Taxpayer Had Not Begun Operation of Business During Year, No Business Deductions Allowed

In order to claim deductions related to a trade or business, the taxpayer must be able to show not just that the expenditures were incurred by the taxpayer for a legitimate trade or business reason, but also that the trade or business in question has actually begun operation.  The IRS was not disputing that the taxpayer had an honest intent to operate a trade or business for which she incurred expenses, but rather that the business had not commenced operations in the case of Tizard v. Commissioner, T.C. Summ. Op. 2016-42.

The taxpayer in question was a pilot for a major commercial airline who was approaching her mandatory retirement age and looking for a way to generate income once she hit that age.  She decided to acquire an aircraft she could use to offer various services in a business she planned to operate.  As the opinion describes the issue:

Petitioner concluded that a Slingsby T-67C “Firefly” military training aircraft (Firefly) would allow her to provide a variety of aviation services. The Firefly, manufactured in England, is constructed of fiberglass and is powered by a single engine and propeller. The aircraft provides seating for a pilot and one passenger and offers a small cargo space. Petitioner selected the Firefly primarily because it is fuel efficient, provides excellent visibility through the canopy to perform aerial photography, and is "responsive" and aerobatic (e.g., it can withstand spins and stalls), making it well suited for flight instruction and "upset recovery" training.

She acquired the aircraft in October of 2010 with the intent to use it for such income producing activities.  During 2010 she took various actions related to the aircraft:

  • While she was negotiating with the seller she discussed providing aerial land survey related to a real estate development with the seller. She claimed she entered into a “verbal agreement” to provide such services but was never actually hired by the seller to perform this service.
  • She took an acquaintance that she believed might be a client on an “incentive orientation flight” on the day the aircraft was delivered to her local airport.  While she wrote up an invoice for the flight, she did not charge the acquaintance for the services and the acquaintance moved out of state shortly thereafter, never hiring the taxpayer.
  • She posted a notice on Facebook in October noting that she had her own plane.  She received 50 “likes” from her 230 Facebook followers.  Although she later set-up a Facebook page for the operation in 2011, it was targeted by hackers and closed, remaining offline until 2014.

The taxpayer claimed a loss on her 2010 income tax return of $13,295 from the operation and no receipts from the operation for the year. 

IRC §162(a) allows a deduction for “ordinary and necessary” expenses related to a trade or business.  But, as the Tax Court notes, deductions are not allowed to be taken on the return until the business is in operation:

Although a taxpayer may be committed to entering into a business and invest considerable time and money in preparing to do so, the activity does not constitute a trade or business for section 162(a) purposes until the business is actually functioning and performing the activities for which it was organized. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965); see also Glotov v. Commissioner, T.C. Memo. 2007-147. Business operations with respect to the activity must have actually commenced. See McKelvey v. Commissioner, T.C. Memo. 2002-63, aff'd, 76 F. App'x 806 (9th Cir. 2003). “Until that time, expenses related to that activity are not ‘ordinary and necessary’ expenses currently deductible under section 162 (nor are they deductible under section 212) but rather are ‘start-up’ or ‘pre-opening’ expenses.” Woody v. Commissioner, T.C. Memo. 2009-93, slip op. at 9-10.

Such expenses are rather governed by IRC §195 which only allows a deduction once the business commences operations and then generally over 180 months, with a potential immediate deduction upon commencement of business of $5,000 when expenses are below certain limits. 

Thus the taxpayer would only be allowed an immediate deduction for expenses incurred after business operations had commenced, and would only get the allowable deduction under §195 in her case if the business had actually commenced operations before the end of 2010.

In this case the Tax Court found that business operations had not begun prior to the end of 2010 and, thus, no deduction of any sort would be allowed for 2010. 

The Court found the taxpayer truly intended to enter into an aviation business for profit and found her testimony “credible and forthright” regarding what had taken place.  But such good intentions were not enough, as the Court held:

In 2010 petitioner acquired the Firefly and arranged to have it delivered to Glendale, drafted a business plan, and filed articles of organization for Tizard. These were all steps preparatory to beginning her aviation business. However, other than the picture and short statement (that makes no mention of her aviation business) that she posted on her personal Facebook page in early October 2010, petitioner did nothing in 2010 to formally advertise to the general public (either by way of print or electronic media) that Tizard was open for business or describe and promote the various services that Tizard would offer to its clients. Petitioner's informal efforts to promote Tizard's services, her optimism that Mr. Derby might become a paying client, and the complimentary flight that she provided to Ms. Clark do not impress the Court as evidence that Tizard was actually functioning and performing the activities for which it was organized. In 2010 Tizard had no clients, no contracts for aviation services, and no gross receipts.

Considering all the facts and circumstances, we conclude that petitioner was not carrying on an aviation-related trade or business in 2010.

Unfortunately, it’s difficult to find a “bright line” to determine when a business actually commenced operations, especially in the early days when a taxpayer may have a difficult time finding clients.  Advisers who have clients trying to start up such new businesses should advise the client of the need to show actions geared towards finding clients and carefully document those steps.

In this case the results likely would have been different had actually been contracted by either the seller or her acquaintance based on her activities—even if they hadn’t actually received the services until 2010.  But in this case it appears the Court decided her “low-key” marketing activities were not serious business operations. 

That might be viewed as “unfair” as many of those reading this who operate their own practice may have gotten their own first clients via similarly informal operations.  But, nevertheless, such actions will likely only be seen as “enough” on an exam if the taxpayer actually obtains work from the activity or if the taxpayer can show significant obviously business related hours on that informal activity.  Had she openly solicited business in that Facebook post it very well might have been viewed as inappropriate given online etiquette, but such an action could very well have caused the Court to take a different view of that sort of activity—especially if her Facebook marketing had expanded, rather than shut down, in 2011.