New businesses may not be immediately profitable. To help mitigate the financial risk, many businesses are started by workers who have a day job. If the business is not immediately profitable it can help the owner finance the business if the owner is able to use the tax losses from the business to offset the tax on the owners other income.
There have been quite a few tax disputes involving this situation, as evidenced by the published court cases. The facts of each court case differ, except for the fact that the taxpayers did not plan for the tax losses before filing their tax returns. The De Sylva v. Commissioner, T.C. Memo. 2018-165, case provides an opportunity to consider this topic.
Facts & Procedural History
The taxpayer is an engineer with a focus on reviewing patents. He had a helicopter pilot’s license. He purchased a 30 year old yacht with the intent of installing a helicopter pad and renting the yacht to others. He believed that his connections with helicopter companies would allow him to find tenants.
The taxpayer hired a boat restoration company to repair the yacht. After a year of work, the repair company stopped work and litigation ensued. The taxpayer paid others to repair the yacht, but he did not have the funds to finish the work.
Eight years after purchasing the yacht, the boat was still not repaired or sea worthy. The yacht sat idle.
The taxpayer did not file an individual income tax return for this later year. The IRS eventually did so for the taxpayer, including the taxpayer’s income from his engineering patent review work. The taxpayer presented the IRS with a tax return reporting the losses given the tax deductions for expenses associated with his yacht rental business.
On audit, the IRS did not allow the tax deductions and litigation in tax court ensued.
Trade or Business Expenses
Taxpayers are generally allowed to deduct ordinary and necessary business expenses in carrying on a trade or business. The courts generally consider the following factors in determining whether there was a trade or business:
- Whether the taxpayer undertook the activity intending to earn a profit,
- Whether the taxpayer is regularly and actively involved in the activity, and
- Whether the taxpayer’s activity has actually commenced.
The dispute in this case focused on the last factor. The question for the court was whether the taxpayer’s yacht rental business had actually commenced. The evidence established that the yacht was not ready to be used as a rental:
During 2012 petitioner did not rent out the boat to anyone. Since his purchase of the boat in 2004, the boat has been unusable and never in any condition to be rented. Consequently, petitioner has never had any contracts or agreements for rental of the boat or marketed the boat as available for charter or rental. Accordingly, even though petitioner made a decision in 2004 to enter into a boat rental business by purchasing the boat and he has strived over a considerable period to repair it so that it can be rented out, he has yet to commence the boat rental activity and be engaged “in carrying on any trade or business” within the meaning of section 162(a).
Thus, the court concluded that the taxpayer was not carrying on the yacht rental business in 2012.
The Start-Up Expense Rules
In addition to the carry on requirement, Section 195 limits certain start-up expenses. These expenses include those:
- That are paid or incurred in connection with (i) investigating the creation or acquisition of an active trade or business, or (ii) creating an active trade or business, or (iii) 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, and
- Which, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred.
The court cited Section 195, but, given that it concluded that the trade or business requirement was not met, it did not address or apply the start-up rules in this case.
Capitalization and Depreciation Rules
The court also did not have to consider the capitalization and depreciation rules. These rules can be problematic for business activities that require the development of an asset for use in the business.
Real estate assets provide a prime example. With certain exceptions, the construction costs for real estate are generally capitalized into the tax basis for the property and once the property is able to be placed in service, the costs are recovered via depreciation deductions for the property. The placed in service date is generally the date when the property could be used for its intended purpose.
These same rules have been applied to other business assets as well. The Brown v. Commissioner, T.C. Memo. 2013-275, case provides an example. The case considered whether an airplane purchased by a high-end insurance agent was placed in service in time to qualify for bonus depreciation. The airplane was undergoing renovations after its purchase and the IRS argued that it was not available “in a condition or state of readiness and availability” for the “specifically assigned function” for which it was purchased. The court noted that the plane did not have to actually be used in the business, it just had to be functional such that it was ready for regular use in the business. The court noted that the airplane was “fully functional for air transportation,” but it was not ready and available for a “specifically assigned function.”
The Facts & Presentation Matter
While a business owner usually cannot control whether a business will be successful. They can control some aspects of the facts. For example, imagine the facts in De Sylva were slightly different:
- What if the taxpayer already had a trade or business as evidenced by some minimal income from being a helicopter pilot and the yacht would further that business?
- What if the taxpayer had used the yacht to store a helicopter periodically?
- What if the taxpayer was working on developing a patentable design for a helicopter landing pad for yachts, given that he was a patent application engineer?
Would these types of facts result in losses that are allowable immediately? With advance planning, could the facts have been marshaled such that the yacht was tied to an existing business activity and functional and/or actually used in some capacity in this business, thereby allowing immediate deductions?