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Does Section 195 Apply to Section 212 Activities?

Technical topics regarding tax preparation.
22-Jun-2018 1:21pm
I have seen it asserted on this forum numerous times that "section 195 applies to section 212 activities".

Specifically, it is contended that the term "active trade or business" as used in section 195 applies equally to section 162 activities and section 212 activities. Coddington is the main purveyor of this position, and he has often stepped in to explain it using references to Hardy v. Commissioner, Toth v. Commissioner, and the committee reports on section 195. See for example this thread: viewtopic.php?f=8&t=14685.

I am highly skeptical of this position, and I intend to offer arguments against it in this thread. Before I do that, I'd like to make sure that I have a complete understanding of the arguments in support of the position.

I have attempted to clearly articulate Coddington's arguments in the four points that follow. I'd like to invite Coddington, or indeed anyone else familiar with any arguments for the application of section 195 to section 212 activities, to examine the following four points and suggest any citations, clarifications, or additional reasoning that will bolster them. If there are additional arguments, please suggest those as well. Put forward the best possible case for the position I intend to dispute:

  1. The intent of the 1984 amendment to section 195 was to make clear that the pre-opening expense doctrine applied to section 212 activities just as much as it did to section 162 activities. Therefore, this amendment should be interpreted to cause pre-opening expenses for section 212 to be capitalized, and if they are capitalized under section 195, they can therefore be amortized under that section.
  2. The senate committee report on The Deficit Reduction Act of 1984, which added section 195(c)(1)(A)(iii), states that a trade or business that is "in many respects passive" can nevertheless be considered an "active trade or business" for purposes of section 195. The report goes on to provide the example of a net lease rental activity being considered active even though it is seemingly passive. Because net lease rental activities are section 212 activities, we can conclude that the senate report was discussing section 212 activities when they discussed "passive" trades or businesses. Therefore, the senate intended that a section 212 activity can be considered a section 195 "active trade or business".
  3. An equivalency standard between section 162 and section 212 was announced in Hardy v. Commissioner (93 T.C. 684) and confirmed in Toth v. Commissioner (128 T.C. 1). In the words of the Hardy court, "[s]ection 162 and section 212 are in pari materia as to the distinction between capital expenditures and ordinary expenses". Section 162 start-up expenditures are capitalized under section 195. Because section 212 expenses are treated equivalently, this means they, too, are capitalized under section 195. If they are capitalized under section 195, they can therefore be amortized under that section.
  4. Although divergent from the plain reading of the statute, section 195(c)(1)(A)(iii) can be interpreted to include section 212 activities within the definition of an "active trade or business", and that is the interpretation that the Toth and Hardy courts, as well as the legislative history of the section, have confirmed for us.

21-Apr-2014 8:50pm
Fort Worth, TX
That's an exceptionally fair presentation. Is the TCJA the motivation for for this discussion?

As we all know, the TCJA added Code section 67(g), which suspended section 212 deductions for eight years (not counting deductions under section 62(a)(4)). If an activity passes through an active section 212 stage in anticipation of an eventual section 162 stage, the plain reading of section 195(c)(1)(A)(iii) would seem to permit require capitalization of the section 212 expenses for later deduction or amortization under section 195 once the active section 162 trade or business commences. Thus we avoid the suspension of section 212 deductions. Before continuing the discussion, it would probably be useful (for others) for us to briefly describe the facts of the relevant cases.

1. Hoopengarner involved the 1976 tax year. The taxpayer acquired a leasehold interest on which to construct building. He tried to deduct the 1976 rental payments to the ground lessor. Construction commenced and finished in 1977. The first tenant took possession in September 1977. The Tax Court found that the property was held for the future production of income in 1976 and thus held the pre-opening expenses were not deductible under section 162, but were deductible under section 212(2).

2. In Hardy, the Tax Court overruled Hoopengarner. Hardy involved a taxpayer who held down a full-time government job, but also managed 45 rental homes. Of those homes, he had an equity interest in only one. He deducted loan fees on his 1982 return related to an attempt to enter the hotel business. The Tax Court found that he was not in the hotel or commercial leasing business. This relegated the attempt to a pre-opening situation and the Court held that pre-opening doctrine applied to section 212 as well as section 162. The deductions were denied.

3. In Toth, the taxpayer conceded that her activities in 1998 and 2001 were not section 162 activities, but rather section 212. So there are minimal facts in the opinion. All we know is that the taxpayer was already qualified to teach certain horse eventing skills, but held down a full-time job with Pfizer. In 1998, while still working for Pfizer, she started the horse training and boarding activities, which resulted in a small income. (She lost her job with Pfizer in 2000.) By 2004, the active trade or business under section 162 had commenced.

Two possible attacks on my position are that the plain-meaning of section 195(c)(1)(A)(iii) precludes the holding in Toth or that section 195's "start-up expenditures" do not include section 195(c)(1)(A)(iii) "start-up expenditures", (though I am curious to see if Chay takes another route). In the first case, Toth is wrongly decided. What then? Is there another decision on point that would elevate the contrary position to MLTN or substantial authority? In the second case, we don't have ammo against the TCJA suspending deductions.

There is a pretty good article that covers more of the theory involved in this area here
Tax accounting methods and credits consultant for hire.

22-Jun-2018 1:21pm
Coddington, thank you for the summaries and the links to the relevant cases. Those will help with the discussion.

As a matter of fact, the TCJA has nothing to do with my arguments. I agree with the Toth court's holding that once a section 212 activity has begun, "the deduction of ordinary and necessary expenses paid or incurred in that activity is not precluded by section 195 regardless of whether that activity is subsequently transformed into a trade or business" (128 T.C. at 4). The key phrase that requires this treatment is "in anticipation of such activity becoming an active trade or business". This phrase means that in the case of an ongoing 212 activity, only where the a taxpayer has expenses related specifically to the transformation of that activity into a 162 activity does that taxpayer have "start-up expenditures". The only way for such a taxpayer to get around the section 67(g) limitation is for them to actually start up a bona fide "trade or business", which is very much in line with the intent of the TCJA.

Nor do I contend that section 195(c)(1)(A)(iii) expenses do not fit within the definition of "start-up expenditures". Indeed, section 195(c)(1), drawing on all three clauses of subparagraph (A), sets forth the very definition of "start-up expenditures".

It is in fact my contention that the term "active trade or business" as used in section 195 applies only to section 162 activities and not to section 212 activities.

In support of this contention, I will first show that it was explicitly the intent of the Congress to exclude section 212 activities from the benefits of section 195 when they first enacted that section in 1980. I will then show, contradictory to point 2 in post #1, that their intent to exclude section 212 activities did not change, and was in no way defeated, when the 1984 amendment was made in response to the Tax Court's findings in Hoopengarner. Finally, I will show that points 1, 3 and 4 of post #1 misinterpret both section 195 as written and the court holdings subsequent to the 1984 amendment. In so doing, I will offer better interpretations of what the statute and the case law imply.

In the interest of good inquiry, organization, and adhering to a discussion format, I will address each of these three points separately and in order. For anyone reading, if you have any questions, comments, support, or counter-arguments, please post these without waiting for me to move on to my next point. This will allow us to fully address all ideas as they arise and it will potentially allow me to incorporate more detail or nuance into my arguments.

22-Jun-2018 1:21pm
Point 1 — The original version of section 195 clearly and deliberately excludes section 212 activities

In arguing this point, it is tempting for me to resort immediately to committee reports that state what the legislative intent was. However, doing so would cloud our ability to focus the discussion on the plain meaning of this statute, and in the end, it is that meaning which matters more than anything else. As the Supreme Court put it, "where the language of an enactment is clear and construction according to its terms does not lead to absurd or impracticable consequences, the words employed are to be taken as the final expression of the meaning intended" (United States v. Missouri Pacific R. Co., 278 U.S. at 278).

So I will approach things "the hard way" and begin by introducing the text of section 195 as it was originally enacted in 1980, available here and copied below:

Code: Select all
   (a) ELECTION TO AMORTIZE.—Start-up expenditures may, at the
election of the taxpayer, be treated as deferred expenses. Such
deferred expenses shall be allowed as a deduction ratably over such
period of not less than 60 months as may be selected by the taxpayer
(beginning with the month in which the business begins).
   (b) START-UP EXPENDITURES.—For purposes of this section, the
term 'start-up expenditure' means any amount—
        (1) paid or incurred in connection with—
             (A) investigating the creation or acquisition of an active
         trade or business, or
             (B) creating an active trade or business, and
        (2) which, if paid or incurred in connection with the expansion
     of an existing trade or business (in the same field as the trade or
     business referred to in paragraph (1)), would be allowable as a
     deduction for the taxable year in which paid or incurred.
   (c) ELECTION.—
        (1) TIME FOR MAKING ELECTION.—An election under subsection
    (a) shall be made not later than the time prescribed by law for
    filing the return for the taxable year in which the business
    begins (including extensions thereof).
        (2) SCOPE OF ELECTION.—The period selected under subsection
    (a) shall be adhered to in computing taxable income for the
    taxable year for which the election is made and all subsequent
    taxable years.
      (3) MANNER OF MAKING ELECTION.—An election under subsec-
    tion (a) shall be made in such manner as the Secretary shall by
    regulations prescribe.
   (d) BUSINESS BEGINNING.—For purposes of this section, an
acquired trade or business shall be treated as beginning when the
taxpayer acquires it.

Take note of the fact that the current section 195(a), disallowing deductions for start-up expenditures outside of section 195, is missing from this version, as is the language in 195(c)(1)(A)(iii) relating to activities for profit or for the production of income. Both of these differences are material to this discussion and will come into play later.

Also take note of the magic words "trade or business", which appear five times and are traded for the lone word "business" on two further occasions.

The phrase "trade or business" was introduced in the Revenue Act of 1918 and has remained a staple of income tax law ever since (see Higgins v. Commissioner, 312 U.S. at 215). The phrase has, apparently, been used in more than 60 different Code sections since at least 1960 (try googling the phrase "60 different Code sections" in quotation marks). Often, these various sections, or the regulations thereunder, will explicitly cross-reference section 162 for their definition of "trade or business" (e.g., sections 41, 179, 513, 1402, 1411, etc.), and it is beyond dispute that in most cases, when "trade or business" is spoken, activities under section 162 (and no other section) has been invoked.

However, the fact that there are so many explicit references may lead one to question whether, in the case where a cross-reference does not exist, a different meaning was intended.

Generally, we will find this not to be the case. Courts have favored applying a consistent definition of "trade or business" across the various statutes so long as the purpose of the statutes is similar (see Folker v. Johnson, 230 F.2d 906). However, in some cases, we are presented with embellishments to the phrase "trade or business" that seem to point more strongly to a new concept with a different meaning from the one in section 162. In these cases, courts have been more reluctant to rely solely on prior case law (see for example King v. Commissioner, 55 T.C.677, regarding section 355 and "active conduct of a trade or business").

As it happens, section 195 lacks a cross-reference to section 162 while also containing the phrase "active trade or business", which could be argued as an example of an embellishment and a new concept. On these facts we could base an argument that the language of this enactment is not clear and that it cannot be relied upon as the sole source of interpretation. Depending on what else we draw upon to clarify the ambiguity, we could even go so far as to argue for the inclusion of a section 212 activity within the new concept of "active trade or business".

All of that would be folly.

For one thing, the term "active trade or business" in section 195 does not strongly suggest a new and therefore ambiguous concept. "Active" is only inserted in front of "business" or "trade or business" in two out of seven occasions, suggesting that the phrase in its normal presentation is controlling in this section. Even where the term "active trade or business" is used, the plain term "trade or business" is then substituted immediately thereafter (195(b)(2)) to refer to the same thing. This suggests that, whatever an "active trade or business" might be, it is also a trade or business.

But assuming arguendo that we do have a new concept in the phrase "active trade or business", that concept cannot be completely detached from section 162, and will in fact represent a narrowing, rather than a broadening of the original definition. The meanings conveyed by the various "trade or business" phrases found throughout the Code do not differ in their comprehension of what a "trade or business" itself is, but rather in the criteria through which these activities are to be evaluated in the context of the relevant section. See for example Regs. 1.41-2(a), emphasizing that a trade or business must be carried on at the time an expense is paid. Regs. 1.355-3(b)(2)(ii) is the closest we come to a genuinely distinct concept of a "trade or business". The definition offered here appears to conflict with case law because it pays no attention to the level of activity involved in the "group of activities" carried on by the corporation. But this definition cannot be applied without also incorporating the (b)(2)(iii) requirement for "active and substantial management and operational functions", which leads us, again, to a definition that is narrower than the one in section 162.

Even if we move past both of these points and contemplate broadening the definition of "trade or business", we will find it unnatural to stretch that definition to encompass section 212 activities. Section 23(a)(2), the predecessor to section 212, was added to the Code in 1942 with the sole purpose of allowing taxpayers not engaged in a trade or business, but having expenses that would otherwise meet the criteria for business deduction, including profit motive, to deduct those expenses. This purpose is expressed nowhere more clearly than in the regulations under that original section: "Except for the requirement of being incurred in connection with a trade or business, a deduction under this section is subject to all the restrictions and limitations that apply in the case of the deduction under section 23(a)(1)(A) of an expense paid or incurred in carrying on any trade or business" (Reg. 111, § 29.23(a)-15(d) (1943)). Because the very identity of section 212 activities emerges in opposition to trade or business activities, trying to include them in the scope of the term "trade or business" used in any context would be like trying to blend oil and water.

As it happens, the Tax Court did try to do just that on one occasion: Smith v. Commissioner (17 T.C. 136). Their holding that the petitioner could deduct a loss from an investment in a corporation as a business bad debt took the concept of a business and made it, in the words of the dissenting opinion, "extended entirely too far". The dissenting opinion goes on to argue that Congress has never intended to broaden the concept of a trade or business. It argues that in light of the recent addition of the new class of non-trade and non-business activities, where reference to such activities is absent, it is intended for such activities to be specifically excluded from consideration. The IRS appealed, and the majority opinion was overturned based on the dissenting opinion (Commissioner v. Smith, 203 F.2d 310).

In section 195, we have another example of deductions afforded to a "trade or business" wherein any reference to a mere income-producing activity is absent. Given the greater context of the Code, these phrases, and their interpretation, that fact alone is sufficient to conclude that section 162 activities are included in, while section 212 activities are excluded from, amortization under the original version of section 195, and also that this was done deliberately.

But in case there is any controversy left about the original intent behind the statute, I will now conclude with an excerpt from Senate Report 96-1036 (available here) explaining section 195:

    Trade or business requirement
    Expenditures must relate to the investigation or creation of an active trade or business (within the meaning of Code sec. 162). Thus, expenditures attributable to an investment are not eligible for amortization under this provision. For this purpose, an activity with respect to which expenses are deductible only as itemized deductions for individuals (Code sec. 212) is not considered to be a trade or business.
This committee report is clear enough that I could have relied mostly on it to illustrate the original intent and effect of section 195. But by emphasizing statutory construction instead, I have shown not only in an alternative fashion what that intent was, but also that the intent is decisively and unambiguously reflected in the law itself. Thus, in order to defeat this intent, it would require something more than a mere added nuance or judicial intervention.

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