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Deduction for Costs Incurred in Searching for New Business Opportunities Disallowed

(Parker Tax Publishing September 2021)

The Tax Court held that after a taxpayer's homebuilding businesses were put into receivership, (1) the taxpayer was not carrying on a trade or business in 2010 and 2011 when he conducted a search for a new trade or business through wholly owned entities, and (2) the taxpayer and his wife were not entitled to a net operating loss (NOL) deduction in 2012 attributable to an alleged NOL carryover from tax years 2010 and 2011 from the wholly owned businesses. However, because the couple reasonably relied on CPAs to prepare their tax returns, the court rejected the IRS's assessment of a Code Sec. 6662(a) accuracy-related penalty on the couple. Est. of Morgan v. Comm'r, T.C. Memo. 2021-104.


Charles Morgan was a residential real estate developer. In 1983, he began his own home building company, which came to comprise a variety of entities, including: C.P. Morgan Communities, L.P. (CPMC); C.P. Morgan Communities of Charlotte, LLC; C.P. Morgan Communities of the Triad, LLC; the C.P. Morgan Co., Inc.; and C.P. Morgan Investment Co., Inc. (collectively, Morgan entities). From 1983 to 2009, Morgan owned these entities directly or indirectly and was involved in their operations and management. Morgan also flew aircraft owned by Falcon, an entity he formed in 1996 to hold, operate, and maintain aircraft. CPMC had an aviation department that employed the pilots, mechanics, and recordkeepers that flew, serviced, and kept track of the books and records for the aircraft held by Falcon. Morgan used Falcon's aircraft to further the Morgan entities' real estate development business.

In the years leading up to 2009, the real estate and financial markets began to decline. So did the Morgan entities' homebuilding business. In March 2009, an Indiana court entered an order appointing LS Associates, LLC (LS Associates or receiver), as receiver for the Morgan entities. During the pendency of the receivership proceedings - which included tax years 2010 through 2012 - LS Associates was in sole control of the Morgan entities. Morgan was prohibited from infringing on LS Associates' authority or incurring expenses on behalf of the Morgan entities, and he never sought permission to incur any expenses.

Subsequently, Morgan conducted a search for a new trade or business through Legacy, a single-member limited liability company (LLC) he had formed in December 2008 and which was taxed as a disregarded entity for 2010 through 2012. During the receivership proceedings, Morgan continued to use Falcon's aircraft in his search (through Legacy) for new business opportunities. Legacy hired some former CPMC employees, including Kristen Coyer, as director of finance. For 2011 and 2012, Morgan recorded 100 percent of his time spent working for Legacy as "business search/forward looking." In addition to hiring former CPMC employees, Legacy hired various outside consultants to assist in its search for new business opportunities. Despite these efforts Morgan did not make an offer to purchase - nor did he acquire or otherwise form - a new business as a result of Legacy's search.

Apart from Legacy, Morgan indirectly maintained contact with the homebuilding industry. In 2009, Todd Pyatt, the former vice president of CPMC and a close friend and business partner of Morgan, became aware that a number of partially developed properties owned by the Morgan entities were available for purchase from the receiver. He approached Morgan about partnering to purchase and develop the properties but Morgan instead lent Pyatt Builders $180,000 so it could purchase the property from the receiver. Morgan did not hold an ownership interest in Pyatt Builders and was not involved in the daily activities of the business. The loan was repaid, timely and with interest, in July 2010.

For 2010 and 2011, Falcon was taxed as a partnership and its partners included Morgan and an S corporation. For 2012, Morgan was Falcon's sole owner, resulting in the partnership's termination and Falcon's taxation as a disregarded entity. Falcon's principal business activity was listed as "Consulting" on its 2010 and 2011 Forms 1065, U.S. Return of Partnership Income, and on Morgan's 2012 Schedule C. Morgan and his wife reported Schedule C losses relating to Falcon's operations for years 2010-2012, as well as Schedule E losses relating to business investigation expenses incurred by Legacy. When combined with other items of income and loss reported on the Morgans' 2010 and 2011 Forms 1040, the Falcon and Legacy expenses generated net operating loss (NOL) carryforwards from 2010 and 2011 to 2012.

Tax returns filed by Morgan and his wife were prepared by Roy Rice, a CPA who had been the couple's return preparer for over three decades, with input from Coyer, who was also a licensed CPA. In a notice of deficiency, the IRS disallowed a $819,956 Schedule C deduction for Falcon's expenses, a $648,118 Schedule E deduction for Legacy's loss due to unreimbursed expenses, and a $966,121 NOL deduction. The IRS further determined that the Morgans were liable for an accuracy-related penalty under Code Sec. 6662 for an underpayment due to negligence and/or a substantial understatement of income tax. According to the IRS, Morgan was no longer carrying on a trade or business once the Morgan entities were placed into receivership in 2009, and therefore the disallowed expenses (which were incurred after that time) were not deductible under Code Sec. 162. Instead, the IRS said, the expenses were either personal expenses or expenses incurred in the search for a new trade or business. If they were personal, then their deduction was barred by Code Sec. 262(a). If they were incurred in a search for a new trade or business, then they were start-up expenditures, and their deduction was barred by Code Sec. 195 until the Morgans began a business.

The Morgans countered that they were carrying on a trade or business in 2012 and therefore Falcon's Schedule C aircraft-related expenses and Legacy's Schedule E business-search-related expenses were deductible under Code Sec. 162 for that year. Alternatively, the Morgans argued that, if the Falcon and the Legacy expenses were not deductible pursuant to Code Sec. 162, then they were nonetheless deductible under Code Sec. 165(c)(1) as losses incurred in a trade or business. In support of their position, the Morgans noted Mr. Morgan's continued engagement with the homebuilding industry after the receiver was appointed and Mr. Morgan's search for a new business to acquire. They argued that Mr. Morgan did not have to begin a new trade or business because the last one - homebuilding - never ceased. They pointed to his continued engagement with the Morgan entities and his new activities, such as the loan to Pyatt.

Mr. Morgan died in April 2019, and Mrs. Morgan was appointed the personal representative of his estate.


The Tax Court held that Mr. Morgan was no longer carrying on a trade or business within the meaning of Code Sec. 162 after the Morgan entities were placed in receivership in 2009. The court thus sustained the IRS's disallowance of the Morgans' Schedule C and Schedule E deductions. The court further held that Mr. Morgan's continued activities in the aftermath of the recession and receivership - namely, the use of Legacy to search for a new trade or business and the continued existence of Falcon - did not constitute an active trade or business in 2010, 2011, or 2012. As a result, the Morgans were not entitled to the NOL carryforward deduction because Legacy's 2010 and 2011 expenses were not deductible under Code Sec. 162 and Falcon's distributive losses were limited by a failure on the part of the Morgans to substantiate their outside basis in the Falcon partnership before its termination.

With respect to the loan to Pyatt, the court found that the loan did not demonstrate regular and continuous activity in a homebuilding trade or business but rather a one-time loan to a friend so the friend could pursue a development opportunity and then repay the loan with interest. If anything, the court said, the loan would be part of a lending trade or business, but isolated and irregular loans to trusted individuals did not support that conclusion either.

The court found that Mr. Morgan's actions and words supported its conclusion that he was no longer carrying on a homebuilding trade or business. From his perspective in September 2009, the court said, the receivership proceedings shut the company down and began a period of transition in his life. And his focus shifted to starting or acquiring a new trade or business.

The court rejected the argument that Mr. Morgan's search for a new trade or business to acquire was itself an active trade or business in 2012. The court agreed with the IRS that the Morgans could not squeeze into Code Sec. 162 and avoid Code Sec. 195 by claiming that Mr. Morgan's trade or business was searching for a trade or business. Nor, the court said, could they squeeze into Code Sec. 162 by arguing Falcon was in the consulting business during the year at issue because Falcon's activities by themselves did not constitute an active trade or business independent of the Morgan entities. The court observed that Falcon's Schedule C listed its principal business as "consulting," but the Morgans never established that the term encompassed anything other than transporting them and related individuals.

Finally, the court noted that while Mr. Morgan was a well-educated, sophisticated businessman, that did not foreclose his relying on his long-time tax adviser to prepare his return. The court thus concluded that the couple was not liable for the Code Sec. 6662 accuracy-related penalty.

For a discussion of the criteria for determining if an activity is a trade or business, see Parker Tax ¶90,105. For a discussion of expenses that constitute start-up costs, see Parker Tax ¶95,710.

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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