Could taxpayers deduct both the expenses of a construction business and the cost of renovating and landscaping their personal home?

Subject

Construction business had a profit motive, but personal-home renovation costs were not deductible

Plain-English summary

Virginia reached a split result: the wife's construction company was operated for profit, but the taxpayers could not deduct renovation and landscaping costs for their personal home. The company had a contractor's license, separate bank accounts, contracts and active projects, business forms and contractor agreements, rented equipment, and applications to become a government subcontractor. Those facts showed businesslike operations, relevant expertise, meaningful effort, and a profit objective even though the company lost money during 2004 through 2006.

The home-improvement costs were different. The taxpayers said clients visited the residence to evaluate the company's design and craftsmanship, but the home remained their personal residence and they provided no evidence that any portion was used exclusively for business. The ruling therefore denied those renovation and landscaping deductions under the home-use limits in IRC § 280A.

The Department returned the matter to the auditor to allow eligible construction-business expenses and revise the 2004 and 2005 assessments and the 2006 refund accordingly.

What this means for you

• A loss does not by itself prove that an activity lacks a profit motive; Virginia considered the full nine-factor federal test.
• Licenses, separate accounts, contracts, equipment rentals, business procedures, expertise, and sustained work can support a profit objective.
• Showing clients a personal residence does not make all home renovation or landscaping costs deductible.
• For the home-use exception discussed here, the taxpayers needed evidence that a portion of the residence was used exclusively for business.
• When an audit includes both valid operating expenses and personal costs, the final result can allow one category while denying the other.

Common questions

Did Virginia treat the construction company as a hobby?

No. After weighing the facts and circumstances, the Commissioner found that the wife conducted the company for profit.

Were all Schedule C expenses allowed?

No. Only eligible expenses related to operating the construction business were allowed. The home renovation and landscaping expenses remained disallowed.

Why did the client visits not make the renovations deductible?

The ruling found no evidence that any part of the personal residence was used exclusively for business, as required by the home-use rule it applied.

What happened to the assessments?

The case went back to the auditor to revise the 2004 and 2005 assessments and the 2006 refund consistently with the ruling.

Citations and references

• Va. Code §§ 58.1-301, 58.1-322, and 58.1-219.
• IRC §§ 162(a), 183, and 280A(c).
• Treas. Reg. § 1.183-2(b).
• Joseph A. Deihl, et ux. v. Commissioner, Tax Court Memo 2005-287.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-126

Original ruling text

July 7, 2010

Re: § 58.1-1821 Application: Individual Income Tax

This will reply to your letter in which you seek correction of the individual income tax assessments issued to * (the "Taxpayers") for the taxable years ended December 31, 2004 through 2006.

FACTS

The Taxpayers, a husband and wife, are Virginia residents. The wife was the sole member of * (VALLC), for which she conducted design and construction activities while simultaneously employed by another organization. VALLC merged with another construction company, resulting in the wife's co-ownership of VALLC.

During the taxable years at issue, VALLC incurred expenses stemming from certain construction projects that were reported on the Taxpayers' Form 1040 Schedule C. The resulting losses offset the Taxpayers' employment income, as well as any income generated by the construction projects themselves. The Taxpayers also reported expenses from the renovation of their personal residence and surrounding landscaping on the Schedule C.

Under audit, the Department concluded that, the wife's involvement with VALLC was not engaged in for profit. In addition, the auditor concluded that building materials and other expenses used in the renovation of the Taxpayer's home did not qualify as a business expense. As a result, the auditor disallowed the deductions claimed on the Schedule C, resulting in assessments for the 2004 and 2005 taxable years and a reduction of a refund for the 2006 taxable year.

The Taxpayers appeal the assessments, contending that VALLC's activities were conducted with the intent to make a profit and they were entitled to deduct the expenses incurred from VALLC's construction activities. The Taxpayers also assert that the renovations to their personal residence were a deductible business expense because they were used to promote the wife's construction activities.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. However, the Department retains the authority to adjust FAGI where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Va. Code § 58.1-219.

Activity Engaged in for Profit

Under IRC § 183, deductions can be disallowed for activities not engaged in for profit to the extent that the expenses exceed income generated by the activities. The determination whether an activity is engaged in for profit is determined by taking into account all of the facts and circumstances of each case. Taxpayers must have the objective of making a profit.

Treas. Reg. § 1.183-2(b) identifies nine factors that should be taken into account when determining whether an activity has a profit motive: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) 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 losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.

The regulation makes it clear that all facts and circumstances must be considered in determining if an activity is engaged in for profit. The regulation further states that no one factor is determinative and that consideration is not necessarily limited to these nine factors.

Although VALLC's construction activities did not make a profit during the 2004 through 2006 taxable years, the Taxpayers provided significant documentation concerning the construction activities. When VALLC was formed, the wife was employed as a director in a property development and construction business. VALLC obtained a contractor's license and maintained its own bank accounts. VALLC entered into contracts to perform numerous jobs and completed work toward these jobs. The wife established forms, developed contractor agreements, and rented construction equipment for VALLC. VALLC submitted applications to enroll as pre-qualified state and federal sub-contractors. These facts indicate that the wife worked in her capacity as an owner of VALLC in a business like manner, had the expertise to conduct such a business, spent sufficient time and effort in carrying on the activity, exhibited success in similar activities, and did not engage in the activity for recreational purposes.

After weighing all the facts and circumstances in this case, including the Taxpayers' other sources of income for the taxable years at issue, I must conclude that the preponderance of the evidence supports a finding that the wife conducted VALLC for profit. Therefore, the Taxpayers are entitled to claim the eligible business expenses related to the operation of VALLC.

Business Use of Home

The Taxpayers contend that the improvements to their personal residence were done in an effort to showcase the design and construction skill of the company for the benefit of clients. The Taxpayers assert that every construction contract that VALLC procured was derived from clients visiting the Taxpayers' personal residence and approving VALLC's design and craftsmanship.

While IRC § 162(a) provides for a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, IRC § 280A provides limitations as to when expenses in connection with the business use of a home may be allowed. Under IRC § 280A(c), individual taxpayers may not deduct business expenses with respect to the use of a portion of their personal residence during a taxable year unless: (1) it is used exclusively for business on a regular business; (2) it is used as storage for inventory; (3) it is rented; or (4) it is used as a daycare.

In the instant case, VALLC business was conducted from the Taxpayers' home. However, the home was also used as the Taxpayers' personal residence. No evidence has been provided indicating that any portion of the residence was exclusively used for business. As such, the Taxpayers were not entitled to deduct expenses derived from the improvements performed on their personal residence and property. See also Joseph A. Deihl, et ux. v. Commissioner , Tax Court Memo 2005-287.

CONCLUSION

Based on the foregoing, I find that the Taxpayers conducted VALLC for profit during the taxable years at issue, but they were not entitled to deduct any expenses from the renovation and landscaping of their personal residence. As such, the case will be returned to the auditor to adjust the assessments for the taxable years ended December 31, 2004 and 2005, and the refund for the taxable year 2006 in accordance with this determination.

After the auditor makes the appropriate adjustments, the Taxpayer will receive revised bills. The Taxpayers should remit payment for the outstanding balance as shown on the revised bills within 30 days from the date of the bills to avoid the accrual of additional interest.

The Code of Virginia sections cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Linda Foster

Deputy Tax Commissioner

AR/1-21787003168.B