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Inventor-Attorney Can't Take Business Expense Deductions

JAN. 27, 2020

Provitola, Anthony I. et ux. et al. v. Commissioner

DATED JAN. 27, 2020
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Provitola, Anthony I. et ux. et al. v. Commissioner

ANTHONY I. PROVITOLA & KATHLEEN A. PROVITOLA, ET AL.,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

UNITED STATES TAX COURT
WASHINGTON, DC 20217

ORDER

Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is

ORDERED that the Clerk of the Court shall transmit with this order to petitioners and respondent a copy of the pages of the transcript of the trial in this case before Judge Ronald L. Buch at Jacksonville, Florida, containing his oral findings of fact and opinion rendered at the trial session at which these cases were heard.

In accordance with the oral findings of fact and opinion, decision will be entered for respondent.

(Signed) Ronald L. Buch
Judge

Dated: Washington, D.C.
January 24, 2020

Bench Opinion by Judge Ronald L. Buch

December 18, 2019

Anthony I. Provitola & Kathleen A. Provitola v. Commissioner of Internal Revenue

THE COURT: The following represents the Court's oral findings of fact and opinion. These oral findings of fact and opinion may not be relied upon as precedent in any other case. This opinion is in conformity with Internal Revenue Code section 7459(b) and Rule 152(a) of the Tax Court Rules of Practice and Procedure. Any section references refer to the Internal Revenue Code or the Treasury regulations in effect during the years at issue, and Rule references are to the Tax Court Rules of Practice and Procedure.

The Commissioner issued notices of deficiency for 2013 and 2014 to Mr. and Mrs. Provitola. The Provitolas filed a petition challenging the deficiencies. We must decide whether the Provitolas may take deductions for legal and professional services for 2013 and 2014 and other expenses for 2014.

BACKGROUND

Anthony and Kathleen Provitola are married and were married at all relevant times. Mr. Provitola has a B.S. in physics and a law degree. He is a practicing attorney who is admitted to the bar of the Tax Court. Early in his career, he was a personal injury attorney. Later in his career, he transitioned his area of practice to patent law. He practiced law through Anthony I. Provitola, P.A. (APPA), a professional association and subchapter S corporation of which Mr. Provitola is the sole owner.

In roughly 2003, Mr. Provitola stumbled on the idea for a product to enhance television viewing. Sometime thereafter, he began developing a product, and from 2005 to 2016, he was awarded seven patents in connection with the product he was developing.

In 2007, the Provitolas formed Viovision ventures LLC, a limited liability company with Kathleen Provitola as the sole owner. Viovision was formed for the marketing of any product that may result from Mr. Provitola's original concept. From its formation through 2012, Viovision did not report any income or expenses. That changed in 2013.

In January 2013, APPA billed Viovision for five years of services provided by Mr. Provitola through APPA. The bill listed the services provided as "Annual Retainer for IP Services + Business Consult". Mr. Provitola provided all management, product development, and product design services to Viovision through APPA. For those services, APPA billed Viovision $12,000 per year for 2009 through 2013, inclusive, showing a total balance of $60,000 on the January 2013 invoice.

On December 30, 2013, the Provitolas capitalized Viovision by writing a personal check to Viovision for $36,000. On that same date, Viovision wrote a check to APPA for $36,000 as partial payment of the accrued fees. That payment was to compensate APPA for Mr. Provitola's services. APPA then wrote a check to Mr. Provitola for $36,000, also on December 30, 2013. All of those checks were promptly deposited.

Similar payments were made in December 2014. On December 29, 2014, the Provitolas wrote a check for $42,500 to Viovision. In turn, Viovision wrote checks Payable to APPA for $359, $16,992, and $22,000. Viovision also wrote a $2,000 check to Mr. Provitola, individually. With the exception of the check to Mr. Provitola, those checks were deposited into APPA's account along with $10,000 cash on December 29, 2014. And also on December 29, 2014, APPA wrote a check to Mr. Provitola for $49,000.

For 2013, the $36,000 payments were reported by the Provitolas on various returns and schedules. The Provitolas' Form 1040, U.S. Individual Income Tax Return, included a Schedule C, Profit or Loss From Business, for Viovision. That Schedule C reported a $36,000 expense for legal and professional services. The result was a net loss that the Provitolas carried onto the face page of the Form 1040. As for APPA, it reported the $36,000 as gross receipts. Those gross receipts were largely offset by expenses, netting $495 of business income. The Provitolas reported the $495 on Schedule E, Supplemental Income and Loss, where it was more than offset by other nonpassive losses.

For 2014, the payments were again reported on various returns and schedules. The payments from Viovision to APPA were broken out on three different lines on the Schedule C; legal and professional fees of $22,000, other expenses of $20,327, and taxes and licenses of $139. Those amounts do not correspond directly to the reporting by APPA, which reported $32,000 of gross receipts. That income was largely offset by expenses, yielding net income of $341. The Provitolas reported that $341 on Schedule E where, like 2013, it was more than offset by nonpassive losses.

The Provitolas jointly prepared and jointly filed their returns for 2013 and 2014. They were also both involved in the preparation of the APPA returns.

As of 2015, indeed, as of the time of trial, Viovision had not attempted to sell any products and has not generated any revenue or any profit. Approximately 1,000 product units were manufactured after the years in issue, but there has been no attempt to sell them. Viovision never had any employees, never had an office apart from the Provitolas' home, and never did any advertising or marketing. Viovision has developed a website, but that website has not been made public.

The Commissioner examined the Provitolas' 2013 and 2014 returns, issuing separate notices of deficiency for each year.

The Commissioner issued a notice of deficiency with respect to 2013 on March 7, 2016. In that notice, the Commissioner disallowed the $36,000 expense reported on the Viovision Schedule C that was included with the Provitolas' Form 1040. The notice explained that the expense was disallowed because the Provitolas had not established that the expense was paid or incurred in 2013 or that the expense was ordinary or necessary. The notice also determined computational adjustments resulting from the $36,000 disallowance. Lastly, the notice included an accuracy-related penalty under section 6662. Although the notice listed in the alternative several bases for determining an accuracy-related penalty, only the substantial understatement penalty received supervisory approval, which occurred on November 20, 2015.

The Commissioner issued a notice of deficiency with respect to 2014 on May 1, 2017. In that notice, the Commissioner disallowed $42,236 of expenses ($22,000 legal and professional fees and $20,236 other expenses) reported on the Viovision Schedule C that was included with the Provitolas' Form 1040. The notice explained that the expenses were disallowed because the Provitolas had not established that the expenses were paid or incurred in 2014 or that the expenses were ordinary or necessary. The notice also determined computational adjustments resulting from the $42,236 disallowance. Lastly, the notice included an accuracy-related penalty under section 6662. Although the notice listed in the alternative several bases for determining an accuracy-related penalty, only the substantial understatement penalty received supervisory approval, which occurred on February 27, 2017.

 While residing in Florida, the Provitolas filed timely petitions challenging each notice of deficiency. We consolidated the cases and held a partial trial October 22, 2018 and continuing on December 16, 2019. The Provitolas challenge the Commissioner's disallowance of Viovision's expenses, asserting that the expenses were incurred and that they were ordinary and necessary.

The Commissioner's position is less straightforward. Based on the evidence adduced at trial, the Commissioner no longer appears to challenge whether Payments were in fact made. We assume that he continues to challenge whether the expenses were ordinary or necessary, although this point may be subsumed in other arguments made by the Commissioner. He argues: "Viovision is not an actual business, but merely a legal fiction petitioners use to offset their income." We will characterize this as a substance over form argument. The Commissioner also argues: "a person cannot become liable to oneself, one cannot incur legal fees for themselves, and there can be no deduction for legal fees." This criticism of the circularity of payment appears to be a mere rephrasing of the substance over form argument, so we will address it within that discussion. Distinct from the substance over form argument, the Commissioner argues: "Viovision was not actually engaged in business during the 2013 and 2014 tax years. At best, the transfers from Viovision to the law practice could be considered start-up expenses, which are not deductible for the years they were made." We will characterize this as a start-up expenditures argument.

DISCUSSION

I. Burden of Proof

Generally the Commissioner's determinations in a notice of deficiency are presumed correct, and taxpayers bear the burden of proving otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The Commissioner bears the burden of proof, however, on any new matter, increases in deficiency, or affirmative defenses pleaded in his answer. Rule 142(a); Shea v. Commissioner, 112 T.C. 183, 190 n.10 (1999).

II. Substance Over Form

When assessing whether a corporation will be respected as a separate taxable entity, courts often look to Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943). The Supreme Court held in Moline Props, that when a taxpayer adopts the corporate form, and "so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity." Moline Props., Inc. v. Commissioner, 319 U.S. at 439 (citing New Colonial Ice Co. v. Helvering, 292 U.S. 435, 442 (1934), and Deputy v. Du Pont, 308 U.S. 488, 494 (1940)).

Since Moline Props, courts have used this Proposition to determine whether a taxpayer's chosen entity will be recognized for Federal tax purposes. Bertoli v. Commissioner, 103 T.C. 501, 511-512 (1994). Court have applied a two-prong test: the entity (1) must be created for a business purpose, or (2) must carry on a business activity. Bertoli v. Commissioner, 103 T.C. at 511-512. For tax purposes, the "form may be disregarded where it is a sham or unreal. In such situations the form is a bald and mischievous fiction." Moline Props., Inc. v. Commissioner, 319 U.S. at 439. Courts have used the principals in Moline Props to determine the validity of various entities. Bertoli v. Commissioner, 103 T.C. at 512; O'Neill v. Commissioner, 271 F.2d 44, 49 (9th 1959), aff'g T.C. Memo. 1957-193; Campbell County State Bank, Inc. v. Commissioner, 37 T.C. 430, 441 (1961), rev'd on other grounds 311 F.2d 374 (8th Cir. 1963).

These principals apply to both Viovision and APPA. The Commissioner argued at trial that Viovision, the Provitolas' LLC, is "merely a legal fiction". However, we will respect Viovision's form because it is engaged in activities with a business purpose. Mr. Provitola is currently working on inventing and bringing to market his television viewing product through Viovision. He has developed the product and obtained several patents in the process. Although it is unclear at this time whether the product will be commercially viable, approximately 1,000 units of the product have been manufactured with the hope of eventual sale. A website has been created for that purpose, although that website is not yet public. The Provitolas treated Viovision as a discrete entity; for example, Viovision maintains a separate bank account. Viovision is not a "sham or unreal" nor is it "a bald and mischievous fiction." Viovision exists to develop an bring to market Mr. Provitola's invention, and we will respect its existence.

We note that the Commissioner's substance over form argument is inconsistent with the notice of deficiency. In the notice, the Commissioner disallowed the expenses taken by Viovision for the payment of legal and professional fees paid to APPA for lack of substantiation and because the expenses were not ordinary and necessary. Notably, the Commissioner did not make a corresponding adjustment to APPA to remove the income from the legal and professional fees. If the payments made by Viovision were mere circular payments without any substance, then the income to APPA would be disregarded along with the deduction by Viovision. This is not the position set forth in the notice of deficiency and it is not supported by the record. We will give due regard to the separate entities.

III. Start-Up Expenses

Taxpayers may deduct "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Sec. 162(a). An "ordinary" expense is one that commonly or frequently occurs in the type of business at issue. Deputy v. du Pont, 308 U.S. 488, 495 (1940). A "necessary" expense is an expense that is "appropriate and helpful" to the business. Heinbockel v. Commissioner, T.C. Memo. 2013-125, at *17.

Before a taxpayer may deduct trade or business expenses under section 162, there must exist a business "functioning as a going concern and performing the activities for which it was organized." Glotov v. Commissioner, T.C. Memo. 2007-147, 93 T.C.M. (CCH) 1339, 1340. Before the day a business operates as a going concern, expenses related to creating a business are not "ordinary and necessary" expenses to the business and are therefore not deductible. Woody v. Commissioner, T.C. Memo. 2009-93, 97 T.C.M. (CCH) 1484, 1487. To be deductible as a business expense under section 162, rather than amortizable as a start-up expense under section 195, business activities must have actually commenced. Glotov v. Commissioner, T.C. Memo. 2007-147, 93 T.C.M. (CCH) 1339, 1340.

The Provitolas referred the Court to Stanton v. Commissioner, 399 F.2d 326 (5th Cir. 1968), for the Proposition that one can be in the business of inventing. But the Court of Appeals for the Fifth Circuit also observed:

The phrase 'trade or business' presupposes an existing trade or business. Thus, expenditures incurred in investigating a potential new trade or business or in preparation for the possibility of entering into a new trade or business have been held not to have been incurred in connection with a trade or business so as to be deductible in computing taxable income.

Id. at 329 (internal citations omitted).

Though not deductible, start-up expenditures are instead capitalized and amortized under section 195. Start-up expenditures include any amount paid or incurred in creating a trade or business, or engaging in an activity to create profit or produce income prior to the day the active trade or business begins. Sec. 195(c)(1)(A). (We make no determination at this time whether these expenses may, at some future date, be claimed by Viovision.)

To determine whether expenses are deductible section 162 business expenses or amortizable start-up expenses, we must look to whether Viovision is still in the start-up phase of its business or if it has begun an active trade or business. Woody v. Commissioner, T.C. Memo. 2009-93, 97 T.C.M. (CCH) 1484, 1487.

In McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. (CCH) 1339, the petitioner decided to start a tree farm. In preparation for his business, the Petitioner studied the commercial viability of land, forest health, entomology, and risk control issues. After buying the land for his tree farming business, the Petitioner paid for a forest management plan and planted pine trees as a pilot test for his farm. At the time of filing his tax return claiming deductions, the petitioner had not yet commercially harvested the trees. McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. (CCH) 1339, 1340. This Court held that petitioner "had not actually commenced the business activity of tree farming". McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. (CCH) 1339, 1341.

Viovision has not yet commenced an active trade or business. Like the petitioner in McKelvey, Viovision has taken significant steps to prepare for the business of selling Mr. Provitola's invention. Viovision has not yet attempted to market or sell a product. It has not made any sales, made its website public, or attempted to market a product. As in McKelvey where this Court did not consider the petitioner to be engaged in a trade or business before commercially harvesting his trees, Viovision has not yet engaged in a trade or business before attempting to market and sell a product.

Because Viovision's expenses are start-up expenses, the Provitolas may not deduct those expenses under section 162. However, they may capitalize these expenses under section 165(a) in the future. Because we respect the payments made by Viovision, the payments are still income to APPA.

We note that this outcome is consistent with the position set forth in the Commissioner's notice of deficiency, which disallowed the expenses claimed by Viovision but did not adjust the income to APPA. To the extent the Commissioner's start-up expenditures argument is a new matter, he would bear the burden of proof. Rule 142(a)(1). That burden, however, is easily satisfied; it is clear that Viovision is still in the start-up phase and not yet an active trade or business.

IV. Applicable Penalties

Section 6662(a) imposes a 20% accuracy-related Penalty on "any portion of an underpayment of tax required to be shown on a return" if the underpayment is due to negligence or disregard of rules or regulations. Section 6662(d)(1) imposes a penalty for taxpayers who report a substantial understatement of tax. An understatement is substantial if it exceeds the greater of 10 percent of the tax required to be shown for that year or $5,000. Sec. 6662(d)(1)(A). For the Commissioner to properly impose a Penalty, the penalty must be personally approved-in writing-by an immediate supervisor of the person making the initial determination to impose the penalty. Sec. 6751(b)(1). The Commissioner has the burden of production with respect to a taxpayer's liability for any penalty. sec. 7491(c). After the Commissioner has met his burden, the burden shifts to the taxpayer to prove any applicable affirmative defenses to the penalties. CNT Investors, LLC v. Commissioner, 144 T.C. 161, 220 (2015).

The Commissioner determined an accuracy-related Penalty on various grounds for each year. However, only the substantial understatement penalty received supervisory approval as required by section 6751(b). As a result, only the substantial understatement penalty can apply. The amount of the understatement satisfies the threshold for a substantial understatement for each year, and the Provitolas have not shown that any affirmative defenses apply. Mr. Provitola is an attorney, he and Mrs. Provitola jointly prepared their returns, and they offered nothing in the way of substantial authority for their return positions. The substantial understatement penalty applies to each year.

Decisions will be entered for respondent.

(Whereupon, at 9:02 a.m., the above-entitled matter was concluded.)

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