Chapter 6                p.465
Deductions for Business

§162 enables an income tax deduction for business expenses &

§212 enables a deduction for investment expenses.

But, §263 limits the deduction where a “capital expenditure” is made.

What is a “capital expenditure”:  the cost for the improvement or betterment of property.

When Recover Capital Cost for Tax Purposes?

Choices:

• Immediate income tax deduction.

• Spread cost of item over the life of the asset.

• Cost recovery upon final disposition of asset.

Cf., consumption tax approach.

Query:   What is the dividing line between (1) current expense, and (2) a capital expenditure (requiring capitalization of cost for federal income tax purposes)?

Expenditures to be Capitalized                p.466

Encyclopaedia Britannica, p.466.

Expenditures were incurred to acquire a completed manuscript. Tax Court says the cost is deductible since a payment for services.

Ct. of Appeals:  Book is just the acquisition of another rental property.  Income is to be received over several years.  This was the expense for a “turnkey project” and, therefore, was required to be capitalized. 

Idaho Power, Sup. Court
p.467, fn.1

Deductions for the depreciation of trucks and other equipment which were used in constructing capital assets (e.g., power stations for the electric utility).  Allocation of  the depreciation for these items was required to be capitalized since a cost being incorporated into the new capital asset (the new power station).

Similar treatment for wages of personnel used for this construction project?

Other Capitalization Issues                       P.472

- Research & development expenditures - §174 permits immediate deduction

- Advertising costs – See §263A regs. – immediate deduction even though creating “goodwill.”

- Prepaid expenses – Boylston Market case – capitalization required for three year prepayment of  casualty insurance premiums.

- Capitalization of prepaid interest - §461(g).

§263A & Uniform Cap. Rules                        P.472

Cost of producing inventory must be capitalized – to be recovered through inventory costing.

Includes both direct and indirect expenses.

What are indirect expenses in this context?

Depreciation on manufacturing plant?

Utilities, taxes & insurance on manufacturing building?

Fringe benefits for manufacturing employees?

Exceptions from §263A Capitalization Rules P.473

Exceptions from capitalization requirement:

- Marketing & advertising costs.

- Retailers and wholesalers with annual gross receipts less than $10 million.

- Freelance writers, artists and photographers. See §263A(h).

Indopco case & regulations              P.473

Indopco case -  investment banking fees incurred by Target Corp. in a merger transaction must be capitalized.

Incurred by the target corporation?

Why incur these fees?

Basic premise in Indopco:  is a “future benefit” to be realized from the particular expenditure?

What response to this decision and “future benefit” language?  E.g., the Indopco regulations.

Repair and Maintenance Expenses                  p.475

What is the income tax issue concerning incurring a cost for “repairs”?

Is the cost a “period cost” or does this cost produce some continuing value? 

If repair produces a continuing value (e.g., to continue operations), then the cost needs to be capitalized and recovered over time (thereby increasing current income because of a reduced current deduction).

Repair and Maintenance Expenses                  p.475

Midland Empire Packing Co.                   P.476

Concrete lining installed in basement to protect against neighboring refinery leakage, etc.  Problem with federal meat inspectors.

Expenditure did not add value to building.

IRS asserts capital expenditures made and recovery of cost to be through depreciation.

Not an enlargement; only a “repair” and currently deductible. See Reg. §1.162-3&4.

Repair and Maintenance Expenses Regulations                 

Reg. §1.162-3 & 4, etc. (150 pages, 9-2013, replacing Reg. §1.162-4T, noted at p.478) with new rules re “repairs”:

1)  Identify the “unit of property” to which

expense relates, e.g., a building.

2)  Does the expense produce a “betterment,” a

“restoration”(when no longer working) or an “adaptation to new or different use”?

Issue:  Does a “material addition” or “material increase in capacity” result?

Land Remediation Costs    Rev. Rul. 2004-18     p.480         

See Rev. Rul. 94-38 (p. 481) re current deduction for land clean-up costs.

Rev. Rul. 2004-18 - Remediation mandated by various environmental requirements.  Land clean-up costs at a manufacturing facility location -  to be included in inventory costs (under §263A)?  Is this an inventory production cost? These clean-up costs are not repairs, but are to be capitalized (as indirect costs) into the cost of the inventory being produced in the manufacturing plant. 

Inventory Accounting
p.483

Inventory accounting is mandated for the seller of goods who either (1) purchases the goods sold for resale, or (2) manufactures the goods for sale to customers.  §263A(a)(1)(A) specifies that for a taxpayer having inventory certain costs for this inventory shall be included in “inventory costs”.  - These costs include both “direct costs” and “indirect costs.”

- Exception for taxpayer with gross receipts (as reseller) of $10 million or less.  §263A(b)(2)(B).

Determining Inventory Cost for a Tax Year

Gross income from a business selling inventory is computed as follows:

Gross receipts:                    _____

Less: Inventory cost          _____      (next slide)

- (Cost of goods sold

  (CGS); how calculated?)

Equals:  gross income    ______

Note:  Not all inventory will be sold during a particular tax year (unless business liquidation).

Determining CGS (the Cost of Goods Sold)

Calculation of cost of goods sold (CGS):

• Opening inventory

2)  Plus: additions to the inventory during the tax year (whether purchased goods for resale or goods are produced, including parts)

• Less:  Closing inventory

• Equals:  Cost of goods sold (CGS)

Tax planning objective:  minimize the closing inventory amount (thereby increasing CGS).

Method for Identifying Closing Inventory Items

Use the FIFO or LIFO method?

FIFO – the remaining (year-end) inventory consists of those goods most recently added to inventory (the “conveyor belt” approach).

LIFO – the remaining (year end) goods are those first going into inventory (those goods still held are at the “bottom of the barrel”);  the goods sold during the year are those which were the most recently acquired (& the most expensive if inflation is occurring).

Inventory Accounting Example

§61(a)(2) identifies gross income as including business sales income.  How determined?

Year 1:  buy 100 of Item X for $10 = $1,000 cost

Year 2:  buy 100 of Item X for $13 = $1,300 cost

& sell 120 of Item X for $15 each = $1,800

Year 2 gross income computation:

• FIFO - 100 items @$10 & 20 items @$13 = $1,260 cost & $540 income (1,800 less 1,260).

b)  LIFO – 100 items @$13 and 20 @$10 = $1,500 cost & $300 income ($1,800 less 1,500).

“Booking Requirement” §472(c)&(e)(2)          P.485

If the taxpayer uses LIFO for federal income tax purposes this method must also be used for reporting to shareholders and creditors (i.e., for GAAP purposes).

What is the purpose of this financial statement consistency requirement?

Why might a company not choose LIFO when inventory costs are rising? What impact on earnings reported to shareholders (under the “booking requirement”?

Rent v. Installment Purchase                p.485

Starr’s Estate – Sprinkler system installed and treated as “leased” by a seller for 5 years.  Lease renewal could be agreed for a nominal amount.

Would the lessor ever retrieve this property?

What is the income tax issue?  Deduction for:

(1) depreciation (lesser amount – longer recovery period), or (2) rent/lease payments (faster tax deductions, plus ownership eventually will reside with the property where the sprinkler is installed & not removed).

Tax Objectives in Lease Arrangements

- Accelerate income tax deductions to lessee with payments on short term lease.

- Lessor takes depreciation deductions & lessor may be in a higher income tax bracket (& deductions are more valuable).

Defining “Ordinary and Necessary”               p.489

Welch v. Helvering -  Welch paid debts of the former E.L. Welch Company to improve his personal relationship with creditors of old Co.

Held:  Payments by the taxpayer were not ordinary (but were they necessary?) business expenses (§162);  but, were these “capital expenditures” (extraordinary) for the development of the “goodwill” of the business (and, therefore, not “personal expenses).

Note (p.490) re “life in all its fullness…”

Defining “Ordinary and Necessary”              

Three possible categories of expenditures:

- Personal expense (no deduction, unless statutory exception)

Vs.

- Ordinary & Necessary Expense (current deduction)

Vs.

- Extraordinary (Capital) Expense (future deductions, or frozen cost)

Deducting the Cost of Goodwill                  p.492

If the cost incurred is for acquiring goodwill is that cost deductible (amortizable)?

See Code §197 which permits 15 year amortization of purchased goodwill.

But, no amortization of  self-created goodwill.

See Code §197(c)(2)(B).

Advertising Expenses
p.493

Are costs for advertising currently deductible or do they create a “future benefit” (noting the Indopco case) which requires capitalization?

Current deductions for marketing, selling and advertising are not disallowed under §263A.  See Reg. §1.263A-1(e)(3)(iii)(A). 

But, does advertising expense (hopefully) provide a continuing benefit (beyond the current year)?

Educational Expenses
p.493

No deduction for meeting the “minimum educational requirements” for employment qualification.  Reg. §1.162-5(b)(2)(i).

Including a law school education.

But, deduction for CLE expenses:  Reg. §1.162-5(a)(1) provides deduction for cost of maintaining or improving current skills required in the current employment.

Job-hunting Expense
p.494

Reg. §1.212-1(f) denies current deductions (under §212) for expenses incurred in seeking employment.

But, see Rev. Rul. 77-254 where expenses in identifying a specific opportunity are to be capitalized and amortized.  But, general search expenses are “personal” and are not deductible (and not to be capitalized?).  Cf., §195.

Deduction if looking for a new position in one’s current trade or business.  Rev. Rul. 77-16.

Extraordinary Expenses
Gilliam case            p.495

Irrational/disoriented painter/airline passenger – on a business trip – arrested by Feds.

Acquitted by reason of temporary insanity, but incurred legal fees to accomplish the acquittal.

Does §262 preclude a business expense deduction (legal fees and civil claims)?

Held:  These expenses are not ordinary (under §162) to his (artist) trade or business. 

Crazy episodes in an airplane are not ordinary nor in course of one’s trade or business.

Other examples of “ordinary” expense,  p.501

Friedman – lawyer’s client does not fulfill commitment to fund an agreed settlement, so lawyer then does.  Deductible expense to lawyer?  No.  Payment was voluntary.

Trebilcock – cost paid to a religious minister to pray for success of the business and for the employees of the business – personal benefits, and not deductible.  What about psychologist on location?

Reasonable Compensation         p.502

§162(a)(1) provides for deduction for reasonable allowance for salaries and other compensation.

But, if the amount is too large is this really a non-deductible (to employer) amount which should be treated as a profits distribution (i.e., dividend to shareholder employee)?

See §162(m) re limit of $1 million compensation for top executives of a publicly held company.

Note the exception to this limitation for “performance-based compensation.”

§162 and public policy limit on deductions  p.502

U.S. Supreme Court decisions:

1)  Tank Truck Rentals – no deduction to a

trucking company for fines paid for weight limit violations. 

Cf., Sullivan – deduction permitted for rent and wages paid by an illegal gambling operation.

• Tellier – deduction to securities dealer is

permitted for lawyer’s fees paid for an unsuccessful defense in a securities fraud case.

Deduction, Public Policy & Statutory Limits    p.503

§162(f) – no deduction for fine or similar penalty. Cf., J.P Morgan Chase fines in 2013.

§162(c) – no deduction for illegal bribes and kickbacks.  See FCPA, including re “grease payments” permitting deductions.

§162(g) – denying 2/3rds (punitive) portion of anti-trust payment when criminal violation.

§280E – no deduction for drug trafficking expenses; but, deduction for inventory costs of a drug dealer (why?).

Depreciation Deduction p.504

Cost for “wasting assets” should be recovered over time – associating the cost of the assets with the income productivity from particular asset.

Choices:  1) Deduction for the entire cost in the acquisition year.

• No deduction until disposition of the asset.

• Determine actual value decline during year.

4)  Allocate some amount of the acquisition cost to each year of the asset’s anticipated usage.

Current Depreciation Deduction System    p.505

• Determine the useful life (e.g., machinery &

equipment; office and industrial buildings).

• Determine anticipated salvage value (but,

not relevant under current system, MACRS).

• Determine the method of allocation to each

year (e.g., does a greater decline in value occur during earlier years)?   Straight line, declining balance (e.g., DDB); other system (e.g., income forecast)?

Additional depreciation Issues                    p.506-7

First year – full year’s depreciation? Allocated?

Or, use an accounting convention?

“Component” depreciation – divide parts of a building (e.g., elevators) into its various components to allocate useful lives?

Too much depreciation:  recapture the excess depreciation at disposition?  Ordinary income?  See §1245.  Also, impose an interest charge for excess deduction?  What about “market gain? E.g., buy at 100x, depreciate to 85x, sell at 110x.

§168 – Statutory Depreciation Rules   p.508

• Recovery period – depends on the class of

property.  See §168(c)&(e).  Real property?

• Recovery method - §168(b).  Choices include

DDB, 150% DB and straight line.

With salvage value at zero. §168(b)(4).

3) Placed in service conventions - §168(d) re half-year convention, except for real property.

4)  Limited expensing – without regard to the rules above - §179.  For 2013 - $500,000; but, $25,000 in 2014 (to be changed?)

Intangibles & Cost Recovery                   p.510

§167 enable straight line amortization of intangibles – e.g., patents, trademarks.

§197 provides special rules for goodwill and purchased intangibles, including customer lists, skilled work force, non-compete covenant, etc.

Does the value of these items decline? 

Note the Newark Morning Ledger case (p. 511), and the §197 enactment as the response. 

Was enacting §197 a “tax increase”?

Depletion for Oil & Gas and Minerals             p.512

Cost depletion for (1) oil & gas, and (2) hard minerals properties is allowed under §611. 

Tax basis is allocated over the estimated recoverable units for the property. 

Alternative method: §613 - Percentage depletion enables a deduction for a percentage of the gross income derived from the production (except for major, integrated oil companies). But, no limitation on deduction amount even after cost basis equivalent is recovered.  Why?

Percentage Limitation Questions                 p.514

What limits on the % depletion deduction?

-  Percentage limit for 50 percent of the taxable

income from the property.

-  What is the “cutoff point” for determining

“gross income from mining”?  See Cannelton Sewer Pipe Co., p. 514.  When the clay comes from the mine?  When the pipe is finally sold?  

Cf., oil & gas production – the “cutoff point” is at the wellhead for determining gross income.

Defining an “Economic Interest”                   p.513

To qualify for a depletion deduction the taxpayer must have an “economic interest” in the property being depleted.  What is the purpose of this concept?  Looking for a return from the production of the oil or mineral.

An “economic interest” can include a royalty interest, working interest, carved-out interest, etc.

Intangible Drilling Costs           & G&G Costs           p.514

§263(c) authorizes regulations to enable current expensing for “intangible drilling and development” costs.   What are IDCs?  What percentage of the total drilling costs?  Why permit this deduction?  Cf, capitalization.

Consider the tax benefit of the combination of (1) the IDC deduction (no cost basis is established), and (2) percentage depletion deduction (no cost basis is necessary).

Cf., O&G exploration costs.

Hard Mineral Costs
p.514

§616 – development expenditures can be currently deducted – when incurred after proving existence of the deposit.

§617 – exploration expenditures are currently deductible, at the election of the taxpayer.  These are costs incurred to identify the existence and location of the mineral deposit.

Recapture of the deducted amount when reaching the production stage.

Tax Avoidance Arrangements           p.515

What is a “tax shelter”?  P.516

An investment unrelated to the taxpayer’s normal business/investment activities & having an objective to produce a tax loss (but not an economic loss).

Remember the Tufts case  - large depreciation deductions were available for property investment when the taxpayer’s tax basis was increased with non-recourse debt – but no economic risk was incurred.  

Tax Shelters           p.516
Basic Premises

• Tax deferral (exploit time value of money).

• Conversion of ordinary income into capital

gains (39.6% vs. 20% tax rate). Cf., recapture.

• Tax arbitrage – deduct expenses incurred

for non-included gross income.

• Misattribution of income to another

taxpayer  (e.g., low tax bracket or tax exempt).

Plus:  Accompanied by debt leveraging (including non-recourse debt) to increase basis.

Tax Shelter Limitation Provisions            

1)  Passive activity loss rules - §469 –

Deduction limit on a loss incurred in an investment where the investor does not “materially participate.”  This is defined as not spending at least 500 hours per year on the activity (& alternate tests).

Applicable where limited partners are passive.

Special real estate investment tax deduction of $25,000.

Tax Shelter Limitation Provisions            

• Deduction of interest is limited when

“investment indebtedness” is incurred. §163(d).   The current interest expense deduction is limited to the amount of “net investment income.”  But,  a carryforward of excess  interest is possible.

The term “net investment income means the income (including capital gains) received from “portfolio investments.”

Tax Shelter Limitation Provisions, continued            

• At risk rules - §465.  Losses are disallowed

when in excess of the taxpayer’s amount “at risk” in that investment.  Nonrecourse debt is not included in the amount at risk.  Amount at risk includes:  (a) cash investment by taxpayer, plus (b) recourse debt, or (c) debt where other property is pledged as collateral.

Non-deductible loss can be carried forward for later deduction.  Exception for real estate with qualified nonrecourse financing; but, cf. §465(b).

Estate of Franklin
p.523

Ltd. partnership acquires the Thunderbird motel in Arizona for $1,224,000.   Prepaid interest but then deferral over ten years for large principal payments & balloon payment due  after 10 year period.  Nonrecourse debt.

Warranty deed is placed in escrow. Leaseback with net lease payments approximating the P&I payments on the debt. No potential for equity growth for taxpayer. Held: Tax depreciation  predicated on real  investment in the property.

The Option Transaction   p.527

Consider example of a deal for a property acquisition for $100,000:

• $30,000 option price;

• $70,000 at closing in a subsequent year.

What is the objective of this arrangement?  To postpone the “seller’s time of gain recognition, when the “seller” has received significant cash?

Will the “buyer” not close the transaction?

Is the transaction complete in the first year?

The Era of Corporate Tax Shelters                   p.527

E.g., the “lease-strip” shelter, conducted through a partnership:  (1) most lease income is prepaid and allocated to the tax-exempt partner; & (2) other partner (U.S. corporate taxpayer) is allocated cost recovery deductions (to enable tax-sheltering effect).

The effect of significantly reducing federal income tax liability of U.S. corporate investor: 

1) low effective income tax rate, and 2) increased profits since no (or little) tax cost.

Economic Substance Doctrine                    p.529

Knetch v. U.S. – permitted deductions for interest expense?  Knetch bought deferred annuity bonds for $4 million, paying with $4,000 check and $4 million promissory note.  Debt secured by bonds.  Prepaid 1^st year’s interest of $140,000 and borrowed back $99,000 and then prepaid $3,465 interest on this borrowing.

Procedure repeated in subsequent year.

In fourth year this arrangement terminated and net equity of $1,000 received from the contract.

continued

Knetsch case, cont.

Trial court declares transaction as a “sham.”

Sup. Ct. analysis:  taxpayer paid a fee of $91,570 to produce this loan arrangement attempting to facilitate a $294,540 interest expense deduction, thereby enabling a tax reduction of $233,298 (assuming an 80 percent FIT rate).

Post-transaction enacted tax provision limiting this arrangement.

Held: here a sham transaction and no interest expense deduction.    But:  Douglas dissent.

Goldstein & “Economic Substance” Rule       p.534

Taxpayer won $140,000 in Sweepstakes and (1) borrowed funds and (2) prepaid interest expense (to partially offset some of winnings).  Loan proceeds were used to buy U.S. Treasury obligations to provide interest income in later year.  Current economic loss but expected tax savings:  reduced current income tax and pushing certain earnings forward.

Holding:  No §163 interest expense deduction since no non-tax purpose for the borrowing.

Winn-Dixie Stores
p.535

Deduction for interest and fees for borrowing on life insurance policies on the lives of employees?

Company owned life insurance purchased on lives of employees.  Interest expense and administrative costs vs. benefits under policies.

Tax Court says no business purpose.

11^th Circuit:  No deduction for interest and fees. No special tax statute protective status for transactions.  No real function (other than generating interest expense deductions).

Codification of Economic Substance Doctrine  p.538

§7701(o)  provides for codification of the “economic substance” doctrine.  

Transaction has “economic substance” only if transaction is changing the taxpayer’s pre-tax economic position in a meaningful manner and has a nontax goal.

Many questions remain in implementation and application of this provision.

Rules v. Standards
p.540

Better to use (1) statutory rules or (2) general judicial doctrine/standards to seek to limit tax shelters? Can IRS get “ahead of the curve” in this context?

Will the economic doctrine codification help remedy the corporate tax shelter problem?

Responsibilities of the Tax Lawyer             p.540

What is the responsibility of the tax lawyer/advisor in this context?

What responsibility is imposed on the lawyer in providing a “tax opinion”?

Note the responsibilities of the tax advisor as prescribed in U.S. Treasury Circular 230 concerning “covered opinions.”  P.541. 

What about relevance  of state bar licensing authorities?

Sale & Leaseback Transactions           p.543

Property is purchased by a high income tax bracket taxpayer and then leased to a low/zero tax bracket taxpayer.  Owner/lessor has the benefit of tax depreciation deductions, thereby reducing its income tax liability, and passes some of that tax benefit to the lessee.  

How differentiate between ownership (by nominal lessee) and a lease relationship? 

Remember Starr’s Estate case.

Alternative Minimum Tax                          p.545

An alternative tax is imposed at a reduced rate on an expanded tax base.  What origin for this tax system?  What are items which expand the relevant tax base?

Tax-exempt interest (private activity bonds)

Percentage depletion

Intangible drilling costs

R&D deducted expenses

Itemized deductions.

Klaasen v. Commr.
p.547

AMT as a violation of 1^st & 5^th Amendments to U.S. Constitution?

Here AMT limited (1) state and local taxes, (2) medical expenses, and (3) twelve personal exemptions, producing an AMT liability.

Held:  AMT liability applies.

Concurring opinion:  Correct result, but Congress needs to change AMT rules, since inequitable to apply to these taxpayers.