Could taxpayers deduct Schedule C expenses for an information technology activity that won no contracts, kept no separate books, and included personal purchases?

Subject

Information technology activity was not operated in a businesslike manner for profit

Plain-English summary

Virginia upheld three years of assessments because the taxpayers did not operate their information technology activity in a manner showing a business conducted for profit and claimed personal costs as business deductions. Although both taxpayers were information technology professionals and said they spent about 60 hours per week on research, development, and government-contract bids, the activity won no contract during 2004 through 2006.

The record also showed no separate books and records, with virtually all claimed costs paid from personal accounts. The Schedule C included landscaping, exercise and recreational equipment, consumer electronics, and designer clothing described as business-development gifts. The Commissioner found that those facts outweighed the taxpayers' expertise and claimed time commitment.

Because the taxpayers had not shown a qualifying profit-oriented activity or ordinary and necessary trade-or-business expenses, Virginia left the additional tax and interest in place.

What this means for you

• Professional expertise and substantial time are relevant, but they do not establish profit motive by themselves.
• Separate books, records, and payment accounts help show that an activity is run as a business.
• Repeated losses and three years without winning a contract can weigh against the claimed profit objective.
• Personal landscaping, recreation, clothing, and consumer purchases do not become deductible merely because they are labeled as business development.
• Schedule C records should connect each expense directly to the trade or business.

Common questions

Did the ruling say the taxpayers lacked information technology expertise?

No. It recognized their expertise and claimed work effort, but found that the activity was not conducted in a businesslike manner for profit.

What recordkeeping problems mattered?

The taxpayers kept no separate business books, and virtually all expenses were paid through their personal accounts.

Which claimed costs did Virginia identify as personal?

The ruling specifically identified landscaping, exercise and recreational equipment, consumer electronics, and designer clothing labeled as business-development gifts.

What was the final result?

The 2004 through 2006 assessments were upheld, subject to credits already applied from another year's refund.

Citations and references

• Va. Code §§ 58.1-301, 58.1-322, and 58.1-219.
• IRC §§ 162(a) and 183.
• Treas. Reg. §§ 1.162-1 and 1.183-2(b).
• Dilts v. U.S., 845 F. Supp. 1505 (1994).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-127

Original ruling text

July 7, 2010

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

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. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayers, a husband and wife, operated an information technology business (ITB) from their Virginia residence during the taxable years at issue. The business bid on government contracts via the Internet. The Taxpayers reported business expenses on Form 1040, Schedule C for the taxable years ended December 31, 2004 through 2006 that they attributed to ITB.

Under audit, the Department concluded that ITB was not engaged in for profit and the expense deductions were disallowed, resulting in assessments of additional tax and interest for the 2004 through 2006 taxable years. The Taxpayers appeal the assessments, contending that ITB was engaged in for profit and the expenses claimed on their federal Schedule C were for legitimate business purposes. The Taxpayers request that assessments be abated.

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.

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 ITB did not make a profit during the 2004 through 2006 taxable years, the Taxpayers provided significant documentation concerning ITB's activities. The auditor concluded that ITB did not meet some of the factors used to determine if an activity is conducted with a profit motive.

An examination of the evidence shows that the Taxpayers are information technology professionals. They state that they spend approximately 60 hours per week working on ITB's activities, which consist of research and development and completing bids for government contracts. ITB never won a contract during the three taxable years at issue. ITB was operated from the Taxpayer's residence and they did not keep separate books and records. Virtually all of the expenses that the Taxpayers attribute to ITB were paid through the personal accounts of the Taxpayers.

These facts indicate that while the Taxpayer and his wife may have had the expertise to conduct an information technology business and spent significant time on ITB, they did not conduct ITB's activities in a manner reflective of a business operated for profit.

Furthermore, IRC § 162 (a) provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer's trade or business. See Treas. Reg. § 1.162-1 and Dilts v. U.S. , 845 F.Supp 1505 (1994). A review of the Schedule C filed by the Taxpayers indicates they improperly deducted expenses that are personal in nature. For example, the Taxpayers deducted landscaping expenses, the cost of exercise and recreational equipment, and the cost of consumer electronics and designer clothing that they designated as "business development gifts."

Based on the foregoing, the assessments issued to the Taxpayers for the 2004 through 2006 taxable years are upheld. Prior to receiving the Taxpayers' appeal, the Department applied a refund from another taxable year against the assessments for the 2005 and 2006 taxable years. Revised bills will be issued for the remaining balance due. 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 Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Linda Foster

Deputy Tax Commissioner

AR/1-2146573625.B