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Tax Court: Net Operating Loss Deduction Denied

The Tax Court Renders a Split Decision on an Entertainment Company’s Business Deductions and Net Operating Losses
Barker v. Commissioner, T.C. Memo 2018-67.

In a “good news, bad news” decision, the Tax Court found a company qualified as a valid trade or business when entered into with a profit motive but denied the taxpayer’s pass-through net operating loss deduction, because its underlying expenses were unsubstantiated. Furthermore, the Tax Court upheld the penalty imposed by the IRS for failure-to-timely file returns, despite the taxpayer’s claim of reasonable cause stemming from identity theft.

Facts:

In 2002, Cecile Barker formed an LLC called SoBe. Mr. Barker contributed 100% of the capital and owned 95% of its profit and loss with the remaining 5% split between his son and daughter. SoBe was in the business of producing music and/or videos and promoting and distributing the work of its artists. Previous to this business venture, Mr. Barker was involved in the music business and had considerable success as a producer. Mr. Barker served as the company’s managing member from its formation, devoting 40-60 hours per week to the business.

SoBe signed several artists to contracts including the taxpayer’s son and contracted with producers and writers to work with its signed artists. The company incurred the costs of producing, promoting and distributing music and videos of its musicians. Unfortunately, SoBe was formed during a time of major upheaval in the music industry brought on by the advent of online platforms on which people could buy or sell music at low cost or share it for free. The company never earned a profit, and its cumulative losses increased from year-to-year.

In 2011, Mr. Barker reported a $19.6 million net operating loss (NOL) carryover on his late-filed return. The IRS challenged the 2011 NOL, arguing that the entertainment company was a hobby created to further the musical aspirations of the taxpayer’s son. The IRS further asserted that the expenses giving rise to the operating losses weren’t substantiated. Finally, the IRS imposed a late-filing penalty on the 2011 return that was filed two years after its due date.

Findings:

 1. Trade or Business

The Tax Court found that Mr. Barker did have a profit-motive with respect to SoBe and referenced the following facts and circumstances: (1) Mr. Barker had prior successes in the music industry and experience in running a business; (2) he ran SoBe in a business-like manner and devoted significant capital to make it profitable; and (3) while Barker’s son was one of SoBe’s signed artists, SoBe had other artists and did not devote most of its resources to Barker’s son.

Internal Revenue Code Section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred in connection with carrying on a trade or business. While “trade or business” is not defined in the Code, the Supreme Court in Commissioner v. Groetzinger, 480 U.S. 23, 27 (1987) explains “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”

2. Business Expenses and NOL Deduction

The Tax Court agreed with the IRS that SoBe’s business expenses underlying the net operating losses were not substantiated. The documentation provided to the court consisted of bank statements for some years and canceled checks for other years, which was insufficient to establish the business purpose of the expenditures. Furthermore, the court held, even if the business expenses had been substantiated, the court would have been unable to ascertain how much of the NOLs had been absorbed in years prior to 2011, because Mr. Barker didn’t provide his returns for all relevant years.

3. Late Filing Penalty

The Tax Court upheld the penalty for failure-to-timely file returns. Although Mr. Barker claimed that he had been a victim of identity theft and explained that he believed filing was not necessary until the IRS resolved any conflicts surrounding that issue, the Tax Court still found him liable for the penalty. The court said filing was the taxpayer’s non-delegable duty and that he was a sophisticated businessman who should have been aware of his filing obligations despite his circumstances.

The lessons to be learned from the Barker case are numerous. First, if you run a business in an industry in which you’ve had success in the past, the courts are more likely to give you the benefit of the doubt on the issue of whether you intended to earn a profit. Second, if you want to claim a NOL be sure to keep all of your records that relate to the tax years of the losses. Third, if you file your tax return late be prepared to pay a penalty even if you relied upon your accountant to file it or you found yourself the victim of identity theft.

Please contact your local Withum advisor if you have any questions about the net operating loss deduction or the lessons of the Barker Case.

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