United States

Court held exploratory research expenses were not deductible

TAX ALERT  | 

In a summary opinion issued July 20, 2017, the Tax Court found that an electrical engineer was not carrying on a trade or business during the 2013 and 2014 tax years and, as a result, could not deduct exploratory research expenditures in those years.

The case, Samuel Joseph Carrick v. Commissioner, No. 12198-16S, T.C. Summ. Op. 2017-56, involved two distinct activities:

  • During 2013 the taxpayer began developing a website where people could bid for the services of local contractors.  This project was abandoned in the same year.
  •  In 2014 the taxpayer began research and development activities on a device intended to prevent stingray-related injuries.

The IRS rejected approximately $35,000 of deductions related to these activities during the 2013 and 2014 tax years. The taxpayer argued against his notice of deficiency claiming that, under Section 162, his research expenditures were, “ordinary and necessary expenses paid or incurred…in carrying on [a] trade or business.” The primary question before the court, therefore, was whether the taxpayer was, in fact, currently engaged in a trade or business during the years in question.

In answering that question in the negative, the court looked to the fact that the taxpayer had zero gross receipts from either of these activities during either 2013 or 2014. The Tax Court also stated that there was no evidence that either of these activities had reached the point of even offering sales or services to the public. The tax court’s opinion was grounded in the concept that, for an expenditure to be an ordinary and necessary part of carrying on a trade or business, it must be related to more than just preparatory work. Preparatory expenses paid before a business commences are capital expenditures under section 195, and as such, the taxpayer’s exploratory costs were not deductible in the years incurred.

When a trade or business begins is determined using a facts and circumstance test. This case reaffirms that an important factor is that actual sales activity has to have begun or that taxpayers have offered the product (or services) to the public. Ordinary and necessary expenses incurred before a trade or business begins are capitalized and may be recovered over 15 years versus currently deductible if the taxpayer incurs the expenses after the trade or business begins. As the determination is based on facts and circumstances, taxpayers should consult with a professional to assist in assessing when the trade or business actually begins.

AUTHORS


Subscribe to Tax Alerts



How can we help you with your tax planning & compliance?