September 29, 2015
The U.S. Tax Court made it clear in a recent case that taxpayers can’t simply deduct business expenses unless they are actually trying to make a profit in a trade or business.
Valery Pouemi had a full-time job at Verizon, which paid him about $60,000 per year and required him to work from 32 to 40 hours per week. In addition, he sometimes held a second job, took continuing education classes and owned/managed a small real estate business.
He had a real estate business from 2007 through 2009. During this period, Pouemi had one real estate sale, which generated revenue of $9,457. He wrote off very large amounts of expenses in relation to his revenue. This caught the attention of the IRS.
The IRS audited Pouemi’s 2009 Form 1040 with an emphasis on his Schedule C. Pouemi had no revenue and $30,062 in business expenses. After the audit, the IRS sent Pouemi a notice of deficiency disallowing all of the business expenses claimed on the Schedule C for 2009. Pouemi immediately filed suit in Tax Court.
The main issue in court was whether Pouemi’s real estate activity for 2009 amounted to a trade or business engaged in for profit. The Internal Revenue Code allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
To be entitled to deductions, Pouemi should have shown that his expenses were incurred in an activity conducted with continuity and regularity and for the purpose of making a profit. Instead, he kept no business books, had no business bank account or business plan, and offered no evidence of the time he devoted to the business. Documentation of these items is vital.
IRS regulations name nine factors that serve as a guideline in determining whether a taxpayer is conducting an activity with the intent of earning a profit:
1. Manner in which the taxpayer conducts the activity
2. Expertise of the taxpayer or his advisers
3. Time and effort spent by the taxpayer in carrying on the activity
4. Expectation that assets used in the activity may appreciate in value
5. Success of the taxpayer in carrying on other similar or dissimilar activities
6. Taxpayer’s history of income or loss with respect to the activity
7. Amount of occasional profits, if any
8. Financial status of the taxpayer
9. Elements of personal pleasure or recreation
The court deemed most of these factors to be neutral, and none weighed meaningfully in the taxpayer’s favor. For those reasons, the court concluded that Pouemi did not engage in the real estate activity during 2009 with the primary and genuine purpose of making a profit. Therefore, the court upheld the IRS’s denial of all of the business expenses for 2009 (Valery Choutouo Pouemi and Sandrine Atemekeng v. Commissioner. T.C. Memo 2015-161, Aug. 17, 2015).
This article was originally posted on September 29, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.