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IRS: The Mess of the “Trade or Business” Definition

January 15th, 2018 Leave a comment Go to comments

My last post proposed that libel lawsuit income be incorporated or put on Schedule C, but I was wrong in making it seem simple. The law is a real mess here. The problem is the definition of “trade or business”. The tax code, in section 162, says that expenses for a “trade or business” are deductible as what is known as an “above the line” deduction, meaning that it is part of the computation of adjusted gross income, in Schedule C, before “itemized deductions”. In section 212, the tax says that expenses for “other income” are deductible— but this is known a “below the line” deduction, part of “itemized deductions” in Schedule A. Section 67 says that these other income expenses are part of “miscellaneous itemized deductions”, formerly subject to a 2% of income floor, now after the 2017 bill denied entirely (see the bill’s section 11045 amending section 67— though this contradicts section 212, which is unamended, I think).

Thus, it was good for the taxpayer before if his income was from “trade or business”, because he wasn’t subject to the 2% floor for expenses and now it is crucial, since his expenses aren’t deductible at all.

So what is a “trade or business”? Neither statute nor regulation has ever defined this term, crucial though it is to a lot of things. It has a tax common law meaning from various court cases, and a sorry sort of common law it is. The classic case is the 1987 Groetzinger. In Groetzinger, the IRS didn’t want to let a professional gambler deduct expenses. Gambling was clearly his occupation, so the Supreme Court said the IRS was wrong, a correct result. The Court said:

We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify….

We would defer, instead, to the Code’s normal focus on what we regard as a common-sense concept of what is a trade or business

We therefore adhere to the general position of the Higgins Court, taken 46 years ago, that resolution of this issue “requires an examination of the facts in each case.” 312 U.S., at 217 …. But the difficulty rests in the Code’s wide utilization in various contexts of the term “trade or business,” in the absence of an all-purpose definition by statute or regulation, and in our concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code. We leave repair or revision, if any be needed, which we doubt, to the Congress where we feel, at this late date, the ultimate responsibility rests.

So this is  a lame precedent. The Court says it is trying not to create a new test and that the meaning should depend heavily on the context and there shouldn’t be any general test. Moreover, the holding is that professional gambling is a “trade or business” even though gambling for recreation would not be. The holding is not that other money-producing activities would not be a “trade or business”; that’s just extension of the court’s reasoning to completely different contexts such a lawsuit.

Nonetheless, courts talk about the Groetzinger Test as it were a rigid mandatory test, because they want something convenient to use.

The cited case Higgins, as it happens, is an old wrongly decided case. Mr. Higgins had lots of stock investments, a major business, and wanted to deduct such things as the salary of his investment manager. The court said that running a portfolio isn’t a “trade or business” so he couldn’t deduct the expenses. It continues as precedent anyway, never overruled I think.

I thought we might argue that Congress never validated this rule, but unfortunately Congress did pass a couple of statutes around 2000 making expenses deductible for certain kinds of lawsuits. Using expressio unius reasoning, this implies that you can’t deduct expenses for other kinds of lawsuits, though Congress never thought about it, I expect.

So what we have with the 2017 bill is a trial lawyer’s nightmare: a bill that discourages lawsuits by imposing a prohibitive tax rate on plaintiffs by disallowing deduction of expenses.

The question remains of whether the IRS can fix the problem by issuing new regulations. I am inclined to think it can, but since it hasn’t done it before, maybe it has some reason to want not to. I’ll have to figure this out.

Another angle is that if it is Schedule C income, then there is self-employment (Social security) tax to be paid, but if it is Other Income, there is, I think, no self-employment income.

There must be a huge amount of one-off income-generating opportunities, many much more limited in time, scope, and energy than a lawsuit. Are they all Other Income? Maybe if I buy something and resell it, I can put that as Capital Gains instead and deduct the costs somehow there on Schedule D. I think brokerage fees are there, for example.

The situation with a lawsuit is perverse. Suppose I did put the proceeds from my libel suit into an LLC and sold 50% of the shares to Joe, and had the LLC pay the legal fees as they came along.  Could Joe deduct half the legal fees, even though I can deduct none? Or is this not a trade or business for Joe, either? Actually, does this mean all passive investors in companies with pass-through taxation are unable to deduct expenses? That sounds crazy.

To be continued.

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