When Do You Really Start A Business?

It doesn’t sound like much, but it can present a difficult tax issue.

When does a business start?

It helps to have sales. Sales are good. But sometimes you do not have sales.

Then what?

The issue is that tax law allows deductions for expenses incurred in a trade or business. This presumes that the activity has started and is occurring on a regular and continuous basis. Before that point it is more like an intent or hope than an actual business.   

Let’s set-up our story.

Taxpayer was a tax specialist, although I am not sure what that means. His wife was a nurse. For 2013 and 2014 he reported self-employed real estate losses of $15 and $22 thousand, respectively.

Got it. He is tax specialist when is he is not working real estate.

In 2010 he obtained a real estate license. He got together with friends and family and decided to invest in residential real estate. They were going to flip houses. The investor group decided to look in West Sacramento, California, (fortuitously, where he lived). On Saturdays he would leave home, drive 192 miles to Marina, California and pick-up one or more members of the group. They would return to Sacramento to check out houses and then back to Marina. At days-end, our protagonist would finally return home to West Sacramento.

Fortunately, he kept logs for all this driving. He racked up 24,882 miles in 2013 and 25,220 in 2014.

They never bought any property.

He also made no money as a real estate agent.

The IRS audited 2013 and 2014 and bounced the real estate expenses.

Off they went to Tax Court.

His argument was simple: are you kidding me? He was a realtor. He kept mileage logs. He had third parties who could testify that he did what he said he did. What more did the IRS want?

The IRS said that – whatever he was doing – it was not a trade or business.

There was no evidence that he was regularly and continuously working as a real estate agent for those years. You know, no income and all. 

So, what did the IRS think he doing with the family-and-friends consortium?

He was trying to start a business, a business flipping houses. But he and they never flipped a house, Heck, they never even bought a house. He was as much a house flipper as I am a retired ex-NFL player.

That put him in a tough spot.

Here is the Tax Court:

At best, petitioner husband’s activity in 2013 and 2014 was in the exploratory or formative stages of forming a business of flipping houses. Carrying on a trade or business requires more than initial research into a potential business opportunity; it requires that the business have actually commenced.

Section 162(a) does not permit current deductions for startup or preopening expenses incurred by a taxpayer before beginning business operations.”

He lost.

The IRS now wanted penalties – “substantial underpayment” penalties. This is a “super” penalty, for when the regular penalty is just not enough.

Remember that taxpayer listed his occupation as “tax specialist.”

Bad idea when you are trying to get penalties abated.

Here is the Court:

Petitioner husband considered his occupation to be a “tax specialist” and operated a tax preparation services business as a sole proprietorship. However, in preparing their tax returns petitioners failed to exercise due care or to do what a reasonable person would do under the circumstances to determine whether petitioner husband was in a trade or business ….”

Ouch.

The case is Samadi v Commissioner, for the home gamers.

Self-Renting a Big Green Egg

Sometimes tax law requires you to witness the torture of the language. Other times it herds you through a sequence of “except for” clauses, almost assuring that some future Court will address which except is taking exception.

And then you have the laughers.

I came across an article titled: Corporation’s self-leasing rental expense deduction denied.”

I was curious. We tax nerds have an exceptionally low threshold for curiosity.

Before reading the article, I anticipated that:

(1)  Something was being deducted

(2)  That something was rent expense

(3)  Something was being self-leased, whatever that means, and

(4)  Whatever it means, the deduction was denied.

Let us spend a little time on (3).

Self-lease (or self-rental) means that you are renting something to yourself or, more likely, to an entity that you own. It took on greater tax significance in 1986 when Congress, frustrated for years with tax shelters, created the passive activity (PAL) rules. The idea was to separate business activities between actually working (active/material participation) and living the Kennedy (passive activity).

It is not a big deal if all the activities are profitable.

It can be a big deal if some of the activities are unprofitable.

Let’s go back to the classic tax shelter. A high-incomer wants to shelter high income with a deductible tax loss.

Our high-incomer buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo, he/she is passive in the activity.

Contrast that with whatever activity generates the high income. Odds are that he/she works there. We would refer to that as active or material participation.

The 1986 tax act greatly restricted the ability of the high-incomer to use passive losses to offset active/material participation income.

Every now and then, however, standard tax planning is flipped on its head. There are cases where the high-incomer wants more passive income.

In the name of all that is holy, why?

Has to do with passive losses. Let’s say that you had $10,000 in passive losses in 2015. You could not use them to offset other income, so the $10,000 carried over to 2016. Then to 2017. They are gathering dust.

If we could create passive income, we could use those passive losses.

How to create passive income?

Well, let’s say that you own a company.

You rent something to the company.

Let’s rent your car, your office-in-home or your Big Green EGG XXL.

Rent is passive income, right? The tax on our passive income will be zero, as the losses will mop up every dollar of income.

That is the “self-rental” the tax Code is after.

But it also triggers one of those “except for” rules: if the self-rental results in income, the income will not qualify as passive income.

All your effort was for naught. Thank you for playing.

Back to the article I was reading.

There is a doctor. He is the only owner of a medical practice. He used the second story of his house solely for the medical practice. Fair be fair, he had the practice pay him rent for that second floor.

I have no problem with that.

The Tax Court disallowed the corporation a rent deduction.

Whaaat? That makes no sense.

The purpose of the passive/active/material participation rules is not to deny a deduction altogether. The purpose is to delay the use of losses until the right type of income comes around.

What was the Tax Court thinking?

Easy. The doctor never reported the rental income on his personal return.

This case has nothing to do with self-rental rules. The Court simply was not permitting the corporation a deduction for rent that its shareholder failed to report as income.

The case for the home gamers is Christopher C.L. Ng M.D. Inc.

Medical Deduction For Nonconventional Treatments

Is a tax deduction available for alternative medical care?

“Alternative” does not necessarily mean unusual. It includes, for example, chiropractic care. As a decades-long gym rat and chiropractic patient, I find that rather amusing.

What does the tax Code want to see before you are permitted a deductible medical expense?

You may ask: who cares? Starting in 2018 more and more people will claim the standard deduction rather than itemize under the new tax law. And – even if you itemize – what is the nondeductible percentage for medical expenses anyway – 2%, 7.5%, 10%, 100% of adjusted gross income? Congress abuses this deduction like an unwanted toy.

I’ll tell you why: because you have flexible spending accounts, health savings accounts and their siblings. To be reimbursable the expense must meet the definition of a deductible medical expense. This is a separate matter from whether you actually deduct any medical expenses on your tax return.

Let’s look at the Malev case.

Victoria Malev suffers from spinal disease. She had seen a chiropractor, but that offered only temporary and partial relief from pain.

You can probably guess the next type of doctor she would see, but Malev wanted nothing to do with surgery and its associated risks.

She instead decided to try four different alternative treatments.

The Court was diplomatic:

… Petitioner subscribed to various forms of treatment from four individuals, none of whom would be commonly recognized as a conventional medical caregiver. And to be sure, none of the methods utilized by these individuals would commonly be recognized as a conventional medical treatment. The methods Petitioner subscribed to might be termed “alternative medicine” by the polite, but we expect the less tolerant would characterize the treatments in other than legitimate or complimentary terms.”

When asked, Malev said that she had greatly improved.

She went to see an M.D a few years later – in 2016 – and the doctor suggested surgery. The doctor further suggested she investigate “integrative” medical care.

Seems to me she was already doing that.

Question: does she have a medical deduction?

The Court pointed out the obvious: had she seen the M.D. first, there would be no issue, as the M.D. recommended she investigate alternative medicine. By reversing the order, she was claiming medical deductions before the (traditional) medical diagnosis.

One can tell that the Court liked Malev. The Court acknowledged her “sincere belief” that the treatments received were beneficial, pointed out that she had not previously known the four providers and there was no reason to believe she would pay them except for the treatments given.

The Court looked at what the Code and Regulations do NOT require of deductible medical expenses:

(1) The services do not have to be furnished by one licensed to practice medicine in any particular discipline;

(2) The services do not have to be provided in-person;

(3) The services do not need to be universally accepted as effective; and

(4) The services do not have to be successful.

Malev could immediately use (1) and (3).

The Court was skeptical, but it wanted to allow for the wild card: the role a person’s state of mind plays in the treatment of disease.

Malev believed. The Court believed that she believed.

She got her medical deduction.

However, in an effort to indicate how fact-specific the case was, the Court continued:

… it is appropriate to note that we fully appreciate the position taken by the Respondent in this case, and [we] consider their position to be more than justified.”

I read Malev as a one-off. If you are thinking of alternative or integrative health care, see an M.D. – preferably an open-minded one – first. It will save both of us tax headaches.