It may seem like an obvious statement, but I’ve seen it more than once. An entity is formed and an entrepreneur starts racking up what they think are operating expenses, which they will be able to deduct. The only problem is that they have missed the part, where you have to actually have a business. There may be a difference in perspective as to what we think is a business and what the IRS considers a business.
The recent tax court case, Wegener, TC Memo 2019-98, reminds us of this fundamental question. Is there a true trade or business to deduct the expenses?
Kent Wegener lived in California and was an employee of Otis Spunkmeyer, with over $200,000 in annual salary. Kent began corresponding with Cocoa farmers in Ghana and entered into several written partnership agreements with the intent to finance their operations. He made multiple capital contributions from $2,500 to $25,000 in exchange for a 50% ownership interest and a right to 50% of future profits. He also lent additional money to the partnerships. Related to this activity, Kent claimed business expense deductions for “Kent’s Cocoa Farm” on Schedule C. He had no gross receipts.
The IRS disallowed his Schedule C expenses and the tax court agreed.
The court concluded that Kent made financial investments and a loan to the farms rather than establishing a business. Here are a few significant factors that the court used in its decision.
- Kent did not manage the farms or keep the farms books and records
- The farmers were primarily responsible for maintaining the books and records for the farms
- Kent’s primary activity was transferring funds to the farmers for their use.
Kent’s activity did not rise to the level of regular and active involvement in a business and therefore he was not allowed to deduct expenses under IRC Section 162. The court also considered the fact that Kent devoted time to another full time job.
We have observed this type of issue popping up in new Cannabis industry. Owners of newly established business often mistakenly assume that start-up costs are deductible, when they may actually be capital expenditures, that aren’t immediately deductible for tax purposes. Also we’ve seen some entrepreneurs set up holding companies as a separate businesses from the Cannabis trafficking operation. However, if the holding company’s only purpose is to be a financing conduit, to a separate operating company, you have to consider if expenses in the holding company are deductible, for the reasons addressed in this case.
The IRS and courts look to requirements set in the Jafarpour Tax Court Case, 2012.
(1) The taxpayer undertakes the activity intending to earn a profit over a substantial period
(2) He/she is regularly and actively involved with the activity
(3) The activity actually commenced
A taxpayer who fails any of the above three tests is not considered to be engaged in a trade or business and therefore cannot claim business deductions.