By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Ortega v. Comr., T.C. Memo 2011-179, the Tax Court held that Taxpayers were not entitled to currently deduct $46,758 for legal fees and other items reported on Schedule C, Profit or Loss From Business, as expenses of a trade or business. Additionally, the Tax Court held that Taxpayers were liable for the accuracy-related penalty under §6662(a) and (b)(1). The decision in Ortega serves as an important reminder that in order to deduct expenses currently, a taxpayer must be able to demonstrate that actual business operations have been undertaken, and not just a plan to conduct business, and keep contemporaneous records of the expenses.
Since 1973, Taxpayer-Husband, a self-described real estate developer owned 4,500 acres of real property in Mexico, including 6 miles of beachfront. Husband intended to develop various portions of his Mexican real estate. One parcel Husband intended to develop as a recreational vehicle (RV) park. Another parcel Husband intended to turn into a planned community. The third parcel Husband intended to subdivide into lots and sell building sites. However, Husband had undertaken only limited steps to implement these development plans.
Taxpayers timely filed their 2006 Form 1040, U.S. Individual Income Tax Return. On Schedule E, Supplemental Income and Loss, Taxpayers showed a total of $121,743 in expenses relating to U.S. real property and a portion of their Mexican real property. However, these amounts were not taken as current deductions because of the passive activity loss limitations under §469. On the Schedule C, Profit or Loss From Business, Taxpayers claimed the following deductions: (i) car and truck expenses in the amount of $2,649; (ii) depreciation in the amount of $97; (iii) supplies in the amount of $346; (iv) travel in the amount of $8,549; (v) meals and entertainment in the amount of $625; (vi) taxes and licenses in the amount of $4,600; (vii) laundry and cleaning in the amount of $2,800; and (viii) telephone in the amount of $3,092. The IRS sent a timely notice of deficiency for 2006 disallowing the deductions. In addition to the amounts shown on Schedule C, at trial Taxpayers claimed deductions for legal fees in the amount of $24,000 in connection with efforts to move squatters off a portion of their property and web site expenses in the amount of $270 which were not reflected on the 2006 return.
Under §162(a), taxpayers are authorized a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." The term "ordinary" distinguishes those expenses that are currently deductible under §162 from those that are in the nature of capital expenditures governed by §263, which, if deductible at all, must be amortized over the useful life of the asset.
The Tax Court found that Taxpayers were not entitled to deduct any of the expenses listed on Schedule C or the web site expenses because Taxpayers had failed to substantiate the expenses. While Taxpayers had retained receipts, ticket stubs and credit cards statements, the Tax Court held that Taxpayers failed to produce contemporaneously maintained records showing the business purposes for the expenses or the relationships of the expenses to their trade or business. Moreover, the Tax Court noted that Taxpayers failed to establish that the reported expenses were not more properly associated with the passive activities reported on Schedules E of Taxpayers' income tax return.
The Tax Court then turned to the deduction for a $24,000 legal settlement expense, which was the result of a legal action taken by Taxpayers to force "squatters" off their properties. The IRS asserted that these expenses were not based upon a currently active trade or business and, thus, were not current deductions. The IRS argued, in the alternative, that Taxpayers might be entitled to capitalize these expenses. The Tax Court agreed with the IRS, finding that expenses did not relate to a trade or business. The Tax Court found that the $24,000 in legal expenses, the cost of defending or perfecting title to property constituted a capital expenditure and, therefore, no current deduction was allowed for the legal expenses.1
Pursuant to §6662, a taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax: (i) due to negligence or disregard of rules or regulations or (ii) attributable to an understatement of income tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. Under §6662(c), negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code. Negligence has also been defined as the failure to do what a reasonable and prudent person would do under a similar circumstance.2 Additionally, Regs. §1.6662-3(b)(1) provides that negligence includes any failure by a taxpayer to keep adequate books and records or to properly substantiate claimed items. However, under §6662(c)(1), an accuracy-related penalty will not be imposed with respect to any portion of the underpayment as to which all of the pertinent facts and circumstances show that the taxpayer acted with reasonable cause and in good faith.
The Tax Court found that Taxpayers had managed the accounting and bookkeeping for their foreign properties carelessly during 2006. The Tax Court noted that Taxpayers failed to keep records contemporaneous with the expenses. Moreover, the Tax Court concluded that Taxpayers had claimed expenses for businesses that were in the development stage and not yet operational. Accordingly, the Tax Court concluded that the underpayment was negligent and lacking in good faith or reasonable cause.
Small business owners may be at a disadvantage when it comes to deducting business expenses. Not only do they often lack the resources to pay a third party to properly maintain tax and business records, their business operations may be slow to start due to limited capitalization. Prior to taking a business deduction for new business expenses, a taxpayer should analyze his or her activities for that year to ensure activities undertake rose to the level of trade or business carried on for-profit. Additionally, the taxpayer should keep contemporaneous records of the reasons for each expense, similar to what would be required on an expense reimbursement form for a larger company, in addition to keeping receipts and other statements of expenses.
For more information, in the Tax Management Portfolios, see Maule, 505 T.M., Trade or Business Expenses and For-Profit Activity Deductions, and in Tax Practice Series, see ¶2110, Trade or Business Expenses — General Requirements.
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