Kellett v. Comm’r, T.C. Memo 2022-62 | June 14, 2022 | Greaves, J. | Dkt. No. 21518-18

Summary:

The IRS disallowed a $25,992 business expense deduction resulting in a corresponding deficiency of $6,475 in 2015. 

Kellett ran a business information website which started upon the website’s opening in September 2015. This website compiled demographic, social, and economic data and attempted to make a user-friendly version of Google or Yahoo Finance. The website was developed with engineers who built the desired features and functionality. On a timely filed 1040, the taxpayer claimed expense deductions for these engineers as well as a marketing strategist, cell and internet service cost from his home, and some miscellaneous expenses. The IRS denied all deductions on the grounds that the business had not started.

The Tax Court set out to determine:

• When does a business start for purposes of § 195?
• Can a taxpayer expense the costs of developing software under § 174 before the business technically begins, or is he solely relegated to relief under § 195?
• Can a taxpayer use Rev. Proc. 2000-50 to deduct the costs of developing a website?

Key Points of Law:

• 195 Start-up Expenditures: § 195(a) disallows deductions for start-up costs except for provided in this section. Therefore, under § 195(b), a taxpayer generally can deduct up to $5,000 of start-up expenditures. However, if the costs are in excess of $50,000, then the amount is phased out dollar for dollar until $55,000. § 195(b)(1)(A)(i)-(ii). Any amount phased out, or in the event the costs exceed $55,000, the taxpayer must capitalize the capital outlay and then amortize it ratably over 15 years. § 195(b)(1)(B).
• 174 Research and Development: Taxpayers are granted relief from the harsh capitalization standards for start-up costs under § 174, but it applies only in limited circumstances. However, the general rule is that taxpayers may treat R&D connected with their trade or business as expenses not chargeable to the capital account. § 174(a)(1). § 195(c)(1) excludes from the definition of start-up expenditures any amount which a deduction is allowable under § 174.

The Court’s Decision And Learnings:

The court determined the business began in September of 2015 because that is when it began providing the services for which it was organized. Any expenses incurred before this date must be taken under § 195 and any expenses after this date are taken under § 162.

Further review brought the following decision: the taxpayer is disallowed from taking a § 174 deduction (i.e. R&D Tax Credit) since he merely adapted a widely used software rather than developing it from whole cloth.

This case highlights the importance of understanding the difference between development and experimental development. While website or software development may seem as though it is inherently R&D, developers must carefully consider if their product is novel and faces technical uncertainties. Modification of existing software rarely has significant enough technical uncertainty or experimental development work to pass the IRS’s four part test.

Click here to read the full case.

Are you conducting research and development activities? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

Genecure, LLC v. Comm’r, T.C. Memo 2022-52 | May 23, 2022 | Jones, J. | Dkt. No. 14916-15.

Summary:

GeneCure, LLC is a biotechnology company focused on developing gene therapy based technologies to treat genetic and acquired human diseases. The company developed a patented lentiviral delivery platform which they use to further develop novel human vaccines. The company claimed R&D tax credits for this research and were met with adjustments made by the IRS for the 2009-2012 taxable years.

The opinion set out to address numerous issues including taxation of settlement proceeds received in contract dispute, deductibility of item-by-item categories of business expenses, recapture tax for an Affordable Care Act-Qualified Therapeutic Discovery Project (QTDP) grant received by Genecure, characterization of amounts received from an LLC owned by Frank Tung’s wife (i.e., is it a loan, or not a loan), and possible capital contributions from the LLC owned by Frank Tung’s wife.

Key Points of Law:

This is a TEFRA partnership-level case with GeneCure organized as a member-managed LLC. As such, it is treated as a partnership for federal income tax purposes (Treas. Reg. § 301.7701-3(b)(1)).

The IRS first examined the tax returns for 2009-2012, providing a Form 11661, Fraud Development Recommendation-Examination. They then issued Frank Tung, in his capacity as tax matters partner, a separate Notices of Final Partnership Administrative Adjustment (FPAA) for each of the years in issue, as well as a section 6663 civil fraud penalty for underpayment of tax for each year.

Frank Tung gathered and attempted to admit evidence and documentation including emails and letters from GeneCure’s day-to-day business. Most of this documentation the Tax Court refused to admit or consider. This was due to the irrelevance of the evidence. Tax Court evidentiary rulings are determined under the Federal Rules of Evidence (7453; Rule 143(a)).

The Court’s Decision And Learnings:

Frank Tung, acting as tax matters partner for GeneCure, failed to provide acceptable evidence following evidentiary standards. He also failed to provide available exceptions to the rules and therefore the evidence was not submitted. 

GeneCure failed to document and substantiate most of the claimed business expenses it sought to deduct. They further failed to report taxable income including the amounts received in a settlement from a business contract dispute. Deductions and other tax benefits were claimed but could not be substantiated. They further could not prove that a $200,000 payment from Frank Tung’s wife was a loan for rent.

Because of these failures, the Tax Court ruled in favor of the IRS on all tax issues. They found Frank Tung’s testimony to be self-serving, evasive, conflicted, and improbable. The court’s conclusions were as follows:

• That Genecure had unreported income of $6,000; $21,578; and $7,000 in taxable years 2009-11, respectively; 
• That Mr. Tung largely failed to establish Genecure’s entitlement to deductions for various business expenses reported for each of the taxable years at issue; 
• That Genecure is subject to a $230, 979 recapture tax with respect to its taxable year 2010 for excess amounts received as a QTDP grant;
• That Mr. Tung failed to substantiate a $200,000 loan to Genecure from Mrs. Tung in taxable year 2009;
• That Mr. Tung failed to substantiate a $100,000 capital contribution to Genecure from Mrs. Tung in taxable year 2011.

As for the fraud-related penalties, the IRS Civil Penalty Approval Form and its Form 11661 did not satisfy the written supervisory approval requirements for purposes of assessing section 6663 civil fraud penalties; therefore, such penalties were inapplicable against Genecure at the partnership level.

This court case serves as an example of the absolute importance of documentation and substantiation. There are stringent evidentiary requirements which must be considered and having a paper trail to back up any claim is crucial to the vitality of said claim.

Click here to read the full case.

Are you conducting research and development activities? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.