Deductions Outline

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...

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