Paul L. Caron

Monday, February 1, 2021

Lesson From The Tax Court: No Product? No §162 Deduction!

Section 162 has simple language.  It permits deduction for all “the ordinary and necessary expenses paid or incurred in carrying on a trade or business.”  The simplicity is deceptive.  All the terms need further interpretation.  In William Bruce Costello and Martiza Legarcie v. Commissioner, T.C. Memo. 2021-9 (Jan. 25, 2021) Judge Halpern teaches us one interpretation of “carrying on a trade or business”: you need a product.  In this case the taxpayers owned land on which they sequentially tried raising chickens, crops, and beef.  None of the efforts resulted in salable product.  The Tax Court agreed with the IRS that these activities did not amount to carrying on a discernible business because the taxpayers never sold anything.  The Court thus denied deductions for the costs associated with the activities.

The need for product is key.  Other Tax Court cases teach us that a taxpayer does not actually have to sell product to be carrying on a business, but still needs to have product.  No product, no §162 deduction.  No kidding.  Details below the fold.

Law: Some §162 Basics
It takes money to make money.  Congress allows you to deduct the money it takes from the money you make and subjects only the net to taxation---unless, of course, you are in the business of trafficking in controlled substances.  The workhorse provision effectuating that policy is §162.  It permits deductions for all the ordinary and necessary expenses in carrying on a trade or business.  Congress also extends the policy to activities that may not be a “trade or business” but are still income-producing activities that have associated costs.  See §183 (permitting deduction for hobby costs up to amount of hobby income) and §212 (permitting deduction for costs associated with investment and rental property activities).

To get the §162 deduction, however, you have to have to be actually “carrying on” an activity that qualifies as a “trade or business.”  Let’s take a quick look at each requirement.

Trade or Business
Courts distinguish a trade or business activity from two other types of income producing activities.  First, certain investment activities produce income and yet may not amount to a trade or business.  Expenses associated with investment activities may be deducted under §212.  I explored this distinction in Lesson From the Tax Court: Distinguishing Investment from Business Activity, TaxProf Blog (Monday, April 22, 2019).  Second, sometimes an activity that is engaged in primarily for pleasure also throws off some income.  Expenses associate with hobby activities may be deducted under §183 but only up to the amount of the income from the hobby.

Until 1987 the received wisdom was that a “trade or business” must be an activity where a taxpayer is offering to provide goods or services to the public.  Deputy v. du Pont, 308 U.S. 488, 499 (1940) (Frankfurter, J., concurring)(“carrying on any trade or business, within the contemplation of [the predecessor to §162], involves holding one's self out to others as engaged in the selling of goods or services.”)(internal quotes omitted).  If you were not doing that, you were either a hobbyist or an investor.

In 1987 the Supreme Court adopted a broader test.  There the taxpayer was an unemployed salesman who spent a an entire year betting on dog races.  He had gross winnings of over $70,000 which looks pretty good until you realize his losing bets amounted to over $72,000.  If his losing bets were attributable to a trade or business he would avoid the Alternative Minimum Tax (AMT).  If they were not so attributable, they would be considered items of tax preference and would be largely ignored for AMT purposes.  Thus it was important to know whether his activity amount to a trade or business.  The Supreme Court said it did, using this test: “ be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”  Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).  Importantly, however, the Court deliberately declined to give any really helpful general rule to use.  Indeed, the Court explicitly left the rule vague, to be resolved by the facts of each future case.  It did so from a “concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code.”  480 U.S. at 36.

Carrying On: Courts interpret §162 as requiring linkage of costs to an existing business of the taxpayer.  The classic case is Frank v. Commissioner, 20 T.C. 511 (1953).  There, Mr. and Mrs. Frank traveled around the country after WWII looking for somewhere to get into either the newspaper or radio business.  Mr. Frank eventually found newspaper employment in February 1946.  The Tax Court rejected their attempts to deduct their pre-February search costs under either (what is now) §162 or §212.  The Court held:

“There is a basic distinction between allowing deductions for the expense of producing or collecting income, in which one has an existent interest or right, and expenses incurred in an attempt to obtain income by the creation of some new interest. *** The expenses here involved are of the latter classification. The traveling costs were incurred in an endeavor to acquire a business which might, in the future, prove productive of income. It might reasonably be said that petitioners were engaged in the active search of employment as newspaper owners, but that cannot be regarded as a business.” Id. at 514 (citations omitted).

These kinds of start-up costs in creating a business were capital expenditures.  Congress now allows deduction for part of a taxpayer’s start-up expenses (and a 15 year amortization for the rest) under §195.  But to get that a taxpayer still needs to actually start the business.

Figuring out when a business actually starts is a question of fact that depends on the circumstances of each particular case. See Richmond Television v. United States, 345 F.2d 901, 905 (4th Cir. 1965) (“when, in point of time, a trade or business actually begins ... is usually a factual issue”); United States v. Manor Care, 490 F. Supp. 355, 361-62 (D. Md. 1980) (“issues of when a business begins...are issues to be determined on the facts of each case.”).

The Tax Court has long used a functional test to frame the factual inquiry, borrowing from the Richmond Television case.  Here is how the Tax Court put it in Weaver v. Commissioner, T.C. Memo. 2004-108:

“even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not engaged in carrying on any trade or business within the intendment of 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.”  (emphasis supplied)

During the years at issue (2012 and 2013) the taxpayers lived in California.  During those years Ms. Legarcie owned 6,500 acres of apparently desolate land in the Mexican state of Baja California Sur.  Ms. Legarcie had been trying to produce income from the land since at least 2007.  That was not an easy task given her distance from the land and the land’s location next to what is described as the world’s largest salt factory.  Judge Halpern tells us that “evaporation from the salt plant blows across the property and poisons the soil.  Crops grown on the property are not commercially acceptable.”

Ms. Legarcie first tried to raise chickens on the property to sell for meat but reported no sales or income from that activity.  In 2011, she switched to egg production, but then switched back to meat production in 2012, although she reported about $1,000 in egg money in 2012.  She added new chickens to her flock.  It worked no better than before.  Wild dogs ate the chickens in 2014.  They did not pay her for the meat.

In addition to the chickens, Ms. Legarcie tried to grow various crops between 2007 and 2011.  In 2012 she and Mr. Costello planted a test crop of peppers.  They failed.

In addition to the chickens and crops, Ms. Legarcie bought some cows in 2012.  But the cows could not find enough forage on the apparently barren 6,500 acres.  So she and Mr. Costello sold the cows in 2013 for just under $5,000.

On their 2012 and 2013 returns the taxpayers claimed deductions under §162 in excess of income for both 2012 and 2013.  The IRS disallowed the deductions, finding that the taxpayers’ activities on the Baja Sur land were either hobby activities or, if not, were all pre-operational start-up activities.  Favoring the first theory, it appears the IRS allowed deductions up to the amount of the income from sales of the eggs in 2012 and cows in 2013.

Lesson: A Business Starts When It Sells Its Products
Judge Halpern first explained what was not at issue.  He was convinced that the taxpayers were “determinedly seeking during the years in issue to earn a profit from farming.”  This was not a hobby activity.  Second, Judge Halpern notes that the IRS did not dispute the amount of expenses claimed.  This is not a failure-to-substantiate case.

So what was the problem?  That pesky “carrying on” requirement.  Judge Halpern was simply not convinced that the taxpayers were carrying on a trade or business activity in 2012 and 2013.  The had instead spent seven years in pre-operational purgatory.

What Judge Halpern was looking for was evidence of a functioning business.  He found none, regardless of whether he lumped the chickens, crops, and cows together as one activity or treated them each as separate activates.  The reason was that the taxpayers could not show any sale of product.  The income from egg money in 2012, Judge Halpern found, was a “byproduct[] from raising meat chickens.”  Op. at 16.  And the cows sold in 2013 were not product of a business, they instead “ended her cattle activity.”  Op. at 17.  Indeed, Mr. Costello testified that “we have tried several things on this property; so far, nothing has worked.”  Op. at 16.  That is a strong admission against interest.  Thus, whether viewed separately or apart, Judge Halpern concluded, “Ms. Legarcie’s farming activities never moved beyond initial experimentation and investigation into an operating business.”  Id.

Comment 1: Selling Product Is Not Always Necessary
Judge Halpern’s no-sales-no-business rationale makes sense in the context of this particular case.  Remember, the test for “carrying on” is very much based on facts and circumstances.

But actual sales revenue is not always necessary to convince a court, because sales are not the only activities that an ongoing business engages in.  Activities other than sales may be enough to show that a business has started to “function as a going concern” and that constitute part of the "activities for which it was organized."  Weaver, supra.

Notable is the case of Steven Austin Smith v. Commissioner, T.C. Sum. Op. 2019-12 (July 1, 2019).  There, Judge Vasquez held that the taxpayer was indeed carrying on his business even in a year where he had no sales income.  That is because he had formed a business to re-sell other people’s product.  And in the year at issue he had obtained actual distribution agreements to do just that.  To be sure, he still lost because he was unable to substantiate his expenses.  But hey, at least he was within “the intendment of section 162(a)”  Weaver, supra.

Comment 2: What About §212?
One aspect of this case confuses me.  Judge Halpern accepts the taxpayers’ representation that Ms. Legarcie was holding these 6,500 crappy acres with the genuine intent to profit from the land.  It was not a hobby.  The problem was just their activities on the land did not rise to the level of a trade or business because they had no product, much less product to sell.

But could not these activities fall within the scope of §212(2)?  That section explicitly allows the same deductions as §162 for activities that are not business activities but are simply activities “for the production of income.” And remember the IRS was not here challenging the substantiation of the claimed expenses.

Was it just that the taxpayers did not claim under §212, thus putting all their deduction eggs in the §162 basket?  I do not think the Tax Court is that strict with pro se taxpayers like these.

Or perhaps it was because of the legislative history of §212?  That is, Congress added that statute in 1942 to reverse the outcome of a Supreme Court case distinguishing between investment activity and a business.  As the Fourth Circuit explained shortly thereafter, §212 was intended only to extend the deductions allowed by §162 to a larger set of activities and not to change the other requirements.  Bowers v. Lumpkin, 140 F.2d 927, 928 (1944) (“as the reports of Congressional committees show, it was not the intention of Congress to remove the other restrictions and limitations applicable to deductions under [§162(a)]. See S.Rep. No. 1683, 77th Cong. 2d Sess., 88; H.Rep. No. 2333, 77th Cong., 2d Sess., 75. ”).  One of those other requirements is that the taxpayer be “carrying on” the activity.  So that means even for non-business income-producing activities one needs to be "carrying on" the activity.

I do not find that answer satisfactory because if the activity at issue here was trying to make the land profitable, to produce income from the land, it seems these taxpayers were indeed assiduously “carrying on” that activity.  And the activity did produce some income from the use of the land, albeit inconsequential.  I confess I do not know the answer.  I am obviously missing something.  I welcome comments.  

Bryan Camp is carrying on as the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday for a new Lesson From The Tax Court.

Bryan Camp, New Cases, Scholarship, Tax, Tax Practice And Procedure, Tax Scholarship | Permalink


I will take the liberty to disagree with the court, not that they would care. :)

I concede that trying different crops were Sec. 195 R&D expenditures. I have to assume that these crops were small experimental batches without an expectation of a profit if they were to succeed. This is consistent with McKelvey, and also the TP conceded that fact themselves.

However, in addition to the crops, the TP attempted to raise poultry for meat and egg production, as well as livestock, continuously altering their business model. Who knows, maybe if not for the wild dog casualty loss, they would have succeeded. (BTW, thumbs up for your "did not pay her" comment, Bryan)

If anything, their farming activity was more akin a new restaurant changing their menu and offering their space for events trying to find a profitable niche. Or an attorney trying different types of services in different markets until he finds her niche.

IMHO, the non-crop activities of the TP qualify her as "carrying on a trade or business" under Sec. 162 language and "a going concern" per the relevant case law.

Posted by: Michael Plaks | Feb 7, 2021 8:48:05 PM

The "lesson" provocatively mentioned in the title of this blog post was not taught. In fact, nowhere in the court's opinion is there any reference to the lack of product being a guiding principle or even a fact of the case. It seems, that "no product - no Sec 162" conclusion was a product (pun intended) of the blog author's preconceived interpretation.

The court's conclusion that the TP's activities "were for the most part preoperational" is debatable, and I observe inconsistencies in the text of the opinion itself, not to mention the cited cases. The only lesson I see taught by this case is that Sec. 162/195 determination remains highly controversial and continues to be interpreted inconsistently by the courts.

I share the author's surprise that the Sec. 212 argument was not raised.

Posted by: Michael Plaks | Feb 7, 2021 6:48:37 PM

With respect to I.R.C. Sec. 162, I think that Associate Justice Benjamin Cardozo got it right: "Here, indeed, as so often in other branches of the law, the decisive
distinctions are those of degree and not of kind. One struggles in
vain for any verbal formula that will supply a ready touchstone. The
standard set up by the statute is not a rule of law; it is rather a way of
life. Life in all its fullness must supply the answer to the riddle." Welch v. Helvering, 290 U.S. 111 (1933)

Posted by: Jonathan Ingber | Feb 2, 2021 6:58:01 AM

could it be that the taxpayers in Costello/Legarcie did not claim 212(2) because those deductions would miscellaneous itemized deductions that would be subject to the 2% of AGI floor for regular tax purposes and eliminated entirely for AMT purposes, given the years in question? Maybe between those limitations, if the expenses weren't deductible under 162, there wouldn't have been much if any of a deduction left. Just a thought.

Posted by: Kristin | Feb 1, 2021 2:50:36 PM