Tax Court in Brief | Kellett v. Commissioner | Start-Up, Research Expenses, and Other Itemized Business Deductions

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Tax Court in Brief | Kellett v. Commissioner | Start-Up, Research Expenses, and Other Itemized Business Deductions

The Tax Court in Brief – June 13th – June 17th, 2022

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Tax Litigation:  The Week of June 13th, 2022, through June 17th, 2022

Kellett v. Comm’r, T.C. Memo 2022-62 | June 14, 2022 | Greaves, J. | Dkt. No. 21518-18

Opinion

Short Summary: The IRS disallowed a $25,922 business expense deduction resulting in a corresponding deficiency of $6,475 in 2015. The taxpayer ran a business information website which started upon the opening of the website in September 2015. The business compiled demographic, social, and economic data and attempted to make a user-friendly version of Google or Yahoo Finance. He worked with engineers to develop features that he wanted on the website and hired a marketing specialist. Initially, he envisioned the business would generate revenue from advertising, a paywall, selling personalized reports, and/or licensing fees for use of data. He did not pursue these strategies in 2015 and did generate revenues until 2019. On his timely filed 1040, the taxpayer claimed expense deductions for the engineers, a marketing strategist, cell and internet service cost from his home, and some miscellaneous expenses. The IRS denied all deductions on the grounds that the business had not started.

Key Issues:

  • When does a business start for purposes of § 195?
  • Can a taxpayer expense the costs of developing software under § 174 before the business technically begins, or is he solely relegated to relief under § 195?
  • Can a taxpayer use Rev. Proc. 2000-50 to deduct the costs of developing a website?

Primary Holdings:

  • The regulations do not provide a definition for this matter. Therefore, the Tax Court will use any rule developed by the appropriate appeals jurisdiction. In this case, the taxpayer’s business began in September of 2015 because that is when it began providing the services for which it was organized. Any expenses incurred before this date must be taken under § 195 and any expenses after this date are taken under § 162.
  • Under these circumstances, the taxpayer was not allowed to take a § 174 deduction since he merely adapted a widely used software rather than developing it from whole cloth.
  • The Court provides that this revenue procedure cannot create a deduction for the taxpayer by itself. Thus, if the taxpayer does not make an argument that the procedure is consistent with the Code in some way, then he cannot claim a deduction from it. Furthermore, it cannot act to estop the government because he relied on the revenue procedure’s guidance.

Key Points of Law:

  • Right to Deduction and Burden of Proof: Rule 142(a)(1) provides that the IRS is presumed correct in its determinations and the burden is on the taxpayer to prove the determinations are erroneous. See also Welch v. Helvering, 290 U.S. 111, 115 (1933). A deduction is a matter of legislative grace, and the taxpayer must prove he is entitled to any claimed deduction. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992). Under § 7491(a)(1) the taxpayer may introduce credible evidence with respect to any factual issue relevant to determining the tax liability and, thereby shift the burden to the IRS so long as the taxpayer complies with paragraph 2 of that section.
  • 162(a) Ordinary and Necessary Business Deduction: § 162(a) permits taxpayers to deduct all ordinary and necessary business expenses for the current taxable year in carrying on a trade or business.
  • 195 Start-up Expenditures: § 195(a) disallows deductions for start-up costs except for provided in this section. Therefore, under § 195(b), a taxpayer generally can deduct up to $5,000 of start-up expenditures. However, if the costs are in excess of $50,000, then the amount is phased out dollar for dollar until $55,000. § 195(b)(1)(A)(i)-(ii). Any amount phased out, or in the event the costs exceed $55,000, the taxpayer must capitalize the capital outlay and then amortize it ratably over 15 years. § 195(b)(1)(B).
  • 195(c) Start-up Expenditure Defined: § 195(c)(1)(A)(iii) defines start-up expenditure to include any amount paid or incurred in connection with any activity engaged in for profit and for 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. See also Hardy v. Comm’r, 93 T.C. 684, 687 (1989).
  • Appellate Court Rule Selection: Without any regulation to define when an active trade or business begins, the Tax Court will look to any tests developed within the venue of the appropriate appellate court.
  • Active Trade or Business Start Date: A taxpayer does not begin carrying on a trade or business until such time as the business has begun to function as a going concern and performed those activities for which it was organized. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965). This determination is made on the facts and circumstances of the case. Madison Gas & Elec. Co. v. Comm’r, 72 T.C. 521, 566 (1979). The taxpayer’s efforts to sell goods or services may qualify as an active trade or business even if the taxpayer makes no sales and therefore has zero gross receipts. Cabintaxi Corp. v. Comm’r, 63 F.3d 614, 620 (7th Cir. 1995).
  • 262 Personal Expense Disallowed: 262(a) provides that no deduction is allowed for personal, living, or family expenses. The taxpayer bears the burden of proving which amount of expenses paid or incurred in carrying on a trade or business or business are deductible under § 162(a) and which portion falls under § 262(a). Furthermore, the taxpayer may not shift the burden of proof under § 7491(a) to the IRS if he fails to maintain documentation that differentiates his personal and business use of the Verizon services. § 6001; Treas. Reg. § 1.6001-1(a),(e). If the circumstances provide that the taxpayer cannot substantiate the distinction between personal and business, the court may approximate the amount attributable to each. Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930).
  • 174 Research and Development: Taxpayers are granted relief from the harsh capitalization standards for start-up costs under § 174, but it applies only in limited circumstances. However, the general rule is that taxpayers may treat R&D connected with their trade or business as expenses not chargeable to the capital account. § 174(a)(1). § 195(c)(1) excludes from the definition of start-up expenditures any amount which a deduction is allowable under § 174.
  • Research and Experimental Defined: Reg. § 1.174-2(a)(1) defines research or experimental expenditures as expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The costs must be for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Id. As the regulation provides, uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. For software development, the crux of the uncertainty issue depends on whether the taxpayer had to start from scratch and develop the software out of whole cloth using its own expertise. See Suder v. Comm’r, T.C. Memo. 2014-201, at *1-30, *42-44. However, if the taxpayer merely adapts widely used software to solve a complex but familiar problem, then it does not meet the standards of the regulations. United States v. Davenport, 897 F. Supp. 2d 496, 499-501 (N.D. Tex. 2012).
  • Proc. 2000-50 §§ 4, 5.01: The IRS will not disturb a taxpayer’s immediate deduction of certain costs of developing computer software that the taxpayer has not treated as § 174 research of experimental expenditures. Rev. Proc. 2000-50 §§ 4, 5.01. This procedure purports to allow the same timing election for certain costs of developing computer software that the taxpayer has not treated as § 174 expenditures because they so closely resemble that type of expenditure. This does not require the taxpayer to begin his trade or business, but seemingly, requires only a realistic prospect of entering into a trade or business.
  • Revenue Procedure Authority Generally: Courts generally treat revenue procedures as governing internal IRS operations and hold that they do not create substantive rights in the public. Capital Fed. Sav. & Loan Ass’n & Sub. v. Comm’r, 96 T.C. 204, 216-217 (1991). The Tax Court may set aside an IRS action for abuse of discretion if the IRS fails to follow its own guidance. Id.
  • Inconsistent Guidance: If a rule sets forth guidance that is not harmonious with the Code, then the guidance becomes a mere nullity. Dixon v. U.S., 381 U.S. 68, 73 (1965). To the extent that Rev. Proc. 2000-50 establishes a deduction, this Court cannot sustain the rule without a statutory predicate. Therefore, it cannot bar the United States from collecting a tax otherwise due. Dixon, at 73.

Insights: There are some very key points of law here for any entrepreneur. Firstly, the costs of start-up are subject to a rather harsh regime in the Code. § 195 will force a taxpayer to deduct costs over 15 years (180 months) in some circumstances. Oddly, upon the disposition of the business, these amortization payments would be accelerated and taken as a loss if permitted under § 165. Thus, this taxpayer may find relief in some form of reorganization. Additionally, this opinion highlights the analysis for when a business starts for federal tax purposes. It may be different than most people would think, and it depends on the archetype of the business i.e., retail grocers vs. internet information. Moreover, it may change depending on the proper appeals jurisdiction for a taxpayer. This opinion also highlights Rev. Proc. 2000-50 and whether it establishes a deduction. The court leaves open the possibility that it would if a taxpayer could establish it is harmonious with a specific provision under the Code.