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Engineer's Losses from Music Activities Partially Allowed as Business Expenses

(Parker Tax Publishing May 2018)

The Tax Court held that a professional engineer, who recorded two full length albums of music and released them for sale, properly deducted most of the expenses related to the music activities as ordinary and necessary business expenses even though he had no income from his music activities for the years at issue. The court found that the taxpayer, who filed three Schedules C, Profit or Loss From Business, in one year and six the following year, had adequately substantiated most of the expenses he reported on his Schedules C even though some of his records were not maintained in an orderly fashion, were illegible, and required the court to cross reference multiple schedules and bank records. Nicholson v. Comm'r, T.C. Summary 2018-24.

Aaron Keith Nicholson is an engineer who found his work stressful. To reduce stress, he decided to develop his talents as a musician, and during 2013-2014, he produced two full length albums. Nicholson completed all the recordings in 2013, worked with a music producer, and released his music for sale on the internet as well as on CDs in 2014.

Nicholson has three daughters and one son, all of whom participated in various ways in his musical activities. Nicholson claimed that he was most creative and productive as a musician when he was happy and that he enhanced his artistic creativity and productivity by dining out with his children and engaging in recreational pursuits such as bowling, hiking and camping, and traveling.

Nicholson filed a Form 1040 for 2013 and attached three Schedules C, Profit or Loss From Business, identifying the underlying activities as Music Production/Record Company, Photographer, and Musician. Nicholson reported no gross receipts from these activities, but reported expenses of over $48,000. The expenses included contract labor expenses (comprising almost $26,000 paid to a recording studio with the balance apparently paid to his children); vehicle expenses of approximately $4,000, advertising expenses of $3,200; books, camera, and other equipment expenses of $2,900; audio and music equipment of over $3,000; repairs and maintenance expenses of over $1,000; and other miscellaneous expenses, including meals and entertainment, utilities, supplies, bank fees, and rental items.

Nicholson attached six Schedules C to his Form 1040 for 2014, identifying his business activities as Music Production/Record Company, Photographer, Musician, Business Administrative Support, Graphic Arts, and Writer. He reported no gross receipts for 2014 and expenses of over $21,000. The 2014 expenses included contract labor payments of $4,600 to a recording studio and $3,300, apparently paid to his daughter; vehicle expenses of almost $800; advertising expenses of almost $300, books, equipment, software, and business property expenses of over $6,000; repairs and maintenance expenses of $330, meals and entertainment expenses of $1,800, travel expenses of $3,600, and other miscellaneous expenses.

Nicholson kept comprehensive records, including a mileage log, receipts, and bank statements to substantiate the expenses he attributed to his music activities. His records included numerous receipts for meals that he shared with his children and their spouses or dates, hiking, camping and ski equipment, a rowing machine, books and magazine subscriptions, and travel expenses related to trips to various destinations in California and Nevada and to Japan, where his daughter and grandson lived. Nicholson said his hiking, camping and travel-related expenditures were properly attributable to his music activities because he took photos at the more picturesque locations for use as album art and for display on social media sites, and because traveling always inspired him to be more creative. He acknowledged that several receipts that he included in his business records, including those for a baby carrier, children's books, a stud finder, and a chain saw rental, were probably not related to his music activities.

Code Sec. 162(a) permits a deduction for ordinary and necessary business expenses paid during the year in carrying on any trade or business. No deduction is allowed for personal, living or family expenses. If a taxpayer establishes that a deductible expense was paid but fails to establish the amount of the deduction, the court may estimate the amount allowable as a deduction. Under Code Sec. 274(d), more stringent substantiation requirements apply for travel, meals and entertainment expenditures, as well as for expenses related to the use of certain listed property including passenger automobiles. For these expenses, the taxpayer's records must establish the amount, date and time, and business purpose for each expenditure for travel away from home or each expenditure or business use of listed property.

The IRS determined that Nicholson was not entitled to the loss deductions he claimed for the years at issue because he failed to substantiate the expenses reported on his Schedules C. In the alternative, the IRS determined that the expenses did not constitute ordinary and necessary business expenses, although the IRS did not dispute that Nicholson's music activities constituted a trade or business. The IRS also assessed accuracy-related penalties for both of the years at issue.

The Tax Court held that Nicholson adequately substantiated most of the expenses that he reported on his Schedules C. The court found that Nicholson's records were comprehensive, even though they were not maintained in an orderly fashion, some were illegible, and the court had to cross reference multiple schedules and bank records.

The court determined that Nicholson's ordinary and necessary business expenses were limited to his expenses for contract labor, web hosting, vehicle expenses, equipment and repairs, CD purchases, and certain other miscellaneous expenses. The court held that Nicholson had over $25,000 of deductible contract labor expenses in 2013 and approximately $4,600 in 2014. It also found that Nicholson had deductible vehicle expenses of over $1,300 and equipment and repair expenses of over $2,700 for the years at issue. Nondeductible personal expenses included Nicholson's payments to his children, expenses for travel, meals and entertainment, expenses for hiking and camping trips and related equipment, most vehicle expenses, and other nondeductible miscellaneous expenses.

With respect to penalties, the court found that the IRS had met its burden of production because Nicholson had claimed deductions for numerous nondeductible personal expenses. The court found that Nicholson did not offer a meaningful defense other than to assert that he relied on TurboTax to prepare his returns. The court found there was no objective evidence that Nicholson reasonably attempted to ascertain the correctness of the disallowed deductions or to comply with the Code, and therefore sustained the penalty determinations.

For a discussion of the deductibility of ordinary and necessary business expenses, see Parker Tax ¶90,110. For a discussion of travel expenses, see Parker Tax ¶91,105.

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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