Mr. Doherty entered into a purchase agreement with Alpha Telecom to buy 20 pay telephones for $5,000 each. Under the terms of the agreement Alpha would find sites for the pay phones, install them, provide maintenance, and collect revenue. In exchange Alpha would receive 70% of the gross income from the pay phones. Mr. Doherty also entered into a similar arrangement with a different vendor. This time for the purchase of ATM machines.
In an unrelated civil suit brought by the SEC against Alpha, a federal district court determined that the Alpha's pay telephone program was an investment contract. Consequently, it was a security that required registration with the SEC.
On his 2000 and 2001 Schedule C, Mr. Doherty reported income and took depreciation deductions of $162,124 for the pay telephones, and also claimed other business expenses . The IRS determined he was not entitled to depreciation deductions nor was he entitled to deductions for business expenses.
The Tax Court held that since the "benefits and burdens of owning" the payphones did not pass to Mr. Doherty, he was not entitled to take depreciation deductions. Further,transfer of nothing more than "bare legal title" is insufficient.
Secondly, the Tax Court held that Mr. Doherty was not in a trade or business since he "never had the benefits and burdens of owning the payphones . . . and did not conduct any business involving the pay phones."
Lastly, the Tax Court agreed with the IRS that the income received from the pay phones should be reported as other miscellaneous income on the Mr. Doherty's tax return.
The Tax Court came to the same conclusion in two other cases: TCM 2009-98 and TCM 2009-97.
I am pretty dissatisfied with the analysis in this decision. I will not address the benefits and burdens analysis, that would require more than one post. Although, I would like to know if Alpha took depreciation deductions for the pay telephones during 2000 and 2001.
I will, however, take issue with the Court's trade or business analysis, and the determination to treat the income from the pay telephones as other miscellaneous income.
First, the Court's conclusion that Mr. Doherty was not in a trade or business is based on the premise that he did not obtain the benefits and burdens of ownership associated with the pay phones. The law, which the Court laid out, requires regular and continuous activity plus a profit motive. On the facts here, I find it hard to believe Mr. Doherty did not have a profit motive. Over the periods 2000 and 2001, Mr. Doherty received $164,260 in gross receipts from Alpha. Further, he ultimately invested $200,000 of his own money (there is no indication he took loans) to purchase 40 pay phones. These facts seem to favor a profit motive.
The regular and continuous requirement can be met through the use of an agent. On the facts here, it seems that Mr. Doherty's agreement with Alpha to perform all the required work would be no different than if Mr. Doherty had hired employees and agreed to pay them commissions.
I think the better argument for the Court would be to rely on the SEC's determination that the purchase agreement was a security. This makes Mr. Doherty an investor. It also eliminates the depreciation problem because you cannot depreciate the cost basis of a security.
Lastly, the IRS's request to treat the income as other miscellaneous income has no "because" after it. I am not sure why the IRS thinks this is miscellaneous income, particularly since the purchase agreement is a security that requires registration with the SEC. They seem to completely ignore this fact. If the purchse agreement is a security, then the income received is generally interest, dividends, or capital gains.
In the end, maybe the right decision by the Court, but the analysis is weak.