skolnick which envisioned a future gain. The losses continued to accrue during the 2010-2013 period. Bluestone did not derive any gain until 2016, when it sold its breeding rights in one of its horses.

Mr. Skolnick (owner of 70% of Bluestone) performed high-level activities in Bluestone, such as nominal supervision of the employees of Bluestone. He was not involved in de the day-to-day operation of the breeding activity. Mr. Freeman (owner of 15% of Bluestone) had no direct involvement in Bluestone’s operations.

The taxpayers’ CPA advised that Bluestone’s losses were deductible on their personal tax returns during the tax years. The IRS issued a notice of deficiency, and a timely petition was filed by each taxpayer.

Key Issues: Whether the taxpayers’ horse activities were engaged with the intent to make a profit as provided by section 183 of the I.R.C. As a follow-up question, whether the taxpayers were entitled to the NOL carryforwards derived from their horse activities.

Primary Holdings: The taxpayers horse activities were not engaged in for profit.

Key Points of Law:

The Court determined that the horse activities of the taxpayers were not engaged with the intent to make a profit, as provided by I.R.C. 183. Section 183 provides that all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. I.R.C. § 183. If the activity is not engaged in for profit, no deduction is allowed except to the extent of gross income derived from the activity. I.R.C. § 183(b). The taxpayer must have an actual and honest objective of making a profit. See Hulter v. Commissioner, 91 T.C. 371, 392 (1988). To make such determination, the Court loos at objective facts rather than the taxpayer’s assertions. See Keanini v. Commissioner, 94 T.C. 41 , 46 (1990).

As a corollary of the above, losses are not allowable for an activity that a taxpayer carries on… primarily for sport, as a hobby, or for recreation. Treas. Reg. § 1.183-2(a). Consequently, “hobby losses” are not allowed.

In the case of activities involving the breeding, training, showing, or racing of horses, it is presumed that the taxpayer is engaged in an activity for profit if the activity produces gross income in excess of deductions for any 2 out of 7 consecutive years ending with the tax year. I.R.C. § 183(d).

If the safe harbor is not applicable, the Regulations provide with a list of factors that are relevant to ascertain the existence of the intent to earn a profit. Treas. Reg. § 1.1832(b). In this case, the Court discussed all these 9 factors as follows:

  1. Manner in which the taxpayer conducts the activity. The activity must be carried in a businesslike manner which may indicate the activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(1). “Businesslike manner” is suggested by the maintenance of books and records and a plausible business plan. Ibid. In this case, the taxpayers maintained voluminous records of their horse activities. However, such records had critical gaps, such as lack of documentation of the initial contributions made by the taxpayers. More relevantly, such records were not used to improve profitability and implement techniques for controlling expenses and increase income.

Additionally, the taxpayers did not have a current business plan (the more recent was in 2004).

Also, Bluestone’s activities were insensitive to costs and there was a blending of business and personal elements (such as some expenses made for the benefit of the personal residence of Mr. Skolnick or the use of business credit cards by the spouse of Mr. Skolnick to incur in personal expenses). The Court determined that the taxpayers did not carry their activity in businesslike manner and weighed this factor against them.

  1. Expertise of the taxpayer or his advisers. If the taxpayer consults with industry experts and studies accepted business practices when preparing for an activity, that may suggest a profit motive. Treas. Reg. § 1.183-2(b)(2). In this case, the taxpayers had previous experience in the horse business and given that they consulted with various experts about their activities, the Court found this factor in favor of the petitioners.
  2. Time and effort spent by the taxpayer in carrying on the activity. Devotion of considerable time to an activity may indicate a profit motive, particularly if the activity does not have a substantial personal or recreational aspect. Treas. Reg. § 1.183-2(b)(3). In this case, Mr. Skolnick was not a hands-on manager but rather he exercised high-level supervision. Mr. Freeman barely visited the farm. This factor was deemed as neutral by the Court.
  3. Expectation that assets used in the activity may appreciate in value. Profit includes appreciation in the value of assets, such as land. Treas. Reg. § 1.183-2(b)(4). If the taxpayer engages in farming of the land, the farming and the holding of the land are considered as a single activity only if the farming activity reduces the net cost of carrying the land. Treas. Reg. § 1.183-1(d)(1). In this case, the Court found that Bluestone held its farm properties to profit from the increase in value. However, such intent to profit is different from the intent to profit of the horse-breeding activities. Thus, appreciation in land is irrelevant in this case.

As for the appreciation in the value of the horse, the petitioners did not provide a reliable foundation to support a potential appreciation. See Skolnick I, 117 T.C.M. (CCH) at 1321. Finally, although the taxpayers showed a single success with the appreciation of a horse, such was deemed as not conclusive to establish that the whole operation was subject to appreciation

  1. Success of the taxpayer in carrying on other similar or dissimilar activities. The previous business activities of the taxpayers were not related to horse breeding. This factor was deemed neutral by the Court.
  2. Taxpayer’s history of income or losses with respect to the activity. Long period of losses can indicate lack of a profit motive. Treas. Reg. § 1.182-2(b)(6). This does not apply if the losses are due to customary business risks or unforeseen or fortuitous circumstances beyond the control of the taxpayer. In this case, the taxpayers incurred continuing losses since the incorporation of Bluestone until 2016. Also, the 2008 financial crisis is not an impediment to establish the lack of profit motive because the losses were generated much before such event and continued during the economic recovery. This factor weighed against the taxpayers.
  3. Amount of occasional profits, if any. An occasional small profit from an activity generating large losses, would not generally be determinative that the activity is engaged in for profit. Treas. Reg. § 1.183-2(b)(7). Here, Bluestone only generated a small profit in 2016. Compared to the amount of losses, such profit was not enough to make the activity profitable. The factor was weighed in favor of the IRS.
  4. Financial status of the taxpayer. If the taxpayer has substantial income or capital from sources other than the activity subject to inquiry, it may indicate lack of profit intent. Treas. Reg. § 1.183-2(b)(8). Here, the taxpayers had substantial capital from other sources (income from family trust). This factor was weighed against the taxpayers.
  5. Elements of personal pleasure or recreation. If the taxpayer derives personal pleasure from an activity, or finds it recreational, it may suggest lack of intent of a profit. Treas. Reg. § 1.183-2(b)(9). However, “suffering has never been made a prerequisite to deductibility.” See Jackson v. Commissioner, 59 T.C. 312 , 317 (1972). But the activity of raising and racing horses is of a sporting and recreational nature. Treas. Reg. § 1.183-2(c), example 3. In this case, although Mr. Skolnick did not derive personal pleasure from the horse breeding activity, he and his partner enjoyed the buying and selling horses. Moreover, Mr. Skolnick’s residence within the property of Bluestone and the various expenses incurred with Bluestone funds to maintain such property enhanced his enjoyment of this activity.

Based on the above analysis, the Court determined that the taxpayers’ activities were not engaged in for profit.

As for the NOL from previous years, the taxpayer bears the burden of establishing both the existence of the NOL and the amount of any loss that may be carried over to the subject years. Rule 142(a)(1); United States v. Olympic Radio & Television, Inc., 349 U.S. 232 , 235 (1955); Green v. Commissioner, T.C. Memo. 2003-244 , 86 T.C.M. (CCH) 273, 274-275.

In the case of NOLs incurred by a pass-through entity, the entity must prove that (1) the entity incurred NOLs, (2) he had a sufficient basis in the entity to absorb the NOLs, and (3) the NOLs were properly carried forward to the years at issue. See Jasperson v. Commissioner, T.C. Memo. 2015-186, 110 T.C.M. (CCH) 304 , 306 , aff’d, 658 F. App’x 962 (11th Cir. 2016). Taxpayers cannot rely solely on their own income tax returns to establish that losses were actually sustained. See Wilkinson v. Commissioner, 71 T.C. 633 , 639 (1979); Power v. Commissioner, T.C. Memo. 2016-157 , 112 T.C.M. (CCH) 241, 245. In this case, the taxpayers did not support the existence of the NOL in previous years, thus, the NOLs were disallowed.

As for the accuracy-related penalty assessed under Section 6662(a) the Court determined that the taxpayers established reasonable cause by relying on the advice of a professional. I.R.C. § 6664(c)(1). Their CPA was a competent professional with multiple years of experience, the taxpayers provided all the records to the CPA, and they relied on his advice that Bluestone’s losses were deductible.

Insight:  This case confirms previous cases related to the deductibility of “hobby losses”. In these “horse cases”, the taxpayer has a very difficult threshold to overcome to properly show the existence of the profit intent. This case presents a guide to taxpayers as to how to conduct their business particularly in activities that are “joyful” in itself.