Getting the IRS to approve your business deductions is not always easy and sometimes you have to take them to court. An interesting case was decided by the US Tax Court and the opinion released on April 20, 2016 in Amy Ndiaye Delia v. Commissioner of Internal Revenue, T.C. Memo 2016-17.
It’s a fun case to read, but it’s even more important as a short lesson in deductions in a business. In this case, Amy decided that hair braiding was a good business. She leased space, opened the salon began advertising, and showed up every day, trying to make a profit. Unfortunately, she was way too optimistic. The IRS thought she was doing it just for fun and disallowed her claimed losses. She took the Service to court and won on deductability. Unfortunately, she lost on substantiation.
The major issue in the case was whether or not she was actually conducting a trade or business, or simply just having fun. When a taxpayer is facing the IRS, the US Tax Court or a federal District Court, the taxpayer and his/her attorney have to remember that the IRS’ determination in a notice of deficiency is presumed correct and the taxpayer bears the burden of proving those determinations to be in error. And that’s been the law since the 1933 US Supreme Court case of Welch v. Helvering, and it’s been incorporated into the Tax Court rules.
The first thing Amy had to do was to establish that her hair braiding activity was a trade or business engaged in for profit. If not, Section 183 disallows deductions that exceed the gross income derived from the activity for that tax year. Section 162 allows a deduction for all ordinary and necessary expenses paid or incurred in the carrying on of a trade or business. That can be established when the taxpayer shows that she engaged in the activity with an actual and honest objective of making a profit. Deductions are not allowable for activities carried on for sport, as a hobby or recreation. Reg.Sec. 1.183-2(a).
The US Tax Court, as many courts do, looks more at the objective facts and what the taxpayer claims was her intent. The regulations set forth a nonexclusive list of nine factors relevant to ascertaining whether the intent was to earn a profit. The factors listed are: (1) the manner in which the taxpayer conducts the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort spent by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or loss with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. Reg.Sec. 1.183-2(b). No one or two of those are controlling.
In this case, the Tax Court found most of the factors were neutral. The one factor that weighed heavily against Amy was her persistent history of losses. But, the court was convinced that she did conduct her hair braiding business with an actual and honest objective to make a profit (commenting at that point that she was unduly optimistic). The key piece of evidence was that she had signed a lease. If she simply shut down the business, she still would have to pay the lease. If she couldn’t pay the lease, she would go into default and suffer the consequences – perhaps get sued, have a credit problem, etc., so she kept the shop open trying to make something to cover her costs. The court said that she “credibly testified that the business failed for reasons beyond her control, including the 2008-2010 financial crisis, and over-concentration of similar businesses in her community, and a marked change in taste among her prospective customers. It might have been prudent for her to have exited this business before she did, but the long-term rental contract posed a serious obstacle. She concluded, not unreasonably, that trying to salvage as much profit as she could was preferable to risking damage to her credit rating by defaulting on her lease commitment. She closed the business promptly after extricating herself from the lease.”
She lost, but that was because she did not have the requisite records to back up all of her deductions. Here, again, the burden is on the taxpayer to substantiate claimed deductions. For example, she claimed a deduction of $480 for “supplies” but her business records show that amount, accrued at a flat rate of $40 per month, as being attributable to “meals.” She offered no documentation for any meal expense and did not show that meals were an ordinary and necessary expense of her business. She also claimed a deduction of $590 for hair products, but she supplied substantiation only for $181 worth. Overall, her allowable deductions for the year in issue (2011) had to be reduced by $1441. And, because of that, the IRS was able to impose on her a Section 6662 negligence penalty of 20%.