## Facts

- An individual taxpayer began searching for a business to purchase for profit.
- During a general search, the taxpayer placed newspaper advertisements, traveled to investigate multiple businesses, and commissioned audits to evaluate several candidates.
- The taxpayer later decided to purchase a specific business and incurred transaction-specific costs, including retaining a law firm to draft purchase documents.
- Disagreements with the seller arose, and the taxpayer abandoned the acquisition.
- The taxpayer sought guidance on whether unreimbursed expenditures were deductible as a loss under I.R.C. § 165(c)(2).

## Issues

1. Whether expenses incurred in a general search for, or preliminary investigation of, a business are deductible as a loss under I.R.C. § 165(c)(2).
2. Whether expenses incurred in an unsuccessful attempt to acquire a specific, identified business are deductible as a loss under I.R.C. § 165(c)(2).
3. What facts indicate that a taxpayer has “entered” a transaction for profit for purposes of § 165(c)(2) when the acquisition is abandoned.

## Decision

- The IRS concluded that general search and preliminary investigatory expenses (e.g., advertising, travel, and broad evaluations of multiple businesses) are not deductible under § 165(c)(2).
- The IRS concluded that expenses directly related to an unsuccessful attempt to acquire a specific business (e.g., legal fees to draft purchase documents) are deductible under § 165(c)(2) as a loss from a transaction entered into for profit, if not compensated by insurance or otherwise.
- The ruling amplified prior administrative guidance by clarifying that a taxpayer may be treated as having entered a profit-seeking transaction once the taxpayer moves beyond general investigation and focuses on a specific acquisition, based on all facts and circumstances.

## Legal Principles

- I.R.C. § 165(a) permits a deduction for losses sustained during the taxable year that are not compensated for by insurance or otherwise, subject to limitations for individuals in § 165(c).
- Under § 165(c)(2), an individual may deduct losses incurred in a transaction entered into for profit, though not connected with a trade or business.
- Costs incurred in a general search for, or preliminary investigation of, a business are not treated as arising from a transaction entered into for profit and therefore are not deductible under § 165(c)(2).
- A taxpayer is considered to have entered a transaction for profit when the taxpayer has gone beyond general investigatory activity and has focused on acquiring a specific business or investment, determined from all facts and circumstances.
- Once the taxpayer is focused on a specific acquisition, unreimbursed expenditures directly related to that acquisition may be deductible as a § 165(c)(2) loss if the transaction is abandoned.

## Conclusion

The IRS drew a line between nondeductible exploratory costs and deductible deal-specific abandonment losses: broad search and investigation expenses are not deductible under § 165(c)(2), but expenses incurred after the taxpayer focuses on acquiring a particular business—such as legal drafting fees—are deductible as a § 165(c)(2) loss when the acquisition is abandoned without reimbursement.


Rev. Rul. 77-254, 1977-2 C.B. 63 (1977)