TAX COURT OPINION

Case: Ronald Albert Kelly & Catherine A. Kelly
Docket Number: 2381-13
Judge: Holmes
Opinion Type: bench
Filed: 02/27/2014
Pages: 11

UNITED STATES TAX COURT WASHINGTON, DC 20217 RONALDALBERT& CATHERINE A. KELLY, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. ) ) ) ) ) ) ) ) ) ORDER Docket No. 2381-13. Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the transcript of the trial in the above case before Judge Mark V. Holmes at San Francisco, California, on January 31, 2014, containing his oral findings of fact and opinion rendered at the trial session at which the case was heard. (Signed) Mark V. Holmes Judge Dated: Washington, D.C. February 27, 2014 SERVED MAR - 6 2014 Capital Reporting Company 3 Bench Opinion by Judge Mark V. Holmes January 31, 2014 Ronald Albert Kelly & Catherine A. Kelly Docket No. 2381-13 THE COURT: In the case of Kelly v. Commissioner, the Court has decided to render oral findings of fact and opinion, and the following represents the Court's oral findings of fact and opinion. This bench opinion is made pursuant to the authority granted by Section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court's Rules of Practice and Procedure. Mr. and Mrs. Kelly were California residents when they filed their petition. arties made some concessions on smaller issues, reached a stipulation of facts with attached exhibits, and together these constitute, with the testimony, the record of the case. The major issue by far was the Schedule C expenses for the Kellys' 2009 and 2010 tax returns for Mr. Kelly's multimedia weather education project. These amounts of disallowed expenses totaled $63,619 in 2009 and $49,332 in 2010. The effect of these expenses was to greatly reduce the taxable income 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 4 from Mrs. Kelly's work as a professor and Mr. Kelly's work at Sprint. The Respondent, the IRS, objected on substantiation grounds to many of these expenses, but also made a more overall objection based on Section 195 of the Internal Revenue Code. That section deals with a business's startup expenses and states: Except as otherwise provided in this section, no deduction shall be allowed for startup expenditures. So a great deal in this case turns on the question of whether the expenses that Mr. Kelly put on his Schedule Cs for 2009 and 2010 meet the definition that the Internal Revenue Code has for startup expenditures. The Code, in Section 195(c), states that: The term "startup expenditure" means any amount paid or incurred in connection with . . . creating an active trade or business or any activity engaged in for profit and further production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and which, if paid or incurred in connection with the operation of an existing active trade or business in the same field as the trade or business referred to in subparagraph (a) would be 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 allowable as a deduction for the taxable year in 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 5 which paid or incurred. Now this is obviously a fuzzy line. Some businesses we know are actually in business; other businesses are just starting up but incurring expenses. So the Code goes on to state that, in Section 195(c)(2): The determination of when an active trade or business begins shall be made in accordance with such regulations as the Secretary may prescribe. The Secretary, however, despite the antiquity of this provision, has never actually defined when a business starts up. So that has left it to judges over the course of the last 30 years to try to figure this out. As I've noted, Section 162(a) allows a deduction for ordinary and necessary expenses of carrying on a trade or business. In order for expenses to be deductible under that section, the expenses must relate to a trade or business functioning when the expenses were incurred. Hardy v. Commissioner, 93 TC 684, 687 (1989). A taxpayer has not "engaged in carrying on any trade or business" under 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. Richmond Television Corp. v. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 6 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 US 68 (1965). Carrying on a trade or business requires showing of more than initial research into or investigation of business potential. See Dean v. Commissioner, 56 TC 895, 902 (1971). The business operations must actually begin. See McKelvey v. Commissioner, TC Memo 2002- 63, 2002 WL 341044, at *3, affd., 76 Fed. Appx. 806 (9th Cir. 2003). Until the time a business is "performing the activities for which it was organized", expenses related to that activity are not currently deductible under Section 162. Glotov v. Commissioner, TC Memo 2007-147, 2007 WL 1702618, at *2. They are instead classified as startup or preopening expenses. Hardy, 93 TC at 687. And startup expenses, which include those incurred "before the day on which the active trade or business begins" are only deductible over time once the active trade or business begins. The McKelvey case is instructive here. The taxpayer in McKelvey was a longtime analyst at the California Department of Forestry and bought 39 acres with a barn and cabin 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 7 included on which he planned to start a tree farm. See McKelvey, 2002 WL 341044, at *1. Before buying the land, Mr. McKelvey conducted an economic and market feasibility study of its commercial viability and made several visits to the property to survey the forest's health and learn about local insects, wildlife hazards, and other risks he might face. He continued to prepare for his tree farm business for two years after he bought the property. He had a forest management plan prepared and even test-planted 51 pine trees. All this cost money, and he claimed current deductions of almost $20,000. By the time he came to Tax Court, though, he still hadn't commercially harvested any trees, he hadn't planted any more trees, and hadn't decided what species of trees to plant. We agreed with the Commissioner in McKelvey that all this meant that the taxpayer did not yet have a functioning business. Id. at *3. All his expenses were therefore startup expenses for which we allowed no current deduction. Id. at *3-*4. The taxpayer in McKelvey at least planted a few test trees. In this case, Mr. Kelly has not yet sold his program, and thus I have to disallow all of 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 8 1 the expenses that the Commissioner disallowed. But I 2 will defer them under Section 195 until Mr. Kelly's 3 4 5 6 7 active trade or business begins. I therefore urge him to keep his records of expenses, and these expenses will be deductible over time, once his business actually starts selling. So he should keep his records, and I'm specifically not 8 making any findings on whether those would qualify as 9 ordinary and necessary business expenses when 10 Mr. Kelly's business actually starts bringing in some 11 money. 12 Now there was question here as to whether 13 Mr. Kelly's business was a new business, startup 14 15 16 17 18 business, or whether it was a reinvigoration of his preexisting weather forecasting business. And although I believe Mr. Kelly to be sincere when he says that it was a reinvigoration, I think it was a reinvigoration of his clearly deeply held passion for 19 meteorology. The business that he used to have in 20 21 22 23 24 Colorado had a different model entirely. It sold weather forecasting and consulting services. His current project is to educate schoolchildren in meteorology and forecasting. I find that he is clearly passionate and extremely well 25 trained in his field, and again I urge him to keep 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 9 1 2 3 4 5 6 7 the records that he produced in this case for when his business actually starts in the sense of selling the service and selling the media education program that he's developed. But I do have to sustain the IRS on this issue. That leaves the question of penalties here. The IRS asserts a 20 percent penalty against the 8 Kellys' under Section 6662(a) of the Internal Revenue 9 Code, which adds that penalty for, among other 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 things, any substantial understatement of income tax. The notice of deficiency in the Kelly case stated that this 6662(a) penalty could be based on either negligence or substantial understatement. A substantial understatement of income tax occurs when the amount of the understatement for a particular tax year exceeds the greater of 10 percent of the tax required to be shown on the return for that tax year, or $5,000. IRC Section 6662(d)(1); Treas. Reg. Section 1.6662-4. In this case, the amount of tax required to be shown on the Kellys' 2009 and 2010 returns is approximately $18,000 for 2009 and $14,000 for 2010, that 10 percent of which is less than 5,000, so the greater amount under 6662(d)(1) is 5,000. Their understatement for the two years is approximately 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 10 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 $14,000 for 2009 and approximately $9,000 for 2010. Each of those amounts is greater than $5,000, so there is under law a substantial understatement of income tax with respect to the Kellys' 2009 and 2010 tax year. But, of course, there's a defense to the substantial understatement penalty, and that defense is whether Mr. Kelly behaved reasonably in good faith in taking the return position that he did. Whether the defense exists is governed by Treasury regulation Section 1.6664-4(b)(1), which states that "the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances . . . . Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest 20 misunderstanding of fact or law that is reasonable in 21 22 23 24 25 light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Here, Mr. Kelly is clearly very well educated and trained in meteorology, and he did take 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 11 1 2 3 4 5 6 7 8 9 one accounting course many years ago as part of an MBA program. But he testified that he prepared the taxes himself and that he just looked briefly at the instructions for Schedule C. So I went back and I looked at the instructions for Schedule C as well, and they just say that "if your business began in 2013, you can elect to deduct up to $5,000 of certain business startup costs." Goes on to refer people to 10 Publication 535. Publication 535, if he had thought 11 12 13 14 15 to look at it, doesn't give much more. There's not a synopsis, for instance, of all these 30 years of case law. And for somebody who's not legally trained or an accountant or has prior experience with the tax system, and here I specifically credit as truthful 16 Mr. Kelly's testimony that he has not previously had 17 18 19 20 21 22 bad audit or tax penalty experience, these wouldn't be much help if, as again I find, he sincerely thought that this was a reinvigoration rather than the startup of a new business. I don't think that was a reasonable interpretation, but then I'm a tax lawyer and I know 23 more than Mr. Kelly does about the tax system. But I 24 25 have to look at it not from my perspective, and not from the perspective of somebody who can work his way 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 12 1 2 3 4 5 6 through regulations and 30 years of case law, but from somebody who has Mr. Kelly's education, training, and experience and prior experience with the tax system. So my conclusion is that I sustain the government on the substance of things, but that I 7 won't sustain the government's assertion of a penalty against the Kellys. This concludes the Court's oral findings of fact and opinion in this case. Computations under Rule 155 will be necessary before I can enter a final decision. With that, this case and this session are over. Thank you very much for your time and patience. Thank you, too, Mr. And Mrs. Kelly. (Whereupon, at 12:35 p.m., the above- entitled matter was concluded.) 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com