#12332 - Deductions - Taxation

Deductions

1. Ordinary and Necessary

1. Introduction. Some deductions are necessary to accurately measure net income. Others are tax subsidies for certain activities or investments. Deductions and exclusions are similar, but a taxpayer generally will prefer an exclusion, because an exclusion can be used in addition to the standard deduction, and because an exclusion, unlike a deduction, reduces AGI (and thus the 2% AGI floor that miscellaneous itemized deductions must exceed in order to be deductible).

2. Sections 162 and 212. Section 162 allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Examples of deductible expenses include employee wages, annual insurance premiums on business assets, office rents, and utilities. Section 212 permits individuals to deduct “ordinary and necessary expenses stemming from income-producing activities that do not qualify as a trade of business.” Examples include expenditures on managing a person’s own investments. §212 deductions are miscellaneous itemized deductions and are thus subject to the 2% floor.

3. What is an Ordinary and Necessary Expense? Welch suggests that a totality-of-the-circumstances test is necessary to determine whether an expenditure is “ordinary and necessary.” However, the case is sometimes understood (see Tellier) to stand for the proposition that an expenditure on the development of good will is a capital expenditure that is not deductible under §162. (Note that Section 263 explicitly prohibits taxpayers from deducting capital expenditures as ordinary and necessary expenses.) Gilliam states that an expense must be incurred in carrying on a trade or business in order to be deductible under §162; an incident that is not undertaken to further a taxpayers trade or business is not deductible under this section.

4. Ordinary and Necessary Expenses: Litigation Expenses. Gilmore employed an “origin of the claim” test to distinguish deductible from nondeductible litigation expenses. Taxpayers may deduct expenses related to defending against litigation (criminal or civil, see Tellier) or prosecuting litigation that is related to their trade or business, but not expenses related to litigation that does not arise from a profit-seeking activity.

5. Ordinary and Necessary Expense: Fines and Penalties. Section 162 now denies deductions for five types of expenditures that were deemed disfavored on public policy grounds, including fines of similar penalties paid to a government for the violation of any law and bribes or kickbacks paid to public officials. Congress apparently intended these five categories to displace the common law “public policy” doctrine, and most courts agree that it has been displaced. Civil penalties are generally not deductible on public policy grounds, unless they are “compensatory” damages.

Halperin suggests that it does not make sense to prevent deductions of fines. If the fine is deductible, the regulated entity will behave the same regardless of its tax bracket. This is efficient. If the fine is not deductible, the regulated entity might be willing to incur the fine if it were tax-free but be unwilling to do so if it is taxed. This is inefficient. Moreover, if the fine is levied by a state government rather than the federal government, the federal government actually loses money by denying the deduction, because the taxpayer will forgo a profitable activity (depriving the federal government of its share of the taxpayer’s income).

6. Ordinary and Necessary Expenses: Executive Compensation. Section 162(m) denies a deduction for compensation in excess of $1 million paid to the CEO or any of the four most highly compensated employees of a publicly held corporation unless the compensation is performance-based. Well-advised corporations have little difficulty avoiding this rule by paying in stock (which is performance-related) instead of cash.

7. Employee Business Expenses. Expenses incurred by an employee in connection with her job are deductible under §162. Expenses which are reimbursed by the employer are deducted “above the line,” which means they are not subject to the 2% floor and can be taken along with the standard deduction. Unreimbursed expenses are generally deductible only if the employee itemizes deductions. A self-employed “independent contractor” can deduct all business expenses above the line.

8. The 2% Floor. §67 provides that a taxpayer can deduct “miscellaneous itemized deductions” only to the extent that, in the aggregate, they exceed 2 percent of the taxpayer’s AGI for that year. “Miscellaneous itemized deductions” are all deductions except deductions for interest, taxes, casualty and wagering losses, charitable donations, medical expense, and a few other categories. Section 67 does apply to unreimbursed employee business expenses (i.e., §162 deductions) and investment expenses (i.e., §212 deductions). The result, in some cases, will be that the taxpayer may owe more tax than her net income.

9. Working Condition Fringe. Section 132(d) defines a working condition fringe benefit as “property or service provided to an employee to the extent that, if the employee paid for such property or service, such payment would be allowable as a deduction” as an ordinary and necessary business expense. The 2% floor is ignored in determining whether the employee could take a deduction. This provision, combined with the fact that reimbursed employee expenses are above-the-line, has created pressure on employers to either provide working condition fringes or reimburse employees for their expenditures on these items.

2. Personal Expenses

10. No Deductions for Personal Expenses. Section 262 bars deductions (except where otherwise provided in the Code) for “personal, living, or family expenses.”

11. Business versus Personal Expenses. Drawing a distinction between business and personal expenses is very difficult. But it is necessary; if personal expenses could be deducted, personal consumption would be omitted from the tax base. But if business deductions were not allowed, gross income, not net income, would be taxed. There are two possible approaches. On one theory, the deduction should be equal to the amount that would have been spent for business purposes. On the second theory, the deduction should be limited to the amount, if any, by which the expenditure exceeds the personal benefit. In attempting to implement one of these two theories, courts have sometimes allowed deductions whenever the expense is “appropriate and helpful” to the taxpayer’s business. In some cases, they have required a demonstration that the expense would not have been made “but for” a business purpose. And in some cases, expenditures have been declared to be “inherently personal” and categorically disallowed as deductions (e.g., haircuts).

Clothing. According to Pevsner, clothing expenses are only deductible if the clothes (1) are specifically required; (2) not adaptable to general usage (judged objectively)}; and (3) not so worn. Thus, the cost of uniforms not adaptable to general use and specifically required for work are deductible.

12. Home Office. The Code allows a deduction for a home office that is used exclusively as the “principal place of business for any trade or business of the taxpayer.” §280A. A home office can qualify as a principal place of business if the taxpayer uses the office to conduct administrative or management activities and there is no other fixed location of the business where the taxpayer conducts substantial administrative or management activities. A home office can also qualify for a deduction if patients, clients, or customers use the office in meetings with the taxpayer. The home office deduction is effectively limited to the net income from the activity that occurs within the office. Disallowed deductions may be carried forward.

13. Food, Lodging, and Entertainment. Section 162(a)(2) allows a deduction for travel expenses incurred “while away from home in the pursuit of a trade or business.” Deductible expenses included not only transportation but also meals and lodging “while away from home.” An employee’s unreimbursed travel expenses are miscellaneous itemized deductions subject to the 2 percent floor. An employee’s reimbursed travel expenses are deductible from gross income and are not subject to the 2 percent floor. Cornell upheld the IRS’s interpretation of the phrase “away form home” as applying only to trips requiring sleep or rest away form home.

14. Section 274. Section 274 generally disallows deductions with respect to activities that constitute entertainment, amusement, or recreation unless (1) the item was directly related to the active conduct of the taxpayer’s trade or business or (2) the item directly preceded or followed a substantial and bona fide business discussion. To take a deduction for a business-related entertainment expense, the taxpayer must provide substantiation. §274(d). The amount allowed as a deduction for any expense for food or beverage (except where covered by the fringe benefit provision, §132} or any expense for entertainment, amusement, or recreation shall not exceed 50 percent of the amount of such expense. §274(m).

15. Transportation Expenses. Transportation expenses, such as air fare, taxicab fare, or the cost of operating a car, are generally deductible when the taxpayer is traveling on business. The cost of commuting from home to work and back are nondeductible personal expenses.

3. Capitalization

16. Distinction Between Deductible Business and Investment...