Gross receipts unnecessary for Section 195 active trade or business test

Tax Hot Topics newsletterThe Tax Court held in Smith v. Commissioner (No. 12354-17S) that business deductions were not limited by Section 195 because the taxpayer began to engage in an active trade or business in the year at issue.

The taxpayer in the case created a disregarded entity, Vegan Worldwide, LLC, in early 2013 to begin selling and distributing vegan food and beverages in foreign markets. In 2014, the taxpayer secured an agreement with a manufacturer to sell its product in foreign countries. The taxpayer actively marketed the products in foreign countries, but did not have any sales. On the 2014 return, the IRS disallowed certain deductions for travel expenses, meals and entertainment, and other expenses for lack of substantiation.

At trial, the IRS argued that Vegan Worldwide’s expenses were startup expenses under Section 195, but because it brought up the Section 195 issue for the first time before the Tax Court, it bore the burden of proof. Under Section 195, taxpayers may neither deduct nor amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.” To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make profit; (2) be regularly and actively involved in the activity; and (3) actually have commenced business operations.

The IRS argued that Vegan Worldwide did not commence business operations in 2014, but was engaged in mere research into a potential business. The court found that the taxpayer was actively engaged in the trade or business of selling vegan products in a number of foreign countries in 2014, even though the taxpayer had no sales. Therefore, it held that Vegan Worldwide’s expenditures for 2014 were not subject to Section 195. However, it disallowed the majority of the expenses for lack of substantiation.

Whether a taxpayer has actually commenced business operations depends on the facts and circumstances. The IRS continues to challenge taxpayers who have not yet had gross receipts. This decision demonstrates that it is possible to meet the test for having actually commenced business operations without having any gross receipts, provided the taxpayer has the right facts, such as securing products to sell and actively marketing the products. Ultimately, the court disallowed the majority of the expenses in this case because the taxpayer failed to substantiate them, which serves as a reminder for taxpayers to keep adequate records that document the business purpose for these type of expenses.

Sharon Kay
Washington National Tax Office 
T +1 202 861 4140

John Suttora
Managing Director
Washington National Tax Office 
T +1 202 521 1523

Caleb Cordonnier
Washington National Tax Office 
T +1 202 521 1555

Jason Seo
Senior Associate
Washington National Tax Office 
T +1 202 521 1556

Tax professional standards statement 
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.