Taxpayer's Business Had Not Yet Commenced, All Expenses Capitalized

The good news for the taxpayer in the case of Provitola v. Commissioner, US Tax Court Bench Opinion, Nos. 12357-16 and 16168-17 (2019)[1] was that the Court rejected the IRS arguments that their business related to a product to enhance television viewing was a sham.  But that was more than offset by the bad news when the Court also found that the business had not yet commenced in the years in question, meaning all expenses were capitalized pursuant to IRC §195 until the year the business actually begins operations.

Mr. Provitola is an attorney who also holds a B.S. in physics.  His law practice specializes in patent law and he is sole owner of the S corporation in which he practices.  Around 2003 he had an idea to enhance television viewing and began developing a product. Between 2005 and 2016 he was awarded seven patents that related to this product he was developing. [2]

The couple formed Viovision Ventures, LLC with Kathleen Provitola as the sole owner of the LLC in 2007.  The LLC was formed to market any product that Mr. Provilota might end up developing based on his concept.  The LLC sat dormant until 2013 when it was billed for five years of services by Mr. Provitola’s law firm, such services including management, product development and product design.  In late 2013, the couple wrote a check for $36,000 to capitalize the LLC and the LLC wrote a check to the law firm to pay that portion of the $60,000 in fees that had been billed.  A similar set of transactions took place at the end of 2014. [3]

The payments were reported as income by the law firm, which had sufficient business expenses to offset almost all of the expenses.  As well, they claimed current deductions on Schedule C for the payments made by the LLC.  During this time period, and right up through the day the case was heard, the LLC had not received any revenue related to the product it hoped to develop. [4]

As the Court described the activities of the LLC to date:

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.[5]

The IRS initially argued that the payments were not actually made in the notice of deficiency, but at trial no longer pushed that position.  As well, the notice of deficiency claimed the payments were not ordinary and necessary expenses under IRC §162.[6]

But at trial the IRS advanced two different arguments:

  • The LLC was a sham and not a real business, only using the expenses to offset the couple’s other income and

  • If it is not a sham, then the business has not yet commenced operations and, as such, all expenses would have to be capitalized as start-up expenses under IRC §195.

While the opinion rejects the IRS’s first position, it does find merit in the second.

The Court found that there was more than enough evidence that the LLC was not merely a legal fiction:

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. [7]

As well, if the LLC was a fiction, then so was the income that the law firm had reported on the S return—but the Court noted the IRS did not argue that this should be reversed:

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. [8]

However, the Court did find far more compelling the second argument the IRS made—that the expenses incurred by the LLC were start-up expenses that had to be capitalized under IRC §195.

IRC §195(a) requires a taxpayer to capitalize start-up expenditures.  Such expenditures are defined by IRC §195(c)(1) as:

(1) Start-up expenditures

The term “start-up expenditure” means any amount—

(A) paid or incurred in connection with—

(i) investigating the creation or acquisition of an active trade or business, or

(ii) creating an active trade or business, or

(iii) any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and

(B) which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred.

The term “start-up expenditure” does not include any amount with respect to which a deduction is allowable under section 163(a), 164, or 174.

IRC §195(b) provides options to recover these costs, but commencing in “the taxable year in which the active trade or business begins” through amortization and/or expensing depending on the amounts incurred.  Prior to that year, the amounts are capitalized and held for possible future deduction.

The Court looked at whether the LLC was in the start-up phase of the business or if it had actually begun as an active trade or business.  The Court found a case it felt was relevant in the case of McKelvey v. Commissioner, TC Memo 2002-63:

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.[9]

Like the tree farm in McKelvey, the opinion finds that the LLC’s business had also not yet commenced:

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.[10]

Interestingly, this leads to a less favorable result for the years before the Court for the taxpayers than if the Court had found the entire transaction to be a sham and ignored the entire set of transactions (both the expense on the Schedule C and the income on the S corporation return), as the opinion notes:

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.[11]

The taxpayers have to recognize the income currently for payments to the law firm on their return, but only get the possibility of a deduction at some point in the future for the expenses.

But what about the fact that the IRS had not argued this position in the notice of deficiency and only raised the issue at trial.  The Court found that this was not a major problem in this case:

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.[12]


[1] Provitola v. Commissioner, US Tax Court Bench Opinion, Nos. 12357-16 and 16168-17, January 24, 2020 (released January 27, 2020), https://www.ustaxcourt.gov/InternetOrders/DocumentViewer.aspx?IndexSearchableOrdersID=313587&Todays=Y (retrieved January 28, 2020)

[2] Provitola v. Commissioner, pp. 3-4

[3] Provitola v. Commissioner, pp. 4-5

[4] Provitola v. Commissioner, pp. 5-6

[5] Provitola v. Commissioner, pp. 6-7

[6] Provitola v. Commissioner, pp. 8-9

[7] Provitola v. Commissioner, pp. 11-12

[8] Provitola v. Commissioner, p. 12

[9] Provitola v. Commissioner, pp.14-15

[10] Provitola v. Commissioner, p. 15

[11] Provitola v. Commissioner, p. 15

[12] Provitola v. Commissioner, p. 15