We all like to dream. But can a dream be deductible?
In effect, this was the question presented to the tax court by Donald Barker, a multi-degreed scientist who worked on the NASA space shuttle program for many years. In 2003, Barker started a company to obtain funding to develop various technologies to explore the planet Mars. Among other things, Barker developed an audio system for space suits to be used on Mars. He attempted to patent his audio system, but the patent was refused because a similar system already had been patented. He also published a design study entitled "Solar System Longboats: A Holistic and Robust Mars Exploration Architecture Design Study."
Barker attempted to get NASA to help fund his venture, but was unsuccessful, and his company never made any money. Barker deducted from his NASA wage income several thousands of dollars in expenses arising from the Mars venture, including travel, meals and entertainment, and other expenses. The IRS disallowed all of these expenses because it concluded that Barker's Mars venture was not an active business. The tax court agreed.
To deduct business expenses you must have an active business. If a venture earns a profit in three out of five years, the IRS will presume it's a business. A venture that does not earn a profit can still qualify as a business, but to do so the owner must be able to convince the IRS that he or she engages in the activity primarily to make a profit some time in the future.
Interestingly, a taxpayer need not have a "reasonable expectation" of earning a profit from the activity. All that is required is that he or she have a good faith intention of making a profit. In other words, what's required is good faith, not realism.
So if Barker ran his Mars company with the good faith intent of earning a profit, it qualified as a business. Unfortunately, neither the IRS nor tax court can read a taxpayer's mind to see if he or she is acting in good faith. Instead, they look at a number of "objective" factors to determine if the taxpayer behaved like a person who wanted to earn a profit. These factors include:
- whether the activity was operated like a business
- the taxpayer's expertize
- the amount of time spent at the activity
- any expectation that the business's assets may increase in value
- the taxpayer's success in other activities
- the history of income or loss from the activity
- the amount of occasional profit earned
- the financial status of the taxpayer, and
- whether the activity contained elements of personal pleasure or recreation.
Barker flunked most of these factors. He had no business records, made few attempts to apply for grants or market his ideas, didn't appear to spend much time on the venture (he had a full-time job at NASA), and had never ran a business before. The tax court didn't doubt that Barker was a passionate exponent of Mars exploration, but concluded that "passion is not synonymous with a profit motive." (Barker v. Comm'r, T.C. Memo. 2012-77.)
The moral: If you want an expensive dream to be a business for tax purposes, you must treat the dream like a business.