When the IRS Agrees You’re Right But the Court Says You’re Wrong – Houston Tax Attorneys

Say the IRS agrees that you are entitled to a sizeable tax deduction. But on audit, the IRS determines that you reported the tax deduction using the wrong form. The form used does not change the amount of the tax deduction or the taxpayer that would ultimately pay the tax. From the IRS’s perspective, the form is of no consequence. Should the taxpayer be denied their tax deduction?

This scenario highlights one of the most frustrating aspects of working with the IRS and courts on tax matters. Procedural technicalities override substantive entitlement to legitimate deductions. Even when the IRS acknowledges that a taxpayer deserves a deduction, courts sometimes apply rigid formalistic rules that prevent recovery based on form-selection errors.

The court in Shleifer v. United States, 2025 WL [citation needed], S.D. Fla. June 9, 2025, addressed this exact situation. The case involved a depreciation deduction on a private jet purchased through a separate LLC. The court applied the variance doctrine to deny the taxpayer’s tax deduction.

Facts & Procedural History

This tax dispute involves a $1.9 million tax refund claim. The husband worked as a partner at an investment firm requiring extensive travel. The taxpayer chose to fly private through his wholly-owned LLC rather than accept his firm’s commercial airfare reimbursements.

The LLC purchased a 37.5% interest in a private jet for $19.7 million in 2014. The LLC wasn’t structured to collect management or rental fees. The court noted that the LLC was not operated for profit. During 2014, the taxpayer logged 54.1 flight hours with 31.1 hours attributable to business travel.

The taxpayers initially filed their 2014 joint tax return claiming $2.6 million in travel expense deductions as unreimbursed partnership expenses on Schedule E. They paid the required taxes on time. In October 2018, they filed an Amended Tax Returns seeking a $1.9 million refund based on a $5.9 million depreciation deduction for the private jet that they had inadvertently omitted from their original return.

The amended return reported this depreciation deduction on Schedule C as a business loss. This left the LLC with zero gross income but substantial depreciation expenses. The large refund claim triggered Tax Audits.

The IRS questioned whether the LLC operated as a legitimate business entitled to Schedule C treatment. The examining agent ultimately determined that the depreciation could not be claimed as a business expense because the LLC lacked the profit motive required for trade or business status. However, the IRS agent acknowledged that the depreciation deduction “might have been valid if it had been claimed on a Schedule E” as an unreimbursed partnership expense. The agent noted in his examination record that the depreciation was “an investment expense that can be deducted against Flow-thru income on Sch. E.” Rather than allow the taxpayer to correct this form-selection error, the agent chose to deny the claim entirely despite knowing the taxpayer was substantively entitled to the deduction.

The IRS issued a claim disallowance letter which led to Tax Litigation in federal district court. Both parties filed cross-motions for summary judgment.

About Depreciation Deductions

Depreciation deductions under Section 167 represent a method of recovering the cost of business assets over their useful lives. The rules in Section 167(a)(1) allow depreciation for “the reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)” of property used in a trade or business or held for the production of income.

When a taxpayer purchases business or investment property, they get a tax deduction. The tax deduction is intended to be allowable over time to match the expected income that will be received from the asset. There are nuances in timing, but this is the general idea.

For business assets, Section 167 is subject to the rules in Section 162. Section 162 is the general rule that applies to business assets. Section 162 imposes additional requirements for business deductions.

There are several nuanced rules that try to expand and limit depreciation deductions to reward taxpayers for certain expenses and deny the deduction for others. These rules also allow faster recovery for some expenses but not for others. When a taxpayer places qualifying property in service during the tax year, they may claim both regular depreciation under Section 168 and bonus depreciation under Section 168(k) for qualifying assets. The parties in this case agreed that the depreciation calculation itself was correct regardless of which schedule should have been used.

Business Deductions Under Section 162

The tax code allows taxpayers to deduct ordinary and necessary expenses incurred in carrying on a trade or business. This can be found in Section 162. Section 162 provides the foundation for most business expense deductions.

Section 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This broad language encompasses various business costs. The requirement that expenses be incurred in “carrying on” a trade or business creates an important threshold test.

Businesses that meet this test can file a separate tax return depending on the type of legal entity and structure. They might file a Form 1120, 1120S, 1065, or other business return. If they are wholly owned LLCs as in this case, they can report the tax deductions on a Schedule C on the taxpayer’s own Form 1040 individual tax return. If the business is not a trade or business, it can still report the same items. It usually has to do so on a Schedule E on the taxpayer’s own Form 1040 individual tax return.

To qualify for Schedule C treatment, an activity must constitute a trade or business with the primary purpose of generating income or profit. The taxpayer must demonstrate a genuine profit motive, regular and continuous activity, and substantial business operations. Courts examine factors such as the manner of conducting the activity, the expertise of the taxpayer, the time and effort expended, and the expectation of profit.

What Qualifies as a Trade or Business?

The determination of whether an activity constitutes a trade or business requires examining the taxpayer’s primary purpose and operational characteristics. The courts have noted that the phrase “trade or business” is not defined in the tax code. This has left courts to develop the definition through case law.

Courts have said that sporadic or passive activities generally do not qualify for trade or business status. This is true even when they involve substantial assets. Courts have said that the activity must be regular and continuous. It must be conducted with a genuine profit motive. It must involve more than mere investment activities.

In this case, the court concluded that the LLC was not a trade or business. This was based on several factors. The entity did not generate revenue. It did not employ workers. It did not provide services to third parties. Its sole function was facilitating the taxpayer’s own business travel. The taxpayers conceded that the LLC was not operated to generate profit.

These facts distinguish this LLC from legitimate aircraft leasing or charter businesses. Those businesses actively market services to customers and maintain profit-driven operations. The absence of commercial activity or profit motive made Schedule C treatment inappropriate for the depreciation deduction.

Understanding Unreimbursed Partnership Expenses

A partnership files its own income tax return. The return generally does not compute tax. It aggregates items of income and expense and then allocates those to the individual partners. The partnership’s return does not function as a report to show the calculation of tax. It shows the net profit and loss to the IRS. The individual income tax returns receive these flow-through items and show the calculation of tax.

This brings us back to the Section 162 expenses here. The partnership tax return can report tax deductions under Section 162. When a partner incurs expenses on behalf of the partnership, they may deduct them as unreimbursed partnership expenses. There are a few other requirements for this treatment. The partnership agreement must require the partner to pay certain expenses from personal funds. The expenses must be ordinary and necessary for the partnership’s business activities. Travel expenses often qualify when partners are required to pay their own transportation costs for partnership business.

The IRS agent in this case did not dispute that these expenses were likely unreimbursed partnership expenses. The agent agreed they were deductible. The taxpayer’s investment firm required extensive travel. He chose to pay private aviation costs rather than accept commercial airfare reimbursements. The partnership agreement required partners to bear their own travel expenses. The depreciation related to business travel could qualify as an unreimbursed partnership expense. The taxpayer had claimed similar deductions in subsequent tax years as unreimbursed partnership expenses.

The Refund Claim & Variance Doctrine

The IRS agent and the taxpayer both were in agreement. The tax deduction would be the same regardless of whether reported on Schedule C or as a flow-through item for an unreimbursed partnership expense. Why did the taxpayer lose its tax deduction here?

The IRS argued that the variance doctrine applied. The court agreed. The variance doctrine comes up in federal tax refund litigation. It prevents taxpayers from filing a refund claim reporting one thing and then taking a different position with the IRS during the litigation for the refund.

This rule is set out in Treasury Regulation 301.6402-2(b)(1). The regulation explains that taxpayers are to “set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.” The regulation warns that claims failing to meet this standard “will not be considered for any purpose as a claim for refund or credit.” This procedural rule prevents taxpayers from asserting grounds for refund in court that were not properly presented to the IRS during the administrative process.

The doctrine serves administrative purposes. It allows the IRS to evaluate claims intelligently before litigation. It avoids the costs of defending against theories that were never properly presented. The doctrine’s rigid application can produce results that seem to elevate form over substance. This may exceed the regulation’s intended scope.

How This Court Misapplied the Variance Doctrine

The court’s application of the variance doctrine makes little sense given the facts. The doctrine requires that taxpayers provide the IRS with sufficient information to evaluate their claims during the administrative process. Here, the IRS agent explicitly acknowledged that the depreciation deduction was valid under Schedule E. The agent documented this acknowledgment in his examination records. The IRS possessed all the information needed to evaluate the claim.

The court focused on the taxpayer’s original Form 1040X, which simply stated they “inadvertently neglected to claim a depreciation deduction for a business asset purchased and placed in service in 2014.” The court treated this as limiting the taxpayer to only the Schedule C theory. This ignores that the IRS agent understood exactly what was being claimed and acknowledged its validity under a different legal theory.

The court’s reasoning that Schedule E would require examining “different facts” is questionable. The partnership agreement and reimbursement policies were already relevant to the taxpayer’s business travel. The IRS knew about the taxpayer’s consistent treatment of similar expenses in subsequent years. These weren’t new facts that would surprise the IRS.

The variance doctrine prevents unfair surprise and ensures intelligent administrative review. Both purposes were satisfied here. The IRS agent knew the alternative legal theory was correct. The agency possessed all relevant facts. Yet the court still applied the doctrine to bar consideration of the claim.

This approach allows the IRS to have it both ways. The agency can acknowledge during an audit that a taxpayer’s position is correct. It can document that acknowledgment. Then it can argue in court that the variance doctrine prevents consideration of that same position. This contradicts established precedent that the IRS cannot feign ignorance of information it actually possesses.

The court created a troubling precedent where form selection errors can defeat otherwise valid claims. The complexity of the tax system creates these situations. Taxpayers shouldn’t lose legitimate deductions when the IRS fully understands their claims and acknowledges their validity.

The Takeaway

This decision demonstrates how rigid application of procedural rules can prevent taxpayers from recovering refunds they may legitimately deserve. This decision elevates formalistic compliance over substantive fairness and, if the taxpayer were to appeal, it may not survive appellate review. The case does show how taxpayers often have to press the government to reach the right result. The government had many opportunities to do so here. More troubling is the IRS agent’s conduct in this case. The agent knew the taxpayer was substantively entitled to the deduction but chose to deny it based on a form-selection error rather than exercise reasonable discretion. The court did the same–leaving it to the taxpayer to appeal the decision to try to get to the right result.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Real Estsate Construction Delays Kill Tax Deductions – Houston Tax Attorneys

Real estate investors regularly pursue new ventures that require substantial upfront investments before generating any revenue. A successful investor might purchase land for a luxury resort, spend hundreds of thousands on architectural plans and permits, and begin construction on facilities designed to serve paying customers. These early expenditures represent legitimate business development costs, incurred with the genuine expectation of future profits.

But what happens to these costs when construction defects or other problems prevent these ventures from ever opening their doors? Can expenses incurred in planning and developing be deducted as trade or business losses? The answer depends on whether the taxpayer was actually “engaged in carrying on any trade or business” when the losses occurred.

The recent Root v. Commissioner, T.C. Memo. 2025-51, case addresses when ambitious real estate projects fail before operations begin.

Facts & Procedural History

The taxpayers selling their family business in 2008. Prior to this, during the 1990s, while still running their business, the taxpayers began planning their next venture: a recreational ranch and guest lodge in Oregon.

The planned lodge would combine fishing with equestrian activities and hospitality. Beginning in 1995, the taxpayers purchased four parcels of land totaling over 90 acres, including waterways, pasture, and farmland. They invested in property improvements, including waterway restoration to enhance fishing opportunities.

In September 2000, the taxpayers contracted with an architect to design a lodge, guest wing, council house, and barn. Construction began in 2003. The scope of work included the main house, council house, and garage, with the total project representing a substantial investment in what was intended to become a commercial hospitality operation.

Problems emerged almost immediately after the lodge received its certificate of completion in May 2006. Snow and rain caused flooding, revealing serious defects in windows, roofing, and weatherproofing. By 2007, the taxpayers discovered hundreds of bats living in the walls along with rats and mice, creating foul odors throughout the structure. A forensic architect later determined that the foundation was defective and the main fireplace was structurally unsound.

County officials condemned the lodge as unsuitable for occupancy in 2010 after receiving reports of the structural defects. The lodge was eventually demolished. The taxpayers sued their contractor and architect to recover their losses. They ultimately recovered approximately $3 million through arbitration and litigation but paid approximately $4 million in legal fees.

Throughout this entire period

Throughout this entire period, the lodge never hosted overnight guests. The taxpayers never obtained an innkeeper’s license, hired hospitality employees, or developed booking systems. While they did host occasional events on the property between 2002 and 2009–including television filming, fundraisers, and dog trials–none involved stays at the lodge.

The taxpayers initially filed their 2014 tax return listi…

The taxpayers initially filed their 2014 tax return listing the husband’s principal business as a consulting business reporting more than $300,000 in gross receipts. However, in May 2018, they filed an amended return claiming a $5 million dollar loss related to the lodge project. They carried portions of this claimed net operating loss to their 2017 and 2018 returns, claiming carryovers of $3 million each year. The IRS examined the tax returns and issued a IRS Notice of Deficiency disallowing the net operating loss carryovers in full and imposing accuracy-related penalties for both years.

Trade or Business Requirements Under Section 165

Section 165(c)(1) allows individual taxpayers to deduct losses “incurred in a trade or business.” This requires the taxpayer actually be engaged in a trade or business when the loss occurs. This is different than the rules under subsection (2), which does not have a trade or business requirement.

The distinction between business losses under Section 165(c)(1) and investment losses under Section 165(c)(2) has significant implications for tax treatment and carryover rules. Business losses (under subsection (1)) can generate net operating losses that may be carried back or forward to offset income in other years, while investment losses (under subsection (2)) are generally limited to offsetting capital gains and may be subject to different timing restrictions. Additionally, business losses (under subsection (1)) aren’t subject to the investment interest limitations that can restrict the deductibility of losses from investment activities. Understanding these distinctions becomes particularly important for real estate activities and rental properties that may qualify for special tax benefits like the Section 199A deduction.

Despite these consequences, neither the tax code nor regulations define the phrase “trade or business.” One has to turn to the court cases for the definition. In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court said that determining trade or business status requires examining all facts and circumstances in each case. Courts apply consistent standards across different code sections, including Section 162(a) for business expense deductions and Section 165(c)(1) for business loss deductions.

These court cases start with the concept of trade or busi…

These court cases start with the concept of trade or business as something that extends beyond simple profit-seeking activities. Many taxpayers engage in profit-motivated transactions that don’t rise to trade or business level.

The courts have developed a three-factor test for establi…

The courts have developed a three-factor test for establishing trade or business status. First, the taxpayer must undertake the activity with genuine profit intent rather than personal or investment motives. Second, the taxpayer must be regularly and actively engaged in the activity, demonstrating continuity and regularity rather than sporadic involvement. Third, the taxpayer’s business activities must have actually commenced, meaning the business has begun functioning as a going concern.

This third factor often proves most challenging in cases involving failed or abandoned ventures. For this factor, the courts distinguish between planning and preparation activities–which don’t constitute trade or business operations–and actual business activities that do qualify for trade or business treatment.

When Do Business Activities Actually Begin?

The leading court case for establishing when business operations commence is Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir. 1965).

In Richmond, the Fourth Circuit held that “even though a taxpayer has made a firm decision to enter into business and over a considerable period of time spent money in preparation for entering that business, he still has not ‘engaged in carrying on any 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.”

This standard requires more than research, investigation, or extensive preparation. The business must actually engage in the activities for which it was designed, even if those activities don’t immediately generate revenue or profits. A business can qualify as operational while losing money, provided it’s performing its intended functions and holding itself out to serve customers.

The distinction between pre-opening expenses and business operations becomes particularly important for hospitality ventures like hotels, restaurants, and lodges. These businesses typically require substantial investments in facilities, equipment, and infrastructure before serving their first customer.

Courts analyze whether the business has crossed the threshold from preparation into operations by examining specific operational indicators. Does the business have systems for accepting customers? Has it obtained necessary licenses and permits? Does it have employees or infrastructure capable of delivering services? Has it begun marketing to potential customers or holding itself out as available for business?

The Lodge Project Was Not a Trade or Business

In the present case, the U.S. Tax Court found that the taxpayers’ lodge venture never crossed the line from preparation into actual business operations. Despite substantial investments exceeding $5 million and genuine business intentions, the lodge failed to meet the Richmond Television standard requiring that the business “function as a going concern and perform those activities for which it was organized.”

The lodge never performed its core hospitality function of housing paying guests. The taxpayers themselves acknowledged that the lodge was never in a condition to provide lodging for paying customers. Beyond the construction defects that ultimately led to condemnation, the venture lacked basic operational infrastructure. There was no booking system for accepting reservations, no website for marketing services, no revenue processing capabilities, and no customer service procedures. The taxpayers never obtained the required innkeeper’s license or hired hospitality staff.

The court systematically rejected each of the taxpayers’ proposed business commencement dates. The 1995 land purchase couldn’t establish a hospitality business when no lodging facilities existed. Construction beginning in 2003 represented preparation rather than operations since a lodge cannot house guests while under construction. Even after construction was completed in 2006, the lodge never opened to paying customers. A single open house event in 2006 was insufficient because promotional activities don’t constitute carrying on a trade or business when the facility remains incapable of generating revenue.

The conditional use permit obtained in 2009 also failed t…

The conditional use permit obtained in 2009 also failed to demonstrate business commencement. While permits may be necessary for business operations, obtaining permits alone doesn’t prove that operations have begun. The permit contemplated additional construction that never occurred, and the existing lodge remained unsuitable for occupancy.

The court’s analysis was strengthened by comparing this c…

The court’s analysis was strengthened by comparing this case to Todd v. Commissioner, 77 T.C. 246 (1981), where a similar IRS audit revealed that abandoned real estate development plans don’t constitute trade or business activities. In Todd, a taxpayer’s “plans to enter the business of renting apartments were never realized,” making the resulting losses from abandoned plans non-deductible as business expenses. The policy underlying net operating loss provisions – allowing businesses to “set off their lean years against their lush years” – doesn’t apply when there were no operational years at all.

The taxpayers also failed the regular and active engagement test. The occasional events hosted on the property were too sporadic and disconnected from hospitality operations to establish ongoing business activity. During the construction period, the taxpayers were simultaneously operating their primary fruit processing business, and after selling that business, one spouse continued leading another company. By the time they might have focused on the lodge, construction defects had made the facility uninhabitable, shifting their attention litation and remediation rather than business development.

The Takeaway

The decision helps explain when activities become trade or business operations for tax purposes. The case shows that substantial investments, genuine business intentions, and professional development don’t create trade or business status when ventures never become operational. Construction defects, permit delays, and market conditions that prevent business opening don’t transform preparation costs into business expenses, regardless of amounts involved or underlying business legitimacy. Taxpayers contemplating similar ventures should focus on establishing operational capabilities as early as possible in development processes. While construction problems may prevent full operations, having booking systems, customer infrastructure, and revenue collection mechanisms might strengthen arguments that trade or business activity has commenced.