In Eason v. Commissioner, T.C. Summary 2024-17, the Tax Court held that the Internal Revenue Service properly disallowed deductions resulting from expenses taxpayers claimed in connection with a real estate business because by the close of the year at issue the taxpayers had not started carrying on any business activity. However, the court found that the taxpayers had reasonable cause with respect to the underpayment and acted in good faith. Therefore, the court rejected the IRS’s determination of a penalty under Code Section 6662(a). The court noted that the Code offers little guidance as to the specific actions that establish when a business begins.
Background of the Case
Taxpayers, Kwaku Eason is an engineer and Ashley Leisner is a nurse. At the beginning of 2016, Eason and Leisner owned two residential properties. One was held for rent and rented out during that year, and the other was sold on June 28, 2016. Eason lost his job shortly before or after the start of 2016. Eason and Leisner then decided to explore various income-generating activities separate and apart from their educational and professional backgrounds. Around that time Advanced Real Estate Education (Education) offered courses on business opportunities available through real estate ownership and investment. During 2016 Eason and Leisner enrolled in two courses offered by Education and paid the company $41,934.
Eason and Leisner formed Ashley & Makai Homes (Homes) on July 29, 2016, a corporation that elected to be taxed as an S corporation. According to Eason and Leisner, Homes was formed to provide advice and guidance to real estate owners and investors, although the specific services that Homes intended to offer and/or provide to customers was unclear. Neither Eason and Leisner nor Homes were required to obtain any federal, state, or local license before the intended business activity could begin. Eason and Leisner had business cards and business stationery printed, and they attended some of the training sessions in connection with Education’s courses. Education defaulted on many of the services that Eason and Leisner expected to receive from the company. By the close of 2018 Education had gone out of business, and Eason and Leisner had abandoned whatever business activities they intended to conduct through Homes.
Expenses attributable to Homes, including the cost of the Education courses, were shown as deductions on a 2016 Form 1120S, U.S. Income Tax Return for an S Corporation, as well as on a Schedule C included with Eason’s and Leisner’s return. Neither the Form 1120S nor Eason’s and Leisner’s return showed any income attributable to the real estate services intended to be offered or offered by Eason and Leisner or Homes. However, both forms, the 1120S and the Schedule C showed a loss resulting from the deductions claimed on each document.
The IRS disallowed all the deductions claimed on Schedule C in a notice of deficiency. Eason and Leisner took their case to the Tax Court. The IRS presented various reasons why Eason and Leisner were not entitled to any of the deductions, one of which was that whatever business activity they intended to carry on had not started by the close of 2016. Eason and Leisner acknowledged that the deductions should have been considered as their pro rata shares of the loss incurred by Homes under Code Section 1366(d)(1) rather than claimed on Schedule C. The court said that to keep things simple, it would ignore the technicalities that govern the taxation of S corporations and their shareholders and focus on Eason’s and Leisner’s entitlement to the deductions as though the deductions were properly reportable as trade or business expenses on the Schedule C included with the return.
Internal Revenue Code Section 162(a) permits a deduction for ordinary and necessary expenses paid or incurred during the tax year “in carrying on any trade or business.” An expense is deductible under Code Section 162 only if it is paid or incurred while the taxpayer is “carrying on” a trade or business, and Code Section 195(a) provides that start-up expenses are not deductible. In Richmond Television Corp. v. United States, 345F.2d901 (4th Cir. 1965), the Fourth Circuit held that a taxpayer has not “engaged in carrying on any trade or business’ within the meaning of Code Section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized.
Analysis
The Tax Court sustained the disallowance of the deductions claimed by Eason and Leisner on Schedule C. The court found that neither Homes nor Eason and Leisner reported any income from a business activity related to the disputed deductions, presumably because none was earned. The court noted that the absence of income is not in and of itself proof that a business has not yet started if other activities show that it has. Here, however, the absence of income coupled with the absence of any activity that showed that services were offered or provided to clients or customers during 2016 supported the IRS’s position that the business had not yet started by the close of that year.
The court said that, more likely than not, Education’s failure to fulfil its contractual obligations frustrated Eason’s and Leisner’s intention to start the business they had expected to conduct through Homes. Regardless of the reason, the court concluded that Eason and Leisner failed to demonstrate that they were carrying on a trade or business themselves or through Homes by the close of 2016. However, the court disagreed with the IRS on whether a penalty under Code Section 6662(a) applied for a substantial understatement of tax. In the court’s view, Eason and Leisner had reasonable cause with respect to the underpayment of tax and acted in good faith under Code Section 6664(c).
The court noted that unlike in many other cases where the imposition of a penalty is supported by a taxpayer’s inability to substantiate a claimed deduction, in this case there was no dispute that the expenses to which the disallowed deductions related were paid. Further, the court found that reasonable minds may differ as to the point in time and/or the specific actions that establish when a business not subject to a licensing obligation begins. The court observed that the Code offers little guidance. Internal Revenue Code Section 195 (c)(2) provides that “the determination of when an active trade or business begins shall be made in accordance with such regulations as the Secretary may prescribe” but there are no such regulations.
The court noted that Eason and Leisner spent a considerable amount to enroll in Education’s courses during 2016. Furthermore, they had business cards and stationery printed during 2016. In the court’s view, but for the failure of Education to honor its contractual obligations to them, they might very well have taken additional actions to allow for a finding that the business started during 2016. Therefore, the court concluded that they were not liable for a Code section 6662(a) penalty.
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