Did a couple operate their short-lived 2007 import business for profit despite losses and closing before year-end?

Subject

Taxpayers did conduct the import business for profit for the taxable year at issue

Plain-English summary

Virginia found the couple operated the 2007 import business for profit and ordered the assessment adjusted. The auditor had treated it as a continuation of a prior loss business and disallowed the Schedule C loss.

The evidence showed a new business formed in 2007. The couple registered it with Virginia and the locality, opened accounts with multiple online auction companies, signed agreements with manufacturers and U.S. resellers, built a website, and brought relevant Country A language, manufacturing, and business experience.

The model depended on high-volume, low-margin imported consumer goods. Unexpected release fees, tariff-increase reports, weaker margins, and a softening wholesale market undermined it. The couple sought alternative inventory and cost reductions before returning inventory, selling assets, and closing in December.

Considering all facts rather than losses alone, Virginia found an objective profit motive. The taxpayers were entitled to audit adjustment and a refund of overpaid tax and interest, subject to reporting any later federal correction.

What this means for you

• Repeated losses are relevant but do not alone prove an activity lacks profit motive.
• Preserve registrations, contracts, market research, sales channels, expertise, and efforts to improve profitability.
• A prompt closure after adverse market changes can support business judgment rather than hobby treatment.
• Later federal Schedule C changes must be reported to Virginia within the stated statutory period.

Common questions

Did the business have to earn a profit in 2007?

No. The ruling examined objective profit intent under all circumstances.

What relief followed?

The audit was returned for adjustment, with a refund of overpaid tax and interest.

Citations and references

• Va. Code §§ 58.1-301, 58.1-322, 58.1-219, 58.1-311, and 58.1-312 A(3).
• IRC § 183; Treas. Reg. § 1.183-2(b).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-36

Original ruling text

March 7, 2011

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter concerning the Virginia individual income tax assessment issued to * (the "Taxpayers") for the taxable year ended December 31, 2007. I apologize for the delay in the Department's response.

FACTS

The Taxpayers, a husband and wife, operated an import business during the 2007 taxable year. The business incurred losses that were reported on federal Schedule C.

Under review, the Department determined that the business had reported consistent losses in prior taxable years and was not operated for profit. As a result, the auditor disallowed the deductions claimed on the Schedule C and issued an assessment for additional tax and interest for the 2007 taxable year.

The Taxpayers paid the assessment but have filed an appeal, contending they intended to make a profit from the operations of the business, but changing market conditions between the United States and * (Country A) affected the viability of the business.

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.

Treasury 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 consideration is not necessarily limited to these nine factors.

The Department's auditor had concluded that the business was a continuation of a business the husband had reported on a Schedule C in prior taxable years. Because the business had shown continuous losses, the auditor disallowed the loss reported on the 2007 Schedule C. The evidence provided by the Taxpayers, however, shows that the business was established in 2007 to facilitate the importation of consumer goods between Country A and wholesalers in the United States.

The Taxpayers registered the business with the appropriate Virginia locality and the Department. They opened on-line accounts with multiple auction-based companies, entered into business agreements with manufacturers in Country A and with resellers in the United States. They created a website for the business.

The Taxpayers had significant contacts and experience with businesses and manufacturers in Country A. The wife was a native of Country A and was employed there before moving to the United States. She also worked as a translator. The husband was previously employed by a manufacturer in County A, and also had worked as a contractor for that manufacturer.

Upon arrival of the initial inventory orders in the United States, the Taxpayers were notified of additional fees required to be paid before they inventory could be released. They also became aware of reports that Congress was considering tariff increases on goods imported from Country A in late 2007.

The Taxpayers' business model was based on a high sales volume of lower-cost goods at a low profit margin. Because of increased tariffs, the profit margin of goods imported from Country A decreased relative to those already in the market. With the possibility of additional increases, the Taxpayers determined that the market for its product category softened substantially, reducing the number of potential wholesale customers.

The Taxpayers sought alternative sources for inventory and explored cost containment methods. The Taxpayers eventually determined that the business model was not viable. In December 2007, the business returned its initial inventory to the manufacturers, sold its assets and closed.

After weighing all the facts and circumstances in this case, it is my determination that the preponderance of the evidence supports a finding that the Taxpayers did conduct the import business for profit for the taxable year at issue. Accordingly, this case will be returned to the Department's auditor and adjusted in accordance with this determination. After the auditor makes the appropriate adjustments, the Taxpayer will receive a revised statement. A refund of overpaid tax and interest will be issued shortly thereafter.

While the Department has ruled that the business appears to have been conducted for the purpose of making a profit, Va. Code § 58.1-311 would require the Taxpayers to report a change or correction in federal taxable income, including Schedule C, within one year of the final determination of such change or correction by filing an amended return with the Department. If a taxpayer fails to file an amended return, Va. Code § 58.1-312 A 3 permits the Department to assess the appropriate tax at any time.

The Code of Virginia sections cited 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 * the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-2510687371.E