The Tax Law Report

Education Expense as Trade or Business Deductions: Part Two

Shah v. Commissioner, T.C. Summ. Op. 2010-6 (2010).

Question for the Tax Court

May a taxpayer deduct education expenses as trade or business expenses when the education expenses directly related to the taxpayer's existing trade or business, but were part of a program of study that led to a new trade or business?

Background

During the years at issue, 2005 and 2006, Mr. Shah was an undergraduate student at New York University (NYU), where he majored in film and television studies. (3).  To meet his graduation requirements he was required to complete both the core courses of his major and elective courses from other fields of study. (3).  A substantial number of the elective courses . . . were in computer science, web design, and multimedia. (3).

While attending high school in Chicago, IL, Mr. Shah began performing information technology services for clients of his Dad's business. (3).  Part of the work involved working on websites for these clients. (4).  He earned between $5,000 and $10,000 during 2003 and 2004 providing these services. (3).

After graduating from NYU, he began working in the entertainment industry . . . creating multimedia content for his employer's website. (4).

On his 2005 and 2006 tax return, Mr. Shah deducted the costs of the classes he took at NYU that related to his trade or business as a website designer while in high school. (8).

When are Education Expenses Deductible as a Trade or Business Expense?

The Tax Court does not recite the applicable regulations in their opinion, but they are helpful for the analysis so I have provided them below.

Regulation 1.162-5(a) states in part:  [e]xpenditures made by an individual for education . . . are deductible as ordinary and necessary business expenses (even though the education may lead to a degree ) if the education -

(1) Maintains or improves skills required by the individual  in his employment or other trade or business, or

(2) Meets the express requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation.

Exceptions to the General Rule

Regulation 1.162-5(b)(2) states in part:  The first category of nondeductible educational expenses . . . are expenditures made by an individual for education which is required . . . to meet the minimum educational requirements for qualification in his employment or other trade or business.

Regulation 1.162-5(b)(3) states in part:  The second category of nondeductible education expenses . . . are expenditures made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.

Argument Made by Taxpayer

Petitioner maintains that he deducted only tuition and book costs for those classes related to his computer work.  (7).  Specifically, petitioner posits that since he was employed in Web design and multimedia while in high school, classes he took at NYU related to those fields should be considered to be qualifying work-related education that improved skills and not a program of study that qualifies him for a new trade or business. (8).

Tax Court's Holding

While his computer and Web design courses may have improved his skills, they also helped qualify petitioner for a new trade or business. (8).  These courses were necessary for him to earn his bachelor's degree since he could not have graduate from NYU without those credits. (8).  Therefore, these courses were part of a course of study that will lead to qualifying petitioner in a new trade or business. (8).  As we stated in Warren v. Commissioner, supra:  "what is important under the regulations is that the degree 'will lead' petitioner to qualify for a new trade or business. (8) citations omitted.  Consequently, we hold that petitioner may not deduct his tuition and book expenses for 2005 and 2006. (8).

Blog Comments

The Court reached the right conclusion, but for the wrong reason.

The Court concludes that Mr. Shah's bachelor's degree qualifies him for a new trade or business different from his web design trade or business, but they don't say what that new trade or business is.  In reaching this conclusion, the Court places emphasis on the fact that Mr. Shah could not graduate NYU without the credits in website design and multimedia classes.  I suppose the inference we are meant to draw from this point is that education leading to a bachelor's degree in XYZ implicitly qualifies the taxpayer for a new trade or business.

However, this ignores the first sentence in the regulation that allows a deduction for education expenses "even though the education may lead to a degree."  Based on the first sentence of the regulations, it would seem irrelevant then that the credits in web design and multimedia classes were required to graduate from NYU.  In fact, if this were the standard, almost every type of secondary education expense would be nondeductible as trade or business expenses.

The Court should have placed their emphasis on the type of bachelor's degree Mr. Shah was pursuing, "film and television studies."  The Court then could reasonably hold that "film and television studies" qualified Mr. Shah for a trade or business different from web design, namely "film and television."  Mr. Shah points out, however, that he only deducted the courses that specifically related to his web design trade or business.  But the Tax Court correctly responds that the regulations exclude education expenses that are "part of a program of study that qualifies him for a new trade or business."  Mr. Shah's web design classes were "part of a program of study".

Separately, the Court might have focused on the first category of nondeductible education expenses, those that "meet the minimum requirements of his employment or other trade or business."  Presumably, Mr. Shah's bachelor's degree "meets the minimum requirements of . . . [an] other trade or business."

Deducting Education Expenses as Trade or Business Expenses

Ortega v. Comm'r, T.C. Summary Opinion 2009-120 (T.C. 2009).

Ms. Ortega deducted $19,885 in education expenses associated with her doctoral degree in psychology on her 2004 tax return. She claimed the expenses were deductible as a trade or business expense because she was already a mental health practitioner. The IRS denied the deduction because the doctoral degree qualified her for a new trade or business, i.e. staff psychologist. The Tax Court agreed with the IRS.

Ms. Ortega's Career and Education History

Ms. Ortega earned her masters degree in psychology from the University of Nebraska in 1996. After several years of working as a Mental Health Practitioner for the State of Nebraska, she went back to the University of Nebraska to earn a doctorate in psychology. Upon earning her doctoral degree in psychology, she moved to New York and began work as a staff psychologist for the Federal Bureau of Prisons. New York required a doctoral degree to practice psychology, therefore Ms. Ortega could not practice as a staff psychologist without it. 

When are Education Expenses Deductible as Trade or Business Expenses?

The Tax Court succinctly states the law here:

Expenditures made by an individual for education are deductible as ordinary and necessary business expenses if the education maintains or improves skills required by the individual in her employment or other trade or business. Sec. 1.162-5(a), Income Tax Regs. However, the general rule under section 1.162-5(a) does not apply [and the expenses are not deductible] if the expenses fall within either of the two specified categories: (1) The expenses are incurred to meet the minimum education requirements for qualification in the taxpayer's trade or business; or (2) they qualify the taxpayer for a new trade or business. Sec. 1.162-5(b).

If the education in question qualifies the taxpayer to perform tasks and activities significantly different from those she could perform before the education, then the education is deemed to qualify the taxpayer for a new trade or business. Browne v. Commissioner, 73 T.C. 723, 726 (1980).

The mere capacity to engage in a new trade or business is sufficient to disqualify the expense for deduction. Weiszman v. Commissioner, 52 T.C. 1106, 1111 (1969).

Did Ms. Ortega's Doctoral Degree Qualify Her for a New Trade or Business?

Ms. Ortega asserts the doctoral degree did not qualify her for a new trade or business because she continued to work in the field of psychology before and after her education.

The Tax Court disagreed. State law controls the outcome here. In both Nebraska and New York, the only requirement for being a mental health practitioner was a masters degree in psychology, which Ms. Ortega already had. In contrast, both states required a doctoral degree in psychology to practice as staff psychologist. When Ms. Ortega left Nebraska and went to work in New York, she started practicing as a staff psychologist. Accordingly, "the doctorate . . . [q]ualified her to perform tasks and activities significantly different from those she could perform before the eduction." Therefore, her education expenses were not deductible as a trade or business expense.

Analysis

This is not a completely straightforward area of the law, but the decision here is correct. For example, though I already practice tax law as a CPA, my law degree will qualify me to be a lawyer. Therefore, even if I never intend to practice as a lawyer, my law degree expenses are not deductible.

Finally, even if Ms. Ortega was allowed to deduct the education expenses in question, the deduction would be limited by section 67. Section 67 imposes a two-percent floor on miscellaneous itemized deductions. That is, itemized deductions, other than those listed in section 67, are deductible "only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income." Sec. 67(a). Adjusted gross income is defined in section 62. Alternatively, you can look at page 1 of the Form 1040 to see how to calculate AGI.

Vehicle Expenses & Substantiation Requirements

The Tax Court provides a thorough explanation of the section 274(d) substantiation requirements for vehicle expenses otherwise deductible under section 162(a).

The taxpayer is self-employed in the promotions and marketing business. She regularly travels to client sites changing out displays and advertising signs. She did not file a tax return for 2003, as a result the IRS prepared one for her pursuant to section 6020(b).

The are two issues for the Tax Court. First, is the taxpayer allowed a mileage deduction for vehicle expenses. Second, is she liable for penalties under 6651(a)(1) and (2), and 6654(a).

Section 162(a) allows a deduction for ordinary and necessary expenses incurred or paid in carrying on a trade or business. Section 274(d) disallows all travel expenses, including vehicle expenses, otherwise allowed under section 162(a), unless the taxpayer substantiates the expenses with adequate records. The taxpayer's records must include the amount, time and place, business purpose of the expense, and business relationship between the taxpayer and the person entertained, etc.

Acceptable forms of records include "an account book, a diary, a log, a statement of expense, a trip sheet, or a similar record and documentary evidence that in combination are sufficient to establish each element of expenditure or use." see Temp. Reg. 1.274-5T(c)(2)(i). Records should be made at or near the time of the actual expenditure or use. As elapsed time increases, the record's credibility decreases. see Temp. Reg. 1.274-5T(c)(2)(ii).

Here, the taxpayer testified that she kept a mileage booklet but unfortunately she could not find it for trial. She also provided a mileage trip list for 2003, but she stated at trial that she prepared the list in 2007 - after the IRS sent her the notice of deficiency at issue in the case. She also produced several different reports showing client names and the dates she serviced their accounts.

The Court holds for the Service because the taxpayer’s records were not made "at or near the time" she incurred the vehicle expense. Thus she did not meet the substantiation requirements. As such, she is not allowed a mileage deduction. There is nothing in the opinion regarding actual vehicle expenses.

The IRS also assessed penalties for failure to file her 2003 tax return, failure to pay the tax shown on the return, and failure to pay estimated taxes. The Tax Court (in fact the same Judge) dealt with this identical topic here. As was the case with Ms. Humes, the IRS did not produce evidence of the taxpayer's 2002 return, thus the Court abated the 6654(a) failure to pay estimated tax penalties. The failure to file and failure to pay penalties under 6651(a) were sustained.

This opinion is subject to section 7463 and may not be used as precedent for any other case.

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Day Trading & Trade or Business Expenses

The Manning brothers are successful day traders – not Payton and Eli; Jim and John. But make no mistake, the IRS went after these boys with all the aggression of a 250lb middle linebacker. The tax year at issue is 2003.

The Tax Court’s opinion is pretty long, but the facts are pretty straightforward. Jim Manning – the taxpayer in the suit – ran a day trading office in Austin, TX for Assent, LLC, a broker-dealer. Jim was not Assent’s employee, he operated the office through his own LLC.

Customers (other day traders) paid commissions to Assent for making stock trades. The normal commission paid was $5 per 1,000 shares traded. Customers with very large trading volumes would receive discounts. But even if a customer did not achieve high trading volumes, Jim could ask Assent for commission reduction to stay competitive – there were other broker-dealers day traders could go to. Out of those commissions paid to Assent Jim would receive a cut.

In addition to individual accounts, Jim also brought in other entities to conduct their day trading through his office. One of these entities was Warrior, LLC, formed by Jim’s brother John. Warrior was the office’s biggest customer and paid average commissions of $3.75 - $4.25 per thousand shares traded. Assent kept $2 profit and Jim’s cut was the rest

Sometimes it took so long to get Assent’s approval to lower commission rates, that Jim would enter into “outside” agreements to take less of a cut and pass the savings on to the customers. Jim entered into just such an agreement with Warrior. For example, Warriors commissions were reduced to $2.25 per thousand shares traded. In this situation Warrior would still pay Assent $3.75 per thousand shares. Assent would keep $2.00 and pay $1.75 to Jim. Jim in turn would pay $1.50 to Warrior and net $.25.

For tax reporting purposes, Jim treated all “outside” commission adjustments the same. He reported the commission rate adjustment payments to each customer on a 1099-B (Proceeds From Broker and Barter Exchange Transactions). He then took a deduction on his Schedule C. Warrior reported all the commission rate adjustment payments it received as income for tax purposes.

The IRS challenges Jim’s deduction for the rate adjustments related to Warrior. Conversely, they allowed deductions for rate adjustments to unrelated parties. The IRS asserts the payments to Warrior were (1) not ordinary and necessary under section 162(a), (2) illegal payments under section 162(c)(2), and (3) lacked economic substance. The Tax Court rejects all three arguments.

The payments are ordinary because it is a common occurrence to lower commissions in the day trader industry. It did not matter whether the adjustment was paid by Assent or Jim so long as the adjustments were negotiated at arm’s length. The payments were necessary because Assent was slow to adjust rates. The Tax Court states, “an expense may be necessary even where the taxpayer could have avoided it by pursuing a different course of conduct.”

Illegal payments under section 162(c)(2) are those that specifically violate “federal statutes, including state laws which are assimilated into federal law by federal statutes, and legislative and interpretive regulations thereunder.” Here, the IRS relies on an ethics rule promulgated by the NASD (National Association of Security Dealers) against commission-sharing as foundation for its illegality argument. First, these were not commission-sharing arrangement as that term is defined. Moreover, since the IRS did not cite any federal statute that was violated, the payments are not illegal under section 162(c)(2).

Finally, the IRS argues the commission adjustments lacked economic substance because the agreement was not at arm’s length. Taxpayer Manning provided enough evidence to show the Court that Warrior could have received the same rates elsewhere.

Just goes to show you, when dealing with the Service, the best offense is a good defense.

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Real Estate Held For Sale To Customers?

This is a pretty dry post (and reads more like a tax law exam), but it's a common issue for taxpayer's that sell real estate.

Mr. & Mrs. Rice bought 14.4 acres for $300,000 in Austin, Texas. Their initial intent was to keep the entire 14.4 acres and build their dream home. Ultimately, they decided to subdivide the property into ten lots. They spent considerable effort subdividing the land, including rezoning, water and sewage, etc.

Afterward they built themselves a 12,000 square foot house (4,000 of which was for garage and porches) on the most desirable lot, and commenced selling the remaining lots. The first lot was sold in 2000 to friends. In 2002 they posted a wooden sign advertising lots for sale. the The next sale did not occur until 2004, at which time the Rice's sold three lots. Two of the lots were sold at a loss to relatives, and one was sold at a gain to friends. The remaining lots were sold in 2005, 2007, and 2008 to friends and acquaintances.

The issue for the Tax Court was whether the gain(loss) from the lots sold in 2004 should be ordinary or capital. When this issue arises the taxpayer usually argues for capital treatment if there is a gain and ordinary if their is a loss. The reason is that capital gains are taxed at lower rates than ordinary gains. Alternatively, capital losses are limited, while ordinary losses can be used to offset other earned income. Here, the Rice's have both a gain and a loss, but they were arguing for ordinary treatment (probably because their losses exceed their gains).

To receive ordinary treatment, taxpayer's must "hold the property primarily for sale to customers in the ordinary course of business." If, however, the taxpayer holds the property for investment, then gains(losses) from sales receive capital treatment.

The law in this area is well settled, though the application of facts to the law is anybody's guess. The governing section is 1221, but the courts have developed a seven factor test to determine whether the taxpayer held the property primarily for sale . . . quoted straight from the 5th Circuit in U.S. v. Winthrop:

1. The nature and purpose of the acquisition of the property and duration of ownership
2. The extent and nature of the taxpayer's efforts to sell the property
3. The number, extent, continuity and substantiality of the sales
4. The extent of the subdividing, developing, and advertising to increase sales
5. The use of a business office for the sale of the property
6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property
7. The time and effort the taxpayer habitually devoted to the sale.

Unfortunately for the Rice's their intent and efforts did not rise to the level of a business, thus there losses and gains are capital not ordinary. The Tax Court primarily considered their lack of effort to sell the lots coupled with the infrequency of sales.

Considering this was all going on during the real-estate boom, and in a thriving city like Austin, the Rice's did not have much of an argument. With the right amount of effort they probably could have sold all the lots in 18-24 months and made a substantial gain. Of course, then they would be arguing for capital gain treatment and the IRS would have argued they were in a business!

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Hobby Loss Rules

Beasley v. Comm'r, T.C. Summary Opinion 2009-93 (T.C. 2009).

The Tax Court writes an excellent opinion on the profit motive requirement to avoid the loss limitations imposed by section 182.

The Beasley's are from Maryland - based on the facts, probably somewhere near the Chesapeake Bay. During 2003, Mr. Beasley started a charter fishing business, all the while working full-time as an HVAC project manager. Mr. Beasley deducted losses from his charter fishing service on a Schedule C: ($101,085), ($47,296), and ($33,769) respectively during the periods 2003 - 2005.

The IRS denied the loss deductions for his charter fishing service pursuant to section 183(a) and (b)(2). This section limits the amount that can be deducted when the activity is not engaged in for profit. Specifically, deductions cannot exceed the gross income from the activity. This rule is commonly referred to as the Hobby Loss Rule.

The Tax Court walks through the nine-factor test stated in the Regulations for determining whether an activity is engaged in for profit. After applying the facts to each factor the Court decides if the factor favors the IRS or Mr. Beasley. On balance Mr. Beasley loses. Here is a table of the nine-factors and the Court's decision.

As you can see, Mr. Beasley did not win a single factor. I thought the first three factors could have gone either way. Mr. Beasley was hard pressed to win the last six. My point here is not whether Mr. Beasley won but how the Tax Court went about making its decision.

The last thing I want to point out is how much depreciation Mr. Beasley deducted. In total, $105,288 in depreciation over the three-year period. Assuming a 28% marginal tax bracket, Mr. Beasley saves $29,481 in taxes. Compared to his total interest expense on the boat of $22,545 for the same three-year period, Mr. Beasley essentially gets his fishing boat paid for by the Treasury for three years. If Mr. Beasley never makes a taxable profit (because a profit is not his objective), then Treasury never gets its money back. In this context, the rule reflects good tax policy.

Trade or Business Requirement & Depreciation

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.

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