Court Opinion

ID: 6349705
Source: CourtListenerOpinion
Date Created: 2022-06-14 19:01:07.500801+00
Date Added: 2024-06-11T09:14:51.914835
License: Public Domain

United States Tax Court

                                T.C. Memo. 2022-62

                         GREGG MICHAEL KELLETT,
                                Petitioner

                                            v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                      —————

Docket No. 21518-18.                                             Filed June 14, 2022.

                                      —————

Lawrence A. Sannicandro, for petitioner.

Ka Tam and Bartholomew Cirenza, for respondent.

         MEMORANDUM FINDINGS OF FACT AND OPINION

        GREAVES, Judge: Respondent disallowed a $25,922 business
expense deduction and determined a corresponding $6,475 deficiency for
petitioner’s 2015 tax year. We must decide what portion of these
expenditures petitioner may deduct on his 2015 federal income tax
return as costs of developing a business information website.
Petitioner’s active trade or business began when he opened his website
to the public in September 2015. Section 162(a) allows him to deduct
the $8,087 of business-related expenditures he paid thereafter as trade
or business expenses, and section 195(b)(1)(B) allows him to ratably
deduct the remaining $16,553 of business-related expenditures as start-
up expenditures over the 180-month period beginning with September
2015. 1

        1 Unless otherwise indicated, all statutory references are to the Internal

Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

                                  Served 06/14/22
                                        2

[*2]                        FINDINGS OF FACT

       The parties filed a Stipulation of Facts and a Supplemental
Stipulation of Facts, both with accompanying exhibits, that are
incorporated by this reference. Petitioner resided in Virginia when he
petitioned this Court.

      Petitioner is an entrepreneur with experience in information
technology. After graduating from Marshall University in 2002 with a
bachelor’s degree in business management, petitioner launched a retail
website, which he operated until 2007. He later joined the online
marketing division of MarketResearch.com, a company that sells online
reports and industry studies from more than 350 publishers. In 2011 he
moved to Bloomberg Industry Group, a major publisher of legal and
business information, where he managed paid advertising, web
analytics and reporting, and search engine optimization for various
Bloomberg brands.

       While working approximately 40 hours per week at Bloomberg,
petitioner began to work part time from home on his next venture:
building an online repository of demographic, social, and economic data.
He settled on the project after studying existing websites that aggregate
this kind of information, which he found less user-friendly than
investment information platforms like Google Finance and Yahoo
Finance. He also discovered that he could download the data from free
public domain sources like the International Monetary Fund, the World
Bank, the United Nations Statistics Division, the World Health
Organization, and the U.S. Department of Labor.

      Petitioner set out to create a single user-friendly interface that
would provide data from these dispersed sources to investment bankers,
economists, journalists, investment management firms, and market
research firms. In 2013 he purchased the vizala.com domain name and
formed Vizala, LLC (Vizala or business), of which he was the sole
member. Petitioner himself created the simple webpages such as the
“About Us” page and instructions on how to use the website. He hired
remote computer engineers to develop Vizala’s interactive features that
allowed users, for example, to create charts comparing countries’ health
expenditures per capita. Users could save their charts, export them to
Microsoft Excel, and upload them to social media and their own

relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure. This opinion rounds monetary amounts to the nearest dollar other than in
the Appendixes.
                                           3

[*3] websites. Petitioner described to the engineers how he wanted
these features to work, and the engineers developed them using open-
source software—free downloadable generic code for databases and
advanced websites. Petitioner and the engineers completed Vizala’s
core functionality in March 2015, and worked to resolve software “bugs”
before opening both the desktop and mobile versions of Vizala to the
public in or around September 2015. In an example of a bug discussed
at trial, petitioner asked an engineer to fix an interactive table that
displayed incorrectly in the Firefox web browser.

       Petitioner envisioned at least four ways to make money from
Vizala: (1) selling advertising space to third parties, (2) implementing
a “paywall” and charging a monthly fee for access to certain features of
the website, (3) selling personalized charts and reports of information
from the website, and (4) licensing data from the website to other
companies. He did not pursue any of these strategies in 2015, and
Vizala did not begin to earn revenue until 2019. Petitioner spent 2015
perfecting and promoting Vizala, convinced he could maximize long-
term profit by cultivating confidence and dependence among users and
advertisers before monetizing the business. After the website opened,
petitioner and a marketing professional promoted the website to over a
hundred universities and professional organizations, and about half
these institutions added Vizala to their lists of research databases.

       Petitioner timely filed Form 1040, U.S. Individual Income Tax
Return, for his 2015 tax year, wherein he deducted $25,922 of “Other
Expenses” on Schedule C, Profit or Loss From Business, 2 using cash
method accounting. 3 These expenses consisted of $20,509 of payments
to the engineers (engineer expenses), $2,410 paid to marketing
professional Stacey Weliver (marketing expenses), $1,856 of payments
to Verizon for cell phone service and internet service at petitioner’s home

        2 Subject to exceptions not applicable here, a business entity that has a single
owner and is not a corporation is disregarded as an entity separate from its owner for
federal income tax purposes. See Treas. Reg. § 301.7701-2(c)(2)(i). An individual who
owns a disregarded entity reports the entity’s tax items on Schedule C. See 2015
Instructions for Schedule C, at C-1.
        3 The cash receipts and disbursements method generally requires that

expenditures be deducted for the taxable year in which actually made. Treas. Reg.
§§ 1.446-1(c)(1)(i), 1.461-1(a)(1); see also Saviano v. Commissioner, 80 T.C. 955, 964
(1983) (“[U]ntil a cash basis taxpayer suffers an economic detriment, i.e., an actual
depletion of his property, he has not made a payment which will give rise to an expense
deduction.” (quoting Rife v. Commissioner, 356 F.2d 883, 889 (5th Cir. 1966), rev’g and
remanding 41 T.C. 732 (1964))), aff’d, 765 F.2d 643 (7th Cir. 1985).
                                          4

[*4] (Verizon expenses), and $1,148 for miscellaneous items related to
Vizala (miscellaneous expenses). See infra Appendixes (listing the date
and amount of each payment in the foregoing four categories).
Respondent disallowed the entire deduction in a notice of deficiency
mailed to petitioner on July 31, 2018, and petitioner sought
redetermination of the deficiency in this Court. 4

                                     OPINION

I.     Burden of Proof

       The Commissioner’s determinations set forth in a notice of
deficiency are generally presumed correct, and the taxpayer bears the
burden of proving the determinations are in error. Rule 142(a)(1); Welch
v. Helvering, 290 U.S. 111, 115 (1933). Moreover, deductions are a
matter of legislative grace, and the taxpayer bears the burden of proving
his entitlement to any deduction claimed.            INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). We denied by Order issued on
February 4, 2021, petitioner’s Motion of January 21, 2021, to shift the
burden of proof to respondent under Rule 142(a)(1).

       Petitioner made an oral motion at trial to shift the burden of proof
to respondent under section 7491(a), paragraph (1) of which provides in
pertinent part that if “a taxpayer introduces credible evidence with
respect to any factual issue relevant to ascertaining the liability of the
taxpayer for [the federal income tax], the Secretary shall have the
burden of proof with respect to such issue.” 5 Paragraph (2)(B) further
provides that the paragraph (1) burden shift applies with respect to an
issue only if the taxpayer has maintained all records required by the
Code.

      As explained infra Part II, the burden of proof does not shift to
respondent as to the date petitioner opened his website, the business
purpose of the Verizon expenses, or the total amount of start-up
expenditures. We otherwise decide the factual issues in this case on the
preponderance of the evidence, and we need not decide which party has

       4 The notice of deficiency imposed a section 6662(a) accuracy-related penalty of
$1,295, which respondent conceded before trial.
       5 Section 7701(a)(11)(B) defines the “Secretary” as the Secretary of the

Treasury or his delegate. The Secretary of the Treasury has delegated to the
Commissioner the authority to litigate cases on behalf of the United States in the Tax
Court. See, e.g., Treas. Reg. § 601.509.
                                          5

[*5] the burden of proof. See Knudsen v. Commissioner, 131 T.C. 185,
189 (2008), supplementing T.C. Memo. 2007-340.

II.    Trade or Business Expenses and Start-Up Expenditures

       Petitioner argues that he can deduct all $25,922 reported on
Schedule C as section 162 trade or business expenses. Respondent
would deny the full amount as section 195 start-up expenditures that
petitioner cannot deduct for 2015 because his active trade or business
had not begun by the end of the year. We conclude in this Part II that
section 162 permits petitioner to deduct the $8,087 of engineer expenses,
marketing expenses, business-related Verizon expenses, and
miscellaneous expenses paid after September 30, 2015, when his active
trade or business began. He may deduct the remaining $16,553 of
business-related expenditures, which are section 195 start-up
expenditures, ratably over the 180-month period beginning with
September 2015.

       A.      When Petitioner’s Active Trade or Business Began

       Section 162(a) permits a deduction for ordinary and necessary
expenses paid or incurred during the taxable year “in carrying on any
trade or business.” Section 195(a), on the other hand, generally denies
a deduction for start-up expenditures, which section 195(c)(1)(A)(iii)
defines in pertinent part to include any amount paid or incurred in
connection with “any activity engaged in for profit and for the 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.” See
Hardy v. Commissioner, 93 T.C. 684, 687 (1989) (“Start-up or pre-
opening expenses are not currently deductible under section 162.”).
Without any regulations to tell us when an active trade or business
begins, 6 we rely on a test developed by the U.S. Court of Appeals for the
Fourth Circuit, the appellate venue for this case absent a stipulation by
the parties. See § 7482(b); 28 U.S.C. § 41 (2018). 7 In the Fourth Circuit,
a taxpayer does not begin carrying on a trade or business “until such
time as the business has begun to function as a going concern and

       6  Sections 195(c)(2)(A) and 7701(a)(11)(B) direct us to determine when an
active trade or business begins on the basis of regulations prescribed by the Secretary
of the Treasury or his delegate, although no regulations have been promulgated.
       7 The Tax Court will follow a Court of Appeals decision which is squarely on

point where appeal from our decision lies to that Court of Appeals alone. Golsen v.
Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).
                                          6

[*6] performed those activities for which it was organized.” Richmond
Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), 8
vacated and remanded per curiam on other grounds, 382 U.S. 68 (1965).
The Tax Court determines when this happens on the basis of the facts
and circumstances of a given case. Madison Gas & Elec. Co. v.
Commissioner, 72 T.C. 521, 566 (1979), aff’d, 633 F.2d 512 (7th Cir.
1980).

       The Fourth Circuit did not allow Richmond Television Corp. to
deduct staff training costs incurred in 1953–55 for its new television
station because the business did not begin until the station went on the
air in 1956. Richmond Television, 345 F.2d at 903–07. A television
station, like a business information website, exists to communicate
information to the public, via television programming in the former case
and data aggregation and analysis software in the latter. Just as a
television station can have no viewers until it begins broadcasting,
Vizala could have no users before the website opened. Petitioner’s active
trade or business could not begin until that happened.

       Unlike the television station in Richmond Television, however,
Vizala had no revenue until well after going live. See id. at 903–04, 909
(explaining that the station launched in 1956 and sought to carry
forward its business expense deductions as net operating losses to 1956
and 1957, which indicates it had income in those years). Respondent
argues that none of the expenditures petitioner reported on Schedule C,
even amounts paid after the website opened, is a section 162 expense
because Vizala had no revenue and no means of generating revenue in
2015. A taxpayer’s effort to sell goods or services may qualify as an
active trade or business even if the taxpayer makes no sales and
therefore has zero gross receipts. See Cabintaxi Corp. v. Commissioner,
63 F.3d 614, 620 (7th Cir. 1995), aff’g in part, rev’g in part T.C. Memo.
1994-316. Vizala, on the other hand, made no attempt to sell anything—

        8 The same case points out that the Code prohibits a business expense

deduction for capital expenditures. Richmond Television, 345 F.2d at 907–08; see also
§ 263 (denying a deduction for capital expenditures). Respondent does not argue that
any portion of the claimed deduction is a section 263 capital expenditure and concedes
that only section 195 is at issue as to the business-related expenditures petitioner
reported on Schedule C.
                                          7

[*7] advertisements, access to website features, customized reports, or
licensed data—until after 2015. 9

       The typical case determining when an active trade or business
begins contemplates a traditional business archetype: If initial
operations succeed, the company should start earning revenue as soon
as the active trade or business begins. For example, a grocery store will
earn revenue by selling groceries as soon as it draws customers. See
Piggly Wiggly S., Inc. v. Commissioner, 84 T.C. 739, 745–48 (1985)
(allowing a store operator to deduct the cost of equipment placed in open
stores, but denying the same deduction for stores not yet open), aff’d,
803 F.2d 1572 (11th Cir. 1986). By the same token, a company operating
an apartment or office building should receive rent payments as soon as
it admits tenants. See Johnsen v. Commissioner, 83 T.C. 103, 114–18
(1984) (denying deductions for pre-opening costs of rental property and
discussing other cases reaching the same result), rev’d on other grounds,
794 F.2d 1157 (6th Cir. 1986).

       Vizala does not fit this traditional archetype. Petitioner doubted
that any of his revenue strategies could succeed until Vizala built
rapport with users and advertisers. He therefore prioritized web traffic
over revenue by charging no user fees and marketing the site to
institutional customers. Even though petitioner made no attempt to
earn revenue in 2015, his business began providing the services “for
which it was organized,” with an eye to long-term profit, once he opened
the website. See Richmond Television, 345 F.2d at 907. Such activity,
at least under these circumstances, constitutes an active trade or
business.

       The parties agree that Vizala opened to the public in or around
September 2015. The burden of establishing the opening date does not
shift to respondent under section 7491(a), see supra Part I, because
petitioner has not proposed, let alone introduced credible evidence of, an
opening date. We therefore err on the side of respondent by postulating

        9 In announcing its going-concern test, the Fourth Circuit cites Justice

Frankfurter’s concurring opinion in Deputy v. du Pont, 308 U.S. 488, 499 (1940), which
asserts that carrying on a trade or business “involves holding one’s self out to others
as engaged in the selling of goods or services.” Richmond Television, 345 F.2d at 907
n.7 (emphasis added).        The Supreme Court later formally rejected Justice
Frankfurter’s gloss on the trade or business inquiry. Commissioner v. Groetzinger, 480
U.S. 23, 34 (1987).
                                          8

[*8] that petitioner opened the website at the end of the day on
September 30, 2015.

       B.      Trade or Business Expenses Deductible for 2015

      Respondent concedes the business purpose of the engineer
expenses, marketing expenses, and miscellaneous expenses. We
therefore conclude that petitioner may deduct the $7,928 of such
expenses paid after September 30 as section 162 trade or business
expenses.    However, respondent argues that petitioner has not
demonstrated the business purpose of the Verizon expenses. The Court
should treat petitioner’s payments for cell phone and internet services
as nondeductible section 262(a) personal expenses, respondent
contends, including amounts paid after petitioner’s active trade or
business began.

       A taxpayer generally bears the burden of distinguishing the
portion of an expense paid or incurred in carrying on a trade or business,
which he may deduct under section 162(a), from any portion that is
nondeductible as a section 262(a) personal expense. See Commissioner
v. Doak, 234 F.2d 704, 708 (4th Cir. 1956) (citing Sutter v. Commissioner,
21 T.C. 170 (1953)), rev’g 24 T.C. 569 (1955). Petitioner’s burden of proof
with respect to the business purpose of the Verizon expenses does not
shift to respondent under section 7491(a), see supra Part I, because
petitioner failed to maintain documentation that differentiates his
personal and business use of the Verizon services, see § 6001; Treas. Reg.
§ 1.6001-1(a), (e).

      In certain circumstances, however, the Court may approximate a
business expense if the taxpayer cannot substantiate its exact amount.
Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930). 10 The Court
must have some basis on which to make an estimate, Vanicek v.
Commissioner, 85 T.C. 731, 743 (1985), and “bear[s] heavily . . . upon the

         10 Although the Court may not approximate business expenses that are subject

to the strict substantiation requirements of section 274(d), Boyd v. Commissioner, 122
T.C. 305, 320 (2004), section 274(d) does not apply to cell phone or internet expenses,
see Small Business Jobs Act of 2010, Pub. L. No. 111-240, § 2043(a), 124 Stat. 2504,
2560 (removing cell phones from the definition of section 280F(d)(4) listed property,
and thus from the scope of section 274(d), for tax years beginning after December 31,
2009); Farran v. Commissioner, T.C. Memo. 2007-151, slip op. at 14–15 (characterizing
internet expenses as utility expenses and therefore not subject to strict
substantiation).
                                          9

[*9] taxpayer whose inexactitude is of his own making,” Cohan v.
Commissioner, 39 F.2d at 544.

       Petitioner credibly testified that he used the Verizon services 80%
to 90% for Vizala in 2015, with the remainder for personal reasons, but
he presented no records tracking his business and personal use.
Petitioner did submit a contemporaneously prepared Excel spreadsheet
indicating that he averaged 49 hours per week working on Vizala during
the last three months of 2015, which we find helpful in approximating
petitioner’s potential business use of the cell phone and internet
services.

       The 49 hours per week petitioner spent on Vizala required
extensive use of his cell phone and the internet: talking with his hired
personnel, downloading data, sending emails, and reviewing the
progress of the website online. Added to the 40 hours per week
petitioner spent working for Bloomberg, during which time he used the
Verizon service only sparingly, that makes 89 hours per week he spent
working and 79 hours per week he spent not working. We appreciate
that he did not use the Verizon service for nonbusiness purposes during
the entire 79 nonworking hours in each week, but petitioner did not
submit evidence allocating this time to other activities such as eating
and sleeping.

       Bearing heavily against petitioner, we estimate his business use
of the Verizon services on the basis of the ratio of the 49 hours per week
he spent on Vizala to the 128 hours per week he spent working on Vizala
or not working. Accordingly, petitioner has established the business
purpose of 38.3% of the $415 of Verizon expenses paid after September
30, or $159.

       C.      Years for Which Petitioner Can Deduct His Start-Up
               Expenditures

      Section 195(b)(1)(A) generally permits a taxpayer to deduct up to
$5,000 of start-up expenditures for the year his active trade or business
begins. 11 Section 195(b)(1)(A)(ii) denies this deduction to a taxpayer
whose total start-up expenditures, including those paid or incurred

        11 Section 195(d) requires a taxpayer to elect into section 195(b), which

petitioner did by claiming a deduction for the start-up expenditures he paid in 2015 on
his timely filed return. See I.R.S. Publication 535, Business Expenses: For Use in
Preparing 2015 Returns, 24; see also Treas. Reg. § 1.195-1(b) (explaining that a
taxpayer is deemed to have made a section 195(b) election).
                                        10

[*10] before the year his active trade or business begins, exceed $55,000.
Petitioner failed to introduce any evidence, let alone credible evidence,
of his costs of developing Vizala from the time he began work on the
project circa 2013 to the end of 2014, leaving us to guess his total start-
up expenditures. Petitioner retains the burden of proof on this issue, see
supra Part I, which he has not satisfied, and he may not deduct start-up
expenditures under section 195(b)(1)(A).

       Section 195(b)(1)(B) allows a taxpayer to deduct start-up
expenditures ratably over the 180-month period beginning with the
month in which the active trade or business begins. Petitioner’s Excel
spreadsheet shows he averaged 37 hours per week working on Vizala
during the first nine months of 2015. By the reasoning supra Part II.B,
petitioner has established the business purpose of 28.8% of the $1,441
of Verizon expenses paid before September 30, or $414. Adding this to
the $16,138 of engineer expenses, marketing expenses, and
miscellaneous expenses paid before September 30 makes a total of
$16,553 of 2015 start-up expenditures. Petitioner may deduct this
amount ratably over the 180-month period beginning with September
2015, when his active trade or business began.

III.   Petitioner’s Alternative Arguments

       To the extent we hold that he may not deduct any of the engineer
expenses as section 162 trade or business expenses, petitioner argues
that he can deduct them as section 174 research or experimental
expenditures, or as costs of developing computer software under Rev.
Proc. 2000-50, 2000-2 C.B. 601. We address each argument in turn.

       A.      Section 174

      Section 195(c)(1) excludes from the definition of start-up
expenditures any amount with respect to which a deduction is allowable
under section 174. Section 174(a)(1), as in effect for 2015, allows a
taxpayer to deduct “research or experimental expenditures which are
paid or incurred by him during the taxable year in connection with his
trade or business.” 12 Treasury Regulation § 1.174-2(a)(1) defines
research or experimental expenditures as “expenditures incurred in
connection with the taxpayer’s trade or business which represent
research and development costs in the experimental or laboratory

       12 Congress withdrew the deduction for amounts paid or incurred in tax years

beginning after December 31, 2021. See Tax Cuts and Jobs Act, Pub. L. No. 115-97,
§ 13206, 131 Stat. 2054, 2111 (2017).
                                          11

[*11] sense.” This means the expenditures “are for activities intended
to discover information that would eliminate uncertainty concerning the
development or improvement of a product.” Id. “Uncertainty exists,”
the regulation continues, “if the information available to the taxpayer
does not establish the capability or method for developing or improving
the product or the appropriate design of the product.” Id. Petitioner
may not deduct any of his expenditures under section 174 because he
did not encounter this kind of uncertainty in creating Vizala.

       A pair of cases involving the section 41 credit for increasing
research activities, which requires the taxpayer to demonstrate that
expenditures may be treated as section 174 expenditures, see
§ 41(d)(1)(A), 13 illustrates how to understand “uncertainty” in the
context of software development. In the first case the court denied
taxpayer Morris Davenport a section 41 credit for wages paid to develop
software that would automate and integrate the manufacturing, design,
sales, accounting, and shipping aspects of his business. United States v.
Davenport, 897 F. Supp. 2d 496, 499–501, 518 (N.D. Tex. 2012). An
outside contractor created the software using a commercially available
software application suite. Id. at 500, 510–11. After conferring with
Mr. Davenport’s employees to understand their needs, the contractor
developed a preliminary product by following a standardized process
based on “industry best practices” and resolved problems and added
functionalities according to the employees’ feedback. See id. at 510–14.
Although the project consumed lots of time and effort, the record
reflected a straightforward application of the tried and true
development process the contractor apparently followed in service of
other clients. See id. at 515.

       At the other end of the spectrum lies Eric Suder, whose company’s
costs of developing a series of phone systems passed the section 174 test.
See Suder v. Commissioner, T.C. Memo. 2014-201, at *1–30, *42–44.
Although the company followed a systematic development process,
neither Mr. Suder nor his team knew exactly what steps to follow to
create the products they conceived or how the products would be
designed. Id. at *8, *42–43. Each project began at the drawing board:
Senior management brainstormed an idea for a new product and drafted
a rudimentary diagram and specifications which their engineers used to
make the idea commercially viable. Id. at *8–9. The company’s

       13 Congress revised section 41(d)(1)(A) effective for tax years beginning after

December 31, 2021, to conform to the revision of section 174 described in the preceding
note. See Tax Cuts and Jobs Act § 13206(d)(1), 131 Stat. at 2112.
                                   12

[*12] hardware was proprietary, so employees had to create what they
needed out of whole cloth using their own expertise. Id. at *10–11.
Software engineers tested and retested computer code to perfect the
timing of the products’ components within milliseconds. Id. at *12. In
one case the company created a softphone that allowed the user to make
calls from a personal computer while traveling, which presented the
challenge of developing software capable of transferring calls through
hotel routers and firewalls. Id. at *18. When the Internal Revenue
Service (IRS) expert questioned the team’s failure to develop the
softphone using open-source software, an employee credibly testified
that this would have required significant and time-consuming changes
to the product. Id. at *41.

       Vizala followed the Davenport paradigm: Petitioner and his
engineers adapted widely used software to solve a complex but familiar
problem. Petitioner’s project did not start from the “drawing board” in
the same sense as Mr. Suder’s softphone. Petitioner aimed to create a
data aggregation website, which companies such as Google Finance had
done before, only his website would present demographic, social, and
economic data instead of the financial information available on
professional-quality platforms. Whereas the softphone required Mr.
Suder’s team to write code from a blank slate, Vizala permitted the use
of open-source software customized for petitioner’s needs. Like Mr.
Davenport’s employees, petitioner described to his engineers how the
product should work, and, as an inherent part of designing complex
software, collaborated with the engineers to troubleshoot problems
before launch. Cf. id. at *39–40 (disagreeing with the IRS’s position that
Mr. Suder’s team encountered only the kind of uncertainty inherent in
every large development effort). As in Mr. Davenport’s case, we
conclude that petitioner may not deduct his expenses under section 174.

      B.     Rev. Proc. 2000-50

      Petitioner argues that he may deduct the engineer expenses on
the basis of Rev. Proc. 2000-50, §§ 4, 5.01, 2000-2 C.B. at 601, which
announces that the IRS will not disturb a taxpayer’s immediate
deduction of certain costs of developing computer software that the
taxpayer has not treated as section 174 research or experimental
expenditures. We must reject this argument because, to the extent Rev.
Proc. 2000-50 purports to establish a taxpayer’s entitlement to a
deduction, petitioner has not demonstrated that the Code authorizes
any such deduction.
                                    13

[*13] Rev. Proc. 2000-50 mimics the section 174 exception to the
capitalization rules of sections 195 and 263. As explained supra Part
II.A, section 162(a) permits a deduction for ordinary and necessary
expenses paid or incurred during a taxable year “in carrying on any
trade or business,” but section 195 generally denies an immediate
deduction for start-up expenditures paid or incurred before the “active
trade or business” begins. Moreover, section 263(a)(1) generally denies
an immediate deduction for amounts paid for permanent improvements
to property, which the title of section 263 calls “capital expenditures.”
See Woodward v. Commissioner, 397 U.S. 572, 575 (1970) (explaining
that a taxpayer cannot deduct a capital expenditure under section 162).
The taxpayer “capitalizes” section 195 and section 263 expenditures, see
§ 1016(a)(1) (providing a basis adjustment for expenditures “properly
chargeable to capital account”), and in some cases can deduct them over
subsequent years through depreciation or amortization, see, e.g., §§ 167,
195(b).

       As in effect for 2015, see supra note 12, section 174(a)(1) overrides
these capitalization rules for research or experimental expenditures
paid or incurred by the taxpayer during the taxable year “in connection
with his trade or business.” The taxpayer need not actually be engaged
in a trade or business to incur an expenditure “in connection with his
trade or business,” but there must be a realistic prospect at the time of
the expenditure that the taxpayer will enter a trade or business
involving the technology being developed. See Lewin v. Commissioner,
335 F.3d 345, 347–48 (4th Cir. 2003), aff’g per curiam T.C. Memo.
2001-10. Such expenditures are not start-up or capital expenditures.
See §§ 195(c)(1) (flush text), 263(a)(1)(B); see also § 263A(c)(2)
(exempting any amount allowable as a deduction under section 174 from
section 263A(a)(1), which requires that certain costs be included in
inventory costs or capitalized). The taxpayer may either deduct the
expenditures in the taxable year they are paid or incurred, § 174(a), or
capitalize and deduct them ratably over 60 months, § 174(b).

       On the theory that they “so closely resemble” section 174
expenditures “as to warrant similar accounting treatment,” Rev. Proc.
2000-50, §§ 4 and 5.01, purports to allow the same timing election for
certain costs of developing computer software that the taxpayer has not
treated as section 174 expenditures. The revenue procedure announces
in pertinent part that the IRS “will not disturb” a taxpayer’s deduction
of these costs “in accordance with rules similar to those applicable under
§ 174(a),” or capitalization and recovery of the costs through
amortization deductions “in accordance with rules similar to those
                                   14

[*14] provided by § 174(b) and the regulations thereunder” or other
rules described in the revenue procedure. Id.; see also T.D. 9107, 2004-1
C.B. 447, 452 (preamble to regulations under section 263 directing
taxpayers to rely on Rev. Proc. 2000-50 to determine when to deduct
computer software development costs).

             1.    Respondent Failed to Explain How to Coherently
                   Apply Rev. Proc. 2000-50.

       Respondent does not dispute that the engineer expenses are costs
of developing computer software as defined in Rev. Proc. 2000-50, but
insists that petitioner cannot deduct any of the expenses he reported on
Schedule C because his active trade or business did not begin until after
2015. Respondent argues that allowing petitioner to deduct amounts
paid before his active trade or business began, even if they satisfy the
criteria of Rev. Proc. 2000-50, is not authorized by the Code and would
be “making new law contrary to congressional intent.”

       We cannot reconcile respondent’s gloss on Rev. Proc. 2000-50 with
the terms of the revenue procedure itself, for two reasons. First, Rev.
Proc. 2000-50 announces that the IRS “will not disturb” a deduction that
satisfies its criteria, with no caveat about an active trade or business.
Unlike section 174, the revenue procedure does not even require that
expenditures be incurred “in connection with” a trade or business. Yet
even if it did, respondent does not deny that petitioner had a realistic
prospect as of the beginning of 2015 of entering a trade or business
involving the website under development. See Lewin v. Commissioner,
335 F.3d at 347–48 (discussed supra). Second, the stated purpose of Rev.
Proc. 2000-50 is to provide accounting treatment of the kind allowed by
section 174, and the manifest purpose of section 174 is to suspend the
capitalization rules of sections 195 and 263 for research or experimental
expenditures. Withholding the Rev. Proc. 2000-50 deduction from a
taxpayer whose active trade or business has yet to begin makes no sense
because the revenue procedure is meant to provide relief from this
requirement.

       Neither do we agree with respondent’s attempt to reconcile Rev.
Proc. 2000-50 with the Code. Rev. Proc. 2000-50 does not say which part
of the Code authorizes its timing rule for costs of developing computer
software that the taxpayer has not treated as section 174 expenditures.
Although respondent argued at trial that the authority comes from
section 162, see also David E. Hardesty, Electronic Commerce: Taxation
& Planning, para. 7.06(3)(b)(iv) (2021), Westlaw ECOMM WGL
                                   15

[*15] (inferring the same), the rule is both too narrow and too broad for
this argument to hold water. On the one hand, section 162 allows as a
deduction “all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business.”
(Emphasis added.) Yet Rev. Proc. 2000-50 applies only to costs of
developing computer software, not any other costs paid or incurred in
carrying on the same trade or business, assuming arguendo that a
taxpayer who pays or incurs such costs is carrying on a trade or business
at all. On the other hand, Rev. Proc. 2000-50 purports to allow a
taxpayer to deduct costs paid or incurred before his active trade or
business begins per section 195, if indeed an active trade or business
ever begins, and irrespective of whether the costs otherwise would be
nondeductible section 263 capital expenditures. As explained supra,
Rev. Proc. 2000-50 exists to supersede these capitalization rules, which
themselves supersede the section 162 deduction for trade or business
expenses.

             2.    Petitioner Failed to Advance a Viable Claim Based
                   on Rev. Proc. 2000-50.

       Petitioner makes no attempt to justify Rev. Proc. 2000-50 as
consistent with the Code. He argues that the engineer expenses satisfy
the Rev. Proc. 2000-50 criteria for deduction and that the IRS is
“estopped” from taking a position contrary to its own guidance.
Petitioner has the burden of establishing his entitlement to any
deduction claimed, as explained surpa Part I, so we assume without
deciding that the Rev. Proc. 2000-50 deduction lacks statutory
authorization.

       Courts generally treat revenue procedures as governing internal
IRS operations and hold that they do not create substantive rights in
the public. Capitol Fed. Sav. & Loan Ass’n & Sub. v. Commissioner, 96
T.C. 204, 216–17 (1991). The Fourth Circuit reached the same holding
as to “rules laid down by the Commissioner for the regulation of the
affairs of his office.” See Luhring v. Glotzbach, 304 F.2d 560, 563–65
(4th Cir. 1962). To the extent Rev. Proc. 2000-50 establishes an
administrative policy not to “disturb” a deduction that complies with its
criteria, irrespective of whether the Code authorizes the deduction,
Capitol Federal and Luhring dictate that Rev. Proc. 2000-50 offers
petitioner no remedy.

      When the IRS has announced to taxpayers in a revenue procedure
how it will exercise discretion conferred by the Code, however, the Tax
                                          16

[*16] Court has set aside as an abuse of discretion the IRS’s failure to
honor the revenue procedure in individual cases. See Capitol Fed., 96
T.C. at 217–20. Section 446(b), for example, grants the IRS broad
discretion to determine whether an accounting method “clearly reflect[s]
income,” a concept the Code does not define, and therefore whether a
taxpayer may use that method to compute taxable income. 14 See
Commissioner v. Hansen, 360 U.S. 446, 467 (1959) (discussing the
predecessor of section 446). The IRS abused this discretion by denying
a taxpayer the use of an accounting method permitted by Rev. Proc.
71-21, 1971-2 C.B. 549, even though the taxpayer qualified to use the
method by the terms of the revenue procedure itself. Barnett Banks of
Fla., Inc. v. Commissioner, 106 T.C. 103, 116–17 (1996).

       Before we can find an abuse of discretion, however, we must find
a grant of discretion. See Woodral v. Commissioner, 112 T.C. 19, 25
(1999) (“[A] person with no discretion simply cannot abuse it.”). The
Supreme Court has acknowledged the self-evident principle that
“Congress, not the Commissioner, prescribes the tax laws.” Dixon v.
United States, 381 U.S. 68, 73 (1965). IRS guidance that operates to
create a rule out of harmony with the Code is a mere nullity, see id. at 74
(citing Manhattan Gen. Equip. Co. v. Commissioner, 297 U.S. 129, 134
(1936)), and cannot in and of itself bar the United States from collecting
a tax otherwise lawfully due, see id. at 73. To the extent Rev. Proc. 2000-
50 purports to establish the taxpayer’s entitlement to a deduction,
therefore, we cannot sustain the rule without a statutory predicate.

       Petitioner apparently asks us to enforce the Rev. Proc. 2000-50
deduction on the basis of a theory of equitable estoppel, 15 whereby courts
aid a party who has relied in good faith to his detriment upon the
representations of another. United States v. Fid. & Cas. Co. of N.Y., 402
F.2d 893, 897 (4th Cir. 1968). The doctrine “operates to place the person
entitled to its benefit in the same position he would have been in had
the representations been true.” CIGNA Corp. v. Amara, 563 U.S. 421,

       14 Sections 446(b) and 7701(a)(11)(B) confer this authority on the Secretary of
the Treasury or his delegate, and the regulations underlying section 446 confirm that
the Secretary of the Treasury has delegated this authority to the IRS. See, e.g., Treas.
Reg. § 1.446-1(a)(2) (“[N]o method of accounting is acceptable unless, in the opinion of
the Commissioner, it clearly reflects income.”).
        15 Petitioner cites Rauenhorst v. Commissioner, 119 T.C. 157 (2002), which did

not estop the IRS from disavowing its own guidance. The Court treated as an IRS
concession its own bright-line rule, announced in a revenue ruling that acquiesced in
a Tax Court decision, simplifying the complex question of when a taxpayer recognizes
income on a post-donation sale of donated property. See id. at 164–73.
                                   17

[*17] 441 (2011) (quoting J. Eaton, Handbook of Equity Jurisprudence
§ 62 (1901)).     Even if the Rev. Proc. 2000-50 deduction lacks
congressional authorization, that is, petitioner argues that it would be
unfair to allow the IRS to deny a deduction it guaranteed in published
guidance. Assuming arguendo that equitable estoppel ever applies
against the Government, see Dawkins v. Witt, 318 F.3d 606, 611 (4th
Cir. 2003) (expressing skepticism), the remedy is available only in a
court of equity, not a court of law, see McCravy v. Metro. Life Ins. Co.,
690 F.3d 176, 180–81 (4th Cir. 2012) (citing Amara, 563 U.S. at 439–41).
As a court of law, the Tax Court has no authority to impose equitable
estoppel. See Stovall v. Commissioner, 101 T.C. 140, 149–50 (1993).

      To reflect the foregoing,

      An order will be issued denying petitioner’s oral Motion to Shift
Burden of Proof under section 7491(a), and decision will be entered under
Rule 155.
                                         18

[*18]             APPENDIX A: Engineer Expenses

                     Date           Recipient          Amount
                  1/2/2015       Joachim Noreiko       $664.46
                  1/2/2015       Thomas Seidl          3,439.76
                  1/26/2015      Joachim Noreiko        513.88
                  4/3/2015       Rik de Boer            280.53
                  4/8/2015       Thomas Seidl          1,876.62
                  8/20/2015      Thomas Seidl          7,347.77
                  10/1/2015      Joachim Noreiko        716.07
                  11/3/2015      Mike Stefanello        100.00
                  12/23/2015     Thomas Seidl          5,569.41

                 APPENDIX B: Marketing Expenses

      Petitioner paid the amounts in the following table to Stacey
Weliver.

                                Date          Amount
                              6/23/2015         $230
                              7/28/2015          250
                              8/20/2015          690
                              9/3/2015           130
                              10/5/2015          430
                              10/19/2015         310
                              11/2/2015          370
                                     19

[*19]              APPENDIX C: Verizon Expenses

       Petitioner paid the amounts in the following table to Verizon for
cell phone service and internet service at petitioner’s home.

                              Date        Amount
                           1/12/2015       $76.13
                           1/20/2015        79.99
                           2/11/2015        84.92
                           2/18/2015        79.99
                           3/11/2015        76.09
                           3/20/2015        79.99
                           4/10/2015        77.35
                           4/17/2015        79.99
                           5/12/2015        77.18
                           5/22/2015        79.99
                           6/10/2015        88.77
                           6/17/2015        79.99
                           7/10/2015        83.71
                           7/20/2015        79.99
                           8/12/2015        79.51
                           8/17/2015        79.99
                           9/10/2015        77.21
                           9/17/2015        79.99
                           10/13/2015       53.00
                           10/19/2015       87.99
                           11/12/2015       49.18
                           11/17/2015       87.99
                           12/10/2015       49.20
                           12/18/2015       87.99
                                    20

[*20]         APPENDIX D: Miscellaneous Expenses

          Date             Schedule C Designation        Amount
        1/5/2015     UPS Store – Business Mailbox        $202.40
        1/20/2015    Audible.com Education                 22.95
        2/3/2015     Harvard Business Services            249.00
        2/20/2015    Audible.com Education                 22.95
        3/23/2015    GoDaddy.com                           25.16
        3/23/2015    GoDaddy.com                           50.32
        4/27/2015    External Hard Drive                   69.15
        4/28/2015    Audible.com Education                 14.95
        5/28/2015    Audible.com Education                 14.95
        6/29/2015    Audible.com Education                 14.95
        7/28/2015    Audible.com Education                  7.49
        8/28/2015    Audible.com Education                  7.49
        9/9/2015     Microsoft Office                       6.00
        9/28/2015    Audible.com Education                  7.49
        10/9/2015    Microsoft Office                       6.00
        10/14/2015   USTPO Trademark application          275.00
        10/28/2015   Audible.com Education                 14.95
        11/9/2015    Microsoft Office                       6.00
        11/30/2015   Audible.com Education                 14.95
        12/9/2015    Microsoft Office                       6.00
        12/28/2015   Crashplan Computer Backup Service     59.99
        12/28/2015   Harvard Business Services             50.00