Tax treatment of expenses incurred by individuals temporarily out of work.

• Author: Kelley, Claudia L.

Since the recession began in December 2007 the U.S. unemployment rate has steadily risen and is currently hovering around 9.5%, with 14.6 million people unemployed in June 2010. (1) The severity of this recession has forced all sizes and types of businesses to either close or downsize. Many employees and self-employed individuals are looking for work. Some taxpayers have temporarily closed their businesses with the intention of reentering their former line of work when conditions improve. Individuals out of work can incur expenditures that, if they were in business, would be deductible. Some of these expenditures, however, may continue to be deductible. This article examines the tax treatment of expenses incurred by individuals who are temporarily out of work.

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Business Expenses

If a taxpayer was previously engaged in a trade or business but is not engaged in the business during the current tax year, expenses incurred related to the business may be deductible. Sec. 162(a) provides for the deductibility of all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. The expenditures must be directly connected to the taxpayer's trade or business, and business expenses are deductible in full, even if they exceed business income. (2) A taxpayer may be entitled to claim business deductions for carrying on a trade or business even though unemployed at the time he or she incurs the expenditures.

Is the Unemployment Temporary?

An important factor in determining whether the taxpayer is still carrying on a trade or business during the period of unemployment is whether the period is a temporary break from carrying on the trade or business. (3) For example, the Tax Court allowed a jewelry salesman to deduct expenses incurred for entertaining buyers during a tax year even though the taxpayer had no inventory to sell and generated no revenue. (4) According to the court, the taxpayer was in a period of transition in which he was actively seeking another connection that would enable him to continue to serve the same customers with whom he had previously dealt. In Schnelten, (5) a self-employed salesman for the trucking industry was allowed to claim certain business expenses despite the fact that he was unemployed. The court noted the following two factors that were important to the decision: (1) the taxpayer continued to seek clients via his duties with a trade association; and (2) the taxpayer conducted trucking business in subsequent years.

Court cases such as these have led to the "hiatus principle" by which the temporary cessation of a trade or business does not preclude a determination that the taxpayer was carrying on a trade or business during that period. However, when the cessation is prolonged, with no continuing connection with the business or intent to actively carry on the business, the taxpayer is not carrying on his or her business. (6)

In order to take advantage of the hiatus principle, taxpayers must at least show that during the hiatus they intended to resume the same business. (7) In Davis, a self-employed insurance agent retired on disability due to health problems but continued to claim business expenses. (8) Davis testified that initially upon his retirement he had intended to resume his insurance business as soon as he could, but health problems had prevented him from doing so. The court concluded that Davis's intent to return at some indefinite future time had become, in view of the state of his health and the passage of time, more of a wish and that his hiatus was no longer temporary.

Expenses Related to Existing Occupation

Regs. Sec. 1.162-6 provides that a taxpayer engaged in a profession may deduct the cost of supplies used in the practice of the profession as well as other professionally related expenses. The U.S. Supreme Court stated that in order to qualify for the business deduction, the expenses must relate to the existing, as opposed to the future, occupation of the taxpayer. (9) In Rev. Rul. 77-32, expenses an anesthesiologist incurred to maintain his professional competence were not deductible because he incurred the expenses in preparation for a possible return to medical practice at some indefinite future date and they were not related to an existing business. The fact that an individual maintains his or her professional license during a period of employment transition is not a sufficient basis for finding that the individual is carrying on a trade or business. In Canter, (10) a nurse who maintained her nursing license while going back to school full time was denied business deductions.

In Gallo, (11) the taxpayer had to suspend his work as a boat repairer due to unrelated injuries. Expecting that he would be able to return to the boat repair business, he stored his tools in a commercial facility and deducted the storage costs. Meanwhile, Gallo obtained his paralegal certificate, worked as an employee of a temporary agency, and subsequently set up an office in his home and began offering paralegal services as an independent contractor. During the years in question, Gallo was not able to earn any income from either his boat repair business or his paralegal business due to additional physical ailments. Because Gallo provided no evidence of either continuing or returning to the boat repair business and sought other means of earning a living by obtaining a paralegal certificate, the court found that he was not in the boat repair business and disallowed the storage costs. However, the court determined that Gallo was on hiatus from earning his living as a paralegal and therefore allowed him to deduct the appropriate related paralegal business...