Is It Important to Identify a Taxpayer’s Business?by
The concept of a business (or trade or business) suggests details of income and expense. The receipt that triggers income may be assets other than money. But even the receipt of services can constitute taxable income that could be part of a business.
In general, we will find that the tax rules don’t clearly define a “business,” yet we will stress that the tax planner’s review should, at times, focus on trying to define the taxpayer’s business, or portion of a business, or multiple businesses.
The Section 162 concept of business expense can be useful. It talks of items “directly connected with or pertaining to the taxpayer’s trade or business…” (Regs. 1.162-1). But it distinguishes inventory, which is an asset on its way to becoming a business expense. The regulation is important to our topic, but even it doesn’t define “trade or business.”
The Supreme Court has resolved the “trade or business” of a particular taxpayer. It noted “the Code’s normal focus on what we regard as a common-sense concept of what is a trade or business.” The Court observed our phrase remains undefined though common within the Code, and found hundreds of times in proposed and final income tax regulations.
The Court concluded the full-time gambler’s activities did constitute a trade or business exempt from minimum tax (Groetzinger, 480 U.S. 23, (1987), discussed “Current Tax Developments, Hobby Loss Expenses Can Only Be Deducted as Miscellaneous Itemized Deductions,” Ed Zollars, Kaplan Financial Education, 10/1/21, currentfederaltaxdevelopments.com).
Classifying cash going in and out of a gaming window as a trade or business is somewhat surprising to this author considering the absence of goods or services. The decision would seem to confirm that classifying activities as a business, even by way of “common sense,” can be problematic.
Those Visits to the Bookstore – Business?
The business or not-business distinction comes up at the bookseller’s check-out stand. However, it is usually pretty easy to distinguish books focused on our businesses. The task may be more difficult when the book stack is diverse and the goal is updating the car log that includes our trip to the bookstore.
Business or Investment
Expenses for investment advice for one not in the investment business would not be deductible under current law. For 2018 to 2025, the Tax Cuts and Jobs Act eliminated temporarily such miscellaneous itemized deductions even when they exceed 2 percent of adjusted gross income.
Expenses for investment advice can also qualify as ordinary and necessary business expenses for someone in the investment (or investment advice) business. At the risk of over simplification, stock held as dealer property by someone in the stock-selling business is akin to the grocer’s canned fruit.
Business or Gift
There’s the business income versus gift question. The kid’s bicycle under the tree may come with a holiday card but the envelope doesn’t need to include a Form 1099. Taxable income doesn’t include gifts, bequests, inheritances (Sec. 102).
A purported gift in a business context is usually going to yield taxable income unless the amount is quite small. The door person’s opening the hotel door is (hopefully) still taxfree whether going inside is personal or business.
In the famous Duberstein case, the Cadillac wasn’t solicited or expected, but the context was business, not disinterested generosity or family business. The Cadillac was taxable when received from someone who’d been given valuable customer names (Commissioner v. Duberstein, 363 U.S. 278 (1960)).
Business or Hobby
There’s the business versus hobby question, which can involve math tests and focus on such details as keeping good records of income, expense and business purpose. The concept can arise in practically any context where gain versus enjoyment, prestige may be an issue.
The tax issue of business purpose might arise, for example, when the busy executive or movie star claims losses on a farm or raises race horses (See Sec. 183; “Not for-Profit Activities,” and Business Expenses, IRS Pub. 535 for use in preparing 2020 Returns, p. 7).
When an activity is considered a hobby, the statute contemplates allowing expenses to offset hobby income (Sec. 183(b)). The Tax Court recently confirmed that related expenses are subject to the limitations accorded miscellaneous itemized deductions (Sec. 67(a); Gregory v. Commissioner, TC Memo 2021-115 (9/29/21)).
Thus, under current law, those not-quite-business deductions are not even deductible against related income. Does that make the trophy for finishing fourth in the local golf tournament taxable at fair market value? Probably not, but it might be difficult to explain should an IRS agent raise the issue.
Business in Progress
There are special rules for pre-operating and organizing costs. These questions often arise with a new business (IRS Pub. 535, p. 26). Even advertising may be considered a pre-operating cost. A helpful planning suggestion: trigger sales as soon as possible to bring in the operational phase of the new business. Questions can arise as to whether a new business is a continuation of an old business.
Employment is a Type of Business
The type of business can affect deductibility. Notable here is the distinction in expenses related to employment versus an operating business.
Employment is considered a business, yet the employee’s business expenses are largely relegated to being itemized deductions which aren’t even currently available. The Tax Cuts and Jobs Act of 2017 largely eliminated employee expense deductions until 2026.
The 20 percent of Business Income Deduction
Employment income also isn’t eligible for the 20 percent of business income deduction. This tax benefit has many limitations that often focus on the type of business (or profession), the level of income, and paying wages.
There are also complex issues under the 20 percent of business income rules with respect to the treatment of multiple businesses, so the lines that create multiple businesses vs a single business become important (See, e.g., Q22 of “Tax Cuts and Jobs Act, Provision 11011 Section 199A – Qualified Business Income Deduction FAQs,” irs.gov. See Q28 raising questions of multiple businesses under the passive loss rules. A key phrase here is “aggregation election” with respect to multiple businesses).
Whether particular sources of income are significant can be a factor in defining a business (See Q6, “What if a single trade or business has multiple sources of income, some from specified service activities and some from other activities?,” “Tax Cuts and Jobs Act, Provision 11011 Section 199A – Qualified Business Income Deduction FAQs,: irs.gov).
Excess Business Losses
We have the relatively new limitations on excess business losses that get treated as net operating losses in the following year (Form 461 proposed for 2021).
“The Coronavirus Aid, Relief and Economic Securities Act (CARES Act), amended section 461(l) to restrict the limitation on excess business losses of non-corporate taxpayers to tax years beginning after 2020 and before 2026. The Act repealed the limitation for tax years 2018, 2019, and 2020… ” (“Limitation on business losses for certain taxpayers repealed for 2018, 2019, and 2020,” IRS.gov).
Such a limitation on business losses is a relatively new phenomenon.
This process is briefly summarized as follows by the IRS:
“For taxable years beginning in 2021, the threshold amounts are $262,000 (or $524,000 in the case of a joint return). A `trade or business’ can include, but is not limited to, Schedule F and Schedule C activities and other business activities reported on Schedule E. Business gains and losses reported on Form 4797 can be included in the excess business loss calculation. They also include pass-thru income and losses attributable to a trade or business. This includes farming losses from casualty losses or losses by reason of disease or drought…” (“Excess business losses,” IRS.gov).
Net Operating Losses
There is also increasing focus on limiting business expenses when they give rise to net operating losses. There was enacted relief as to NOLs arising in 2018-2020, but 2021 and later net operating losses from non-farming activities can only be carried forward. So, the timing of income and expenses becomes even more important.
There is the practical risk of loss of deductibility here. The use of the NOL requires future income, and may vary with the health and longevity of the business owner. NOLs of a business owner expire at death.
This can be a problem even upon the death of one of the spouses in a community property state. The degree of ownership and business involvement of a surviving spouse can have tax consequences.
Assuming the practitioner is dealing with an NOL that still carries back, one could find a surviving spouse carrying back an NOL into a joint return where the task becomes measuring “the part of the income reported on the joint return (filed with your former spouse) that was related to your taxable income.” (Publication 536 (2020), Net Operating Losses (NOLs) for Individuals, Estates, and Trusts,” For use in preparing 2020 Returns, “Change in Marital Status,” p. 6). In the carryback year, this could involve having to bifurcate business or other income reported in the carryback year.
One could have similar problems dividing up the NOL that expires at death.
“If you and your spouse were not married to each other in all years involved in figuring NOL carrybacks and carryforwards, only the spouse who had the loss can take the NOL deduction. If you file a joint return, the NOL deduction is limited to the income of that spouse.”
The practical difficulties here are many. They involve not only defining the business, but measuring a spouse’s portion of a business (and other items) (Publication 555, (Rev. Mar. 2020), “Community Property,” “Business and investment expenses,” p. 5.).
Jurisdiction by Jurisdiction/Tax by Tax
The details of defining a business can also vary with the type of tax. For example, the self-employment tax provisions have their own details.
The what-is-the-business question can also be relevant at the state or local level. For example, one city license tax has special relief that reaches writers, but only that portion of a writer’s income that is “creative.” Is income from this article “creative” for purposes of that tax? No.
The Particulars of a Client’s Business Affairs
Tax analysis that systematically focuses on the details of the client’s business(es) can be helpful. The file might have headings or sub-headings titled “business” and “businesses” and “portions of a business.”
Practitioners should have an overall perspective on how the definition of business may affect a particular taxpayer. This can include tax rules that focus on multiple businesses or portions of a business.
Our analysis may focus not only on a taxpayer or couple but how the business concept affects a related group of taxpayers. The tax analysis may lead the advisor to consider recommending changes in the details of the taxpayer’s “business” as well as expanded documentation.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...