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Business Tax Deductions on Desolate Land

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You may have to spend money to make money, but the tax law allows you to deduct business expenses to offset taxable income from the business. A recent Tax Court ruling showed this is not always the case.

Feb 3rd 2021
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As shown in Costello, TC Memo 2021-9, 1/25/21, the taxpayer must effectively be actively conducting a trade or business to qualify to deduct business expenses.

Background: The key tax law provision for business expense deductions is Section 162. It permits a taxpayer to write off all the “ordinary and necessary” expenses of carrying on a trade or business, including travel expenses, compensation, rental expenses and the like. These deductions may also be subject to special rules.

In another tax code provision, Section 195, a taxpayer may be able to deduct up to $5,000 of start-up expenses, such as certain organization and marketing expenses. To qualify for this business tax deduction, you must actually be “open for business.”

Generally, a trade or business is carried on if there’s a good faith effort to make a profit. The determination is made on a case-by-case basis, factoring in the level of business activities and the production of income. Although you don’t have to actually turn a profit to be carrying on a trade or business, you must display efforts to further your business interests.

Facts of the new case: The taxpayers, a married couple, were residents of California. The wife owned 6,500 acres of desolate land in a remote area of Mexico. She tried to make a go of several ventures on the land without any success.

In 2007, she decided to raise chickens on the property to sell for meat. Apparently, that activity didn’t go well. There were no reported sales of chickens for four years.

The taxpayer switched to egg production in 2011. Subsequently, she went back to meat production in 2012, reporting only $1,000 in egg money. As part of this effort, she added new chickens, but they were eaten by wild dogs.

In addition to raising the chickens, the taxpayer tried to grow various crops during this four-year period, including watermelons, squash, peppers, apples, bananas, pomegranates, date palms and asparagus. They all failed due to the region’s conditions.

Finally, the taxpayers turned to raising cows. But the cows could not find enough to eat on the land. Eventually, the couple sold the cows for less than $5,000.

The couple deducted business expenses on their tax returns for the years in question. But the IRS denied the deductions, claiming that the expenses were either hobby expenses or pre-operational start-up expenses.

Now the Tax Court has agreed with the IRS. It was not convinced that the taxpayers were carrying on a trade or business as there was no real evidence of a functioning business. In essence, a lot of noise but no music.

Moral of the story: It helps to establish that an undertaking has some income to indicate a profit motive and actual business activity. Otherwise, the IRS is likely to challenge deductions for business expenses.   

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