Tax Treatment of Expenses Incurred by Individuals Temporarily Out of Work

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.

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 expenses.

Self-employed taxpayers whose businesses have slowed down as a result of the current economic recession as well as unemployed individuals should be alert to these rules. Business expenses may be deductible regardless of the lack of income if the taxpayer’s cessation of business is temporary. Examples of potentially deductible costs include equipment storage expenses, property taxes, utilities, depreciation, advertising, travel, education, insurance, and job-seeking expenses. If the taxpayer was engaged in a trade or business but the business ceased for other than a temporary period, certain costs incurred in resuming a business must be capitalized and amortized as start-up expenses under Sec. 195.

Employment Changes

The Tax Court has held that a taxpayer may be in the trade or business of being an employee or of holding a particular job, such as a corporate executive or manager.12 The courts have generally allowed taxpayers to deduct expenses related to seeking employment in the same trade or business. However, in cases such as Rockefeller,13 the courts have insisted on a high degree of identity in deciding the issue of sameness. Nelson Rockefeller incurred expenses for legal and other professional services in connection with the confirmation hearings for his nomination to become vice president of the United States. The term “trade or business” includes the performance of the functions of a public office.14 By comparing the duties and responsibilities of the vice president of the United States with the duties of Rockefeller’s prior positions, the court determined that they were not the same trade or business. Thus, Rockefeller’s confirmation hearing expenses were not deductible.

Primuth15 presents a situation in which the court concluded that the taxpayer was in the trade or business of being a corporate executive. In this case, the taxpayer was secretary-treasurer of a small corporation, and he enlisted the aid of a “headhunter” organization that helped him find a job as secretary-controller with a larger company. The court noted that the fee was directly related to the taxpayer’s business of being a corporate executive, which did not change or cease merely because he began to work for a different employer.

Education Expenses

Individuals, whether unemployed or currently employed, may decide to go back to school full time in an effort to improve their future job prospects. This section examines the tax treatment of education expenses incurred between jobs. Education-related expenditures are deductible if they maintain or improve skills required in the taxpayer’s business.16 However, expenditures for education that qualifies the taxpayer for a new position are not deductible.17 For example, in the previously discussed Canter case, the court denied the taxpayer a business expense deduction when she resigned her job and became a full-time nursing student because she was not on temporary leave of absence at the time she incurred the expenses. Likewise, in Goldenberg,18 the taxpayer was a licensed attorney and CPA working with the IRS who resigned and was unemployed while he completed his LL.M. degree on a full-time basis. Goldenberg did not have a leave of absence from the IRS and upon graduation practiced law full time for two years before returning to work for the IRS. The court found that because Goldenberg left his position with the IRS and had neither a connection with his former job nor a clear indication of an intention to carry on the same trade or business upon graduation, he was not carrying on a trade or business, and the deduction for the education expenses was denied.

On the other hand, in Furner,19 a junior high school teacher who resigned from her teaching position to enroll in full-time graduate study for one year was allowed to deduct her education expenses. According to the appellate court, the key question turned on whether the course of study related to the taxpayer’s intended future performance as a teacher in such a way that the expenses could reasonably be considered ordinary and necessary in carrying on the business of teaching. In this case, the education enabled Furner to keep up to date, expand her knowledge, and improve her understanding of the subjects she taught. The court also mentioned that it was more advantageous for Furner to take the courses in her program of study in a single year rather than spread them out over several summers because some of the courses were not regularly available during the summer; in addition, she returned to teaching for the academic year immediately following the year of graduate study. In Rev. Rul. 68-591, the IRS stated that it would follow the Furner decision in cases in which taxpayers, in order to undertake education to maintain or improve skills required in their employment or business, temporarily cease to engage actively in employment or business. Suspension for a period of a year or less, after which the taxpayer resumes the same employment or business, will be considered temporary.

In a similar case,20 a teacher was allowed a business expense deduction for the cost of travel, books, food, and lodging incurred while taking graduate courses in Norway. The graduate study lasted only one academic year, the taxpayer was employed as a teacher before and after the graduate study, and the coursework improved the taxpayer’s teaching skills. However, another teacher was denied a deduction for graduate education expenses because the teacher was away from teaching for four years, had personal reasons for resigning from the teaching job, had not been actively seeking employment as a teacher, and had been temporarily employed in both law and business throughout the period.21

As these cases show, education expenses may be deductible by unemployed individuals if they return to the same type of work immediately after the education and if the education improves their job skills. Teachers returning to school full time and not on a leave of absence should provide evidence, if available, that the courses are not offered on a part-time basis and should return to teaching as soon as possible after completion of the coursework in order to increase the likelihood of a deduction. However, having a leave of absence does not by itself satisfy the criteria for deduction. In fact, there are quite a few cases in which the taxpayer remained employed throughout the time the education was undertaken and still lost the deduction because the education qualified the taxpayer for a new trade or business.22

Job-Seeking Expenses

According to Regs. Sec. 1.212-1(f), expenses incurred in seeking employment or placing oneself in a position to begin rendering services for compensation are not deductible. Further guidance is provided in Rev. Rul. 75-120, which states that expenses incurred by an individual in seeking new employment in the employee’s same trade or business are deductible.23 However, expenses are not deductible if an individual is seeking employment in a new trade or business, even if the taxpayer secures employment. If an individual is presently unemployed, his or her trade or business would consist of the services previously performed for the past employer if there was no substantial lack of continuity between the time of the past employment and the seeking of the new employment. Expenses are also not deductible if the individual is seeking employment for the first time.

Mix of Business and Personal Expenses

If a taxpayer travels to a destination in order to seek employment in his or her present trade or business and also engages in personal activities, the traveling costs are deductible if the trip is related primarily to seeking new employment. The amount of time during the trip that is spent on personal activity compared with the amount of time spent on seeking employment is used to determine if the trip is primarily related to seeking new employment. For example, in Lyle,24 the taxpayer was not allowed to deduct travel expenses incurred for a job-hunting trip to Las Vegas because the court was unable to discern the proportion of time spent on gambling versus job hunting. Even though the traveling costs may not be deductible because the taxpayer spent more time on personal activities, other expenses incurred during the trip that are allocable to seeking employment are deductible.

Same vs. New Job

Although Rev. Rul. 75-120 provides guidance for the tax treatment of job-hunting expenses, it does not address what is considered to be the same job as opposed to a new job, what items are included in job-hunting expenses, and the impact that being temporarily unemployed might have on the tax treatment. For job-hunting costs to be deductible, the taxpayer must be seeking employment in the same trade or business in which he or she is currently engaged.

The courts have generally defined “same trade or business” by focusing on the nature of the employment rather than the status of employment.25 Thus, a CPA who worked as a controller or general manager in industry may deduct expenses incurred seeking employment as a self-employed CPA, as an employee or partner in an accounting firm, or in some other accounting capacity.26 In Leisner,27 a lawyer was held to be involved in the same business whether employed in private practice, as a hearing examiner of the state of New York, or as a court administrator. However, in Evans,28 the court denied a retired Air Force officer a deduction for job-hunting expenses incurred while seeking employment in the private sector. Although Evans failed to categorize the duties in his last Air Force assignment as comparable to the duties of an employee in the private sector, the court stated that in its view the unique duties that Evans performed in his job as an Air Force officer could not be readily compared to any employment in the private sector.

In another case,29 an attorney who was a full-time practicing lawyer as well as a part-time lecturer at a law school was allowed a deduction for career counseling expenses incurred in an effort to seek new employment as a full-time assistant professor of law. Regs. Sec. 1.162-5(b)(3) provides that a change in duties does not constitute a new trade or business if the new duties involve the same general type of work as in the taxpayer’s previous employment.

A taxpayer who is unemployed when job-hunting expenses are incurred is viewed as engaged in the business of providing the same type of services as performed for the previous employer, as long as there is not a substantial lack of continuity between the time of the prior employment and seeking new employment.30 Since a taxpayer may be considered to be in the trade or business of being an employee, job-hunting expenses while unemployed should be deductible if the taxpayer is seeking employment in the same trade or business.31 The court cases suggest that to enhance the possibility of a deduction, an unemployed person should begin looking for work as soon as possible after becoming unemployed.

Unemployed individuals may even be able to accept work in another business while looking for employment in the same trade or business without jeopardizing the job-hunting cost deduction. In Charlton,32 following a period of unemployment as a plumber, the taxpayer accepted a position as a pipefitter while continuing to look for employment as a plumber. The IRS argued that the taxpayer was looking for work in a new trade or business and so disallowed the job-hunting expenses. However, Charlton was able to show that he temporarily took work as a pipefitter because he could not find work as a plumber. The court determined that Charlton’s employment as a pipefitter when he could not find work as a plumber did not constitute abandonment of the plumbing trade.

How Long Is a Temporary Period?

A taxpayer who has been unemployed for more than a reasonably temporary period of time is not considered to be in the trade or business of being employed, so the expenses of searching for a job are not deductible.33 “Temporary” is not defined, but the test has been met for periods of up to nine months.34 What about longer periods of time? Even if a taxpayer is not able to find a job for over a year, this should not automatically preclude the deduction of job-hunting expenses. The courts have focused on the diligence of the taxpayer’s search and the associated economic conditions to determine the reasonableness of the temporary time period.

The taxpayer should begin the job search shortly after becoming unemployed and should actively continue the search while unemployed. The taxpayer should maintain documentation to support all expenses and to support the contention that he or she continued to be in the business of his or her prior employment. In fact, a major requirement for all deductions, including job-hunting expenses, is that the taxpayer adequately substantiates the expenses. For example, in Murata,35 the court did not allow a deduction for job-hunting expenses for a trip on which the taxpayer stayed with family members and could show no documentation of the time or amount of money spent job hunting. However, on a subsequent trip where Murata provided a calendar to substantiate that she had gone on interviews and had made phone calls relating to job prospects, her documented job search expenses were allowed.

Types of Expenses That Are Deductible

All ordinary and necessary expenses incurred in seeking new employment in the same trade or business are deductible if directly connected to the trade or business as determined by all the facts and circumstances.36 Examples of potentially deductible job-hunting expenses include employment agency fees, job counseling and referral fees, and costs for classified advertisements, printing and postage, transportation, travel, meals, and lodging. Deductible travel expenses, including meals and lodging, must meet the substantiation requirements in Sec. 274(d).

Conclusion

As explained earlier, individuals may be able to deduct business expenses despite being unemployed or out of work. Self-employed individuals, who have operated a successful business but find that their business is currently not generating revenue, may be able to continue to deduct business expenses if they can demonstrate that the cessation of business is temporary. Taxpayers should maintain records documenting their intent to continue to carry on the business. Taxpayers should also continue to solicit customers, maintain normal business books and records, and provide evidence supporting the reason(s) for the lack of business. Poor health and unfavorable economic conditions are legitimate reasons for a lull in business, but the taxpayer must document these situations. Individuals should be diligent about efforts to continue the business and should resume business as soon as possible. An extended period of lack of business income suggests that the business has ceased. However, given the current economic conditions, business owners may be able to prove their intent to carry on the business even though it has ceased for a period of time.

Unemployed individuals should be able to deduct job-seeking expenses as long as the services they will render in the new job are similar to those performed for their previous employer and as long as they begin seeking new employment shortly after leaving their prior job. Managers and corporate executives have a broad range of skills and responsibilities that often enable them to change jobs without entering a new business. Individuals may accept temporary work in a new job while continuing to look for work in their former business without forfeiting the deduction as long as the work is in fact temporary and the taxpayers document the timing and regularity of their job search. Individuals with more than one trade or business, even if the secondary business is not the primary source of revenue, should be more likely to be able to deduct job-seeking expenses by seeking work in one of their existing businesses.

In general, the courts have favorably treated teacher education costs for unemployed teachers, especially if a teacher is between teaching jobs and can show that the course of study was not available on a part-time basis or in the summer. If possible, taxpayers wanting to deduct job-related education expenses while unemployed should show that they are on leave from their employer or that they have an informal agreement with their employer to return.

Footnotes

¹ U.S. Department of Labor, Bureau of Labor Statistics, The Employment Situation—June 2010 (July 2, 2010).

² Regs. Sec. 1.162-1(a).

³ Haft, 40 T.C. 2 (1963); Sherman, T.C. Memo. 1977-301; Schnelten, T.C. Memo. 1993-264.

⁴ Haft, 40 T.C. 2 (1963).

⁵ Schnelten, T.C. Memo. 1993-264.

⁶ Estate of Rockefeller, 762 F.2d 264 (2d Cir. 1985); Canter, 354 F.2d 352 (Ct. Cl. 1965); Corbett, 55 T.C. 884 (1971); Evan, T.C. Memo. 2004-180.

⁷ Estate of Rockefeller, 762 F.2d 264 (2d Cir. 1985); Sherman, T.C. Memo. 1977-301.

⁸ Davis, T.C. Summ. 2004-64.

⁹ McDonald, 323 U.S. 57, 60–61 (1944).

¹⁰ Canter, 354 F.2d 352 (Ct. Cl. 1965).

¹¹ Gallo, T.C. Memo. 1998-100 (1998).

¹² See, e.g., Christensen, 17 T.C. 1456 (1952); Abraham, 9 T.C. 222 (1947); Peoples-Pittsburgh Trust Co., 21 B.T.A. 588 (1930), aff’d, 60 F.2d 187 (3d Cir. 1932); and Hochschild, 161 F.2d 817 (2d Cir. 1947).

¹³ Estate of Rockefeller, 762 F.2d 264 (2d Cir. 1985). Most of these cases concerned education expenses, for which there is a regulation (Regs. Sec. 1.162-5). This is discussed below.

¹⁴ Sec. 7701(a)(26).

¹⁵ Primuth, 54 T.C. 374 (1970).

¹⁶ Regs. Sec. 1.162-5(a).

¹⁷ Regs. Sec. 1.162-5(b). A limited deduction is available for qualified higher education expenses before 2010 regardless of the business connection. See Sec. 222.

¹⁸ Goldenberg, T.C. Memo. 1993-150.

¹⁹ Furner, 393 F.2d 292 (7th Cir. 1968).

²⁰ Ford, 56 T.C. 1300 (1971), aff’d, 487 F.2d 1025 (9th Cir. 1973).

²¹ Corbett, 55 T.C. 884 (1971).

²² See, e.g., Galligan, T.C. Memo. 2002-150; Warren, T.C. Memo. 2003-175; and Siewert, 500 F. Supp. 1076 (N.D. Tex. 1980).

²³ Rev. Rul. 75-120, 1975-1 C.B. 55.

²⁴ Lyle, T.C. Memo. 1999-184.

²⁵ Primuth, 54 T.C. 374 (1970).

²⁶ Cornutt, T.C. Memo. 1983-24; Gerhard, T.C. Memo. 1970-262.

²⁷ Leisner, T.C. Memo. 1977-205.

²⁸ Evans, T.C. Memo. 1981-413.

²⁹ Rev. Rul. 78-93, 1978-1 C.B. 38.

³⁰ Estate of Rockefeller, 762 F.2d 270 (2d Cir. 1985); Sherman, T.C. Memo. 1977-301; Rev. Ruls. 75-120 and 77-16, 1977-1 C.B. 37.

³¹ Primuth, 54 T.C. 374 (1970); Charlton, T.C. Memo. 1988-515.

³² Charlton, T.C. Memo. 1988-515.

³³ Franklin, T.C. Summ. 2004-126; Miller, 362 F. Supp. 1242 (E.D. Tenn. 1973).

³⁴ Campana, T.C. Memo. 1990-395.

³⁵ Murata, T.C. Memo. 1996-321.

³⁶ Sec. 162; Rev. Ruls. 75-120 and 77-16.

EditorNotes

Claudia Kelley is a professor and Dixon-Hughes Research Fellow and William Pollard is a professor at the John A. Walker College of Business at Appalachian State University in Boone, NC. For more information about this article, contact Prof. Kelley at kelleycl@appstate.edu.