Website Was a Trade or Business When Opened to the Public, Despite Earning No Income

(Parker Tax Publishing June 2022)

The Tax Court held that an information technology entrepreneur who started a business information website could deduct his payments to engineers and a marketing professional, and a portion of his expenses for internet and cell phone services, as of the time the website became available to the public, even though the website did not begin to earn revenue until several years later. The court found that the taxpayer prioritized web traffic over revenue and that his business began providing the services for which it was organized, with an eye to long-term profit, once he opened the website; under the circumstances, the court found that such activity constituted an active trade or business under Code Sec. 162(a). Kellett v. Comm'r, T.C. Memo. 2022-62.

Background

Gregg Kellett is an entrepreneur with experience in information technology. After graduating from Marshall University in 2002 with a bachelor's degree in business management, Kellett launched a retail website, which he operated until 2007. He later joined the online marketing division of MarketResearch.com, a company that sells online reports and industry studies from more than 350 publishers. In 2011, he moved to Bloomberg Industry Group, a major publisher of legal and business information, where he managed paid advertising, web analytics and reporting, and search engine optimization for various Bloomberg brands.

While working approximately 40 hours per week at Bloomberg, Kellett began to work part time from home on his next venture: building an online repository of demographic, social, and economic data. He settled on the project after studying existing websites that aggregate this kind of information, which he found less user-friendly than investment information platforms like Google Finance and Yahoo Finance. He also discovered that he could download the data from free public domain sources like the International Monetary Fund, the World Bank, the United Nations Statistics Division, the World Health Organization, and the U.S. Department of Labor.

Kellett set out to create a single user-friendly interface that would provide data from these dispersed sources to investment bankers, economists, journalists, investment management firms, and market research firms. In 2013, he purchased the vizala.com domain name and formed Vizala, LLC, of which he was the sole member. Kellett himself created the simple webpages such as the "About Us" page and instructions on how to use the website. He hired remote computer engineers to develop Vizala's interactive features that allowed users, for example, to create charts comparing countries' health expenditures per capita. Users could save their charts, export them to Microsoft Excel, and upload them to social media and their own websites. Kellett described to the engineers how he wanted these features to work, and the engineers developed them using open-source software (i.e., free downloadable generic code for databases and advanced websites).

Kellett and the engineers completed Vizala's core functionality in March 2015, and worked to resolve software "bugs" before opening both the desktop and mobile versions of Vizala to the public in or around September 2015. As an example of a bug, Kellett asked an engineer to fix an interactive table that displayed incorrectly in the Firefox web browser.

Kellett envisioned at least four ways to make money from Vizala: (1) selling advertising space to third parties, (2) implementing a "paywall" and charging a monthly fee for access to certain features of the website, (3) selling personalized charts and reports of information from the website, and (4) licensing data from the website to other companies. He did not pursue any of these strategies in 2015, and Vizala did not begin to earn revenue until 2019. Kellett spent 2015 perfecting and promoting Vizala, convinced he could maximize long-term profit by cultivating confidence and dependence among users and advertisers before monetizing the business. After the website opened, Kellett and a hired marketing professional promoted the website to over a hundred universities and professional organizations, and about half these institutions added Vizala to their lists of research databases.

On his Form 1040 for 2015, Kellett deducted $25,922 of "Other Expenses" on Schedule C, Profit or Loss From Business. These expenses consisted of payments to the engineers and to a marketing professional as well as payments to Verizon for cell phone service and internet service at Kellett's home. The IRS disallowed the entire deduction in a notice of deficiency on the grounds that Vizala was not an active business at any time during 2015. Kellett took his case to the Tax Court.

Code Sec. 162(a) permits a deduction for ordinary and necessary expenses paid or incurred during the tax year "in carrying on any trade or business." Neither the Code nor regulations define when an active trade or business begins. In Richmond Television Corp. v. U.S., 354 F.2d 410 (4th Cir. 1965), the Fourth Circuit held that a taxpayer does not begin carrying on a trade or business "until such time as the business has begun to function as a going concern and performed those activities for which it was organized." In Richmond Television, the Fourth Circuit did not allow a TV station to deduct staff training costs in 1953-55 because the business did not begin until the station went on the air in 1956.

Kellett argued that he could deduct all $25,922 reported on his Schedule C as Code Sec. 162 trade or business expenses. Alternatively, he contended that if the engineer expenses were not deductible under Code Sec. 162, they were deductible as Code Sec. 174 research or experimental expenditures or as costs of developing computer software under Rev. Proc. 2000-50. Rev. Proc. 2000-50 states that certain costs for developing computer software are so similar to research and experimental expenditures that fall within the purview of Code Sec. 174 as to warrant similar accounting treatment. Accordingly, the IRS said it would not disturb a taxpayer's treatment of costs paid or incurred in developing software if the costs are deducted in accordance with rules similar to those applicable under Code Sec. 174(a).

Analysis

The Tax Court held that Kellett's active trade or business began when he opened his website to the public in September 2015. The court found that Kellett introduced no evidence of the opening date, so it determined that he opened the website at the end of the day on September 30, 2015. Therefore, he was entitled to deduct the business-related expenditures he paid thereafter under Code Sec. 162(a) as trade or business expenses. The Tax Court found that Vizala did not fit the traditional stereotype of a business where, if initial operations succeed, the company starts earning revenue as soon as the active trade or business begins. In the court's view, even though Kellett made no attempt to earn revenue in 2015, his business began providing the services for which it was organized, with an eye to long-term profit, once he opened the website. The court said that such activity, at least under these circumstances, constituted an active trade or business.

Next, the court held that Kellett was not entitled to deduct his costs of developing Vizala from the time he began work on the project in 2013 to the end of 2014 as start-up expenses under Code Sec. 195(b)(1)(A) because he presented no evidence of those costs. However, the court found that Kellett could deduct the engineer, marketing, and Verizon expenses he paid in 2015 before September 30 ratably over the 180-month period beginning with September 2015 under Code Sec. 195(b)(1)(B).

The Tax Court rejected Kellett's alternative arguments that his engineer expenses were deductible as (1) Code Sec. 174 research or experimental expenditures, or (2) expenditures as determined on the basis of Rev. Proc. 2000-50. The court explained that to qualify under Code Sec. 174, the expenditures must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, and Kellett did not encounter this kind of uncertainty in creating Vizala because Kellett and his engineers adapted widely used software to solve a complex but familiar problem. Regarding Rev. Proc. 2000-50, the court found that, to the extent the procedure purports to establish a taxpayer's entitlement to a deduction, Kellett failed to demonstrate that the Code authorized any such deduction. In the court's view, Kellett was arguing that the IRS should be equitably estopped from denying a deduction it guaranteed in published guidance, but as a court of law the Tax Court had no authority to grant equitable relief.

For a discussion of determining if an activity is a trade or business, see Parker Tax ¶90,105. For a discussion of the tax treatment of start-up expenses, see Parker Tax ¶95,710. For a discussion of research and experimental expenditures, see Parker Tax ¶95,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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