Chapter 13              p.783
Business & Investment

Assume an expenditure is not “personal” (the subject matter examined in Chapter 12), but business/investment related.

Is expenditure therefore immediately deductible in determining the taxpayer’s accretion to wealth?  Remembering “time value of money.”

Or, do other possible limitations apply?

Consider, e.g., that an expenditure may be made for an asset having continuing value beyond the current tax year, e.g. equipment and land.

Defining “Ordinary and Necessary”            §162           

Three possible categories of expenditures:

- Personal expense (no deduction, unless a statutory exception) - §262

Vs.

- Ordinary & Necessary Expense (current tax deduction is available) - §162

Vs.

- Extraordinary (Capital) Expense (future deductions, or frozen costs) - §263/§263A

Defining “Ordinary and Necessary”               p.783

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.785) re “life in all its fullness…”

Tellier                     p.787
Public Policy Limitation?               

Legal expenses incurred in an unsuccessful defense of a securities law criminal violation.

Deductibility of these expenses under §162?

Yes, as “ordinary and necessary,” and not required to be capitalized.

See Gilmore – what is “origin of the claim”?

But, a public policy limitation?  Not here.

Consider the Sullivan case (p. 789) allowing business expenses to a gambling operator.

Mazzei case            p.790
Counterfeiting Investor?             

Claiming theft loss for the “investment” amount lost in a fraudulent scheme purporting to enable the counterfeiting of U.S. currency.

Loss deduction claimed under §165(c)(2) or (3).

Allowance of a deduction against public policy?

Held: Here he was a co-conspirator to commit the crime of counterfeiting.  Correct result?

Loss was directly related to the illegal act. (?)

But, was this a capital investment gone bad?

Other Public Policy Deduction cases     p.796 

As noted in Sterrett dissent in Mazzei case:

Commr. v. Sullivan – deductibility of rent and wage expenses incurred in operating an illegal bookmaking operation were permitted.

Cf., Tank Truck Rentals – no deduction for fines paid for overweight trucks on highways – to allow a deduction would reduce the impact of the criminal penalty.  (No disallowance of  other transportation expenses)

Deduction, Public Policy & Statutory Limits    p.798

§162(c) – no deduction for illegal bribes and kickbacks. 

See FCPA, including re “grease payments” permitting income tax deductions.

§162(f)– no deduction for fine or similar penalty

Cf., fines paid by the “banksters”.

See §162(f) (enacted in TCJA) re amounts paid re violations of law.

§6050X - reporting by government agencies.

Deduction, Public Policy & Statutory Limits    p.798

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

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

Mt. Morris Drive-In Theatre                   p.799

Capital expenditure inquiry:  Drive-in movie construction caused water drainage onto the adjoining property.  Settlement of the dispute by agreement to construct a drainage system across the neighbor’s property.

Taxpayer claimed depreciation deduction for this cost and, then, when an IRS challenge, asserts a §162 or §165 deduction is available. 

Held: Capital expenditures (for depreciation).

Dissent:This cost does not improve the property.

Mt. Morris Drive-In Theatre, affirmed     p.802            

Federal Court of Appeals (6th Cir.) decision.

Per curiam majority:  This was a capital improvement and the case was affirmed.

Dissent:  This was merely an expense to settle a lawsuit.  Is this a payment equivalent to the payment made to a plaintiff in a tort/nuisance law suit when the settlement of litigation occurs?

Other Capitalization Issues         

Remembering the prior discussion of inventory accounting:  a requirement applies of “full absorption” accounting, i.e., direct and indirect costs are included in inventory costs for federal income tax purposes.  See §263A.

What about the capitalization of costs for non-inventory items, e.g., building and machinery and equipment?   Result: income tax deduction of the capital cost over some recovery period (or, upon eventual disposition of the property).

Idaho Power, Sup.Ct. p.803   Construction Depr.

Tax deductions were claimed for the depreciation of trucks and other equipment which were used in constructing capital assets (e.g., power stations for the electric utility). 

The allocated depreciation for these items was required to be capitalized -  this cost was being incorporated into the new capital asset (e.g., power stations).  Similar treatment for wages of personnel used for this construction project?    What treatment for book accounting purposes?

Improvements and Repairs                    p.808              

Code §263 – no deduction for “improvements or betterments” of property.

What is the difference between: 

(a) an “improvement” (capitalization), and

(b) a “repair” (enabling a current deduction)?

An improvement is (1) a betterment of the property, (2) a restoration of the property, or

(3) the adaptation of the property to a new or different use. Reg. §1.263(a)-3(d).

Treatment of Prepaid Items                       p.810      

Casualty insurance policy premium prepaid

for three years.  Boylston Market case.

2)  Prepaid rent – constitutes a purchase of a

possessory interest in the leased property.  Deferral of the deduction for rent (but the lessor can not defer the income (for tax purposes) when the cash is received).

3)  Prepaid interest expense.  See §461(g) which requires deferral.

Interest and Taxes During Construction           p.811           

Cost of borrowed money (interest) for construction funds is one of construction costs. Real estate tax is also being incurred on property during the construction phase.

See §263A(f) requiring interest expense to be subject to the uniform capitalization rules.

Therefore, these amounts are added to the tax basis of the property during construction and then later recovered through depreciation over the asset’s useful life. 

TCJA (2017) Special Rules             

No UNICAP interest capitalization rules for 2018 and 2019 for production period for beer, wine and distilled spirits. §263A(f).

Small business exception to UNICAP rules expanded to producers and resellers meeting $25 million gross receipts test.  §263A(i).

Special Statutory Treatment for Expenses           

See p. 812 examples re special deduction provisions (avoiding capitalization):

§174 – current deduction is available for research and development (R&D) expenses.

Note:  TCJA – after 2021 amortize over 5 years.

§263(c) – deduction for intangible drilling and development costs for oil & gas wells (IDCs).

Cf., §248 and 15 year amortization of corporate organizational expenditures is permitted. Why?

Indopco case & regulations              P.813

Indopco case -  investment banking fees were incurred by target corp. in a merger transaction & must be capitalized. Why incur these fees?

Basic inquiry in Indopco:  Is a “future benefit” (p. 817) to be realized from the particular expenditure?   If so, capitalization is required.  

What response to this decision and “future benefit” language?  E.g., (a) examples and (b) the Indopco regulations (p. 820).

Patton v. Commr.
P.821      (& p.825, note 4)

§162(a)(1) allows a deduction for a “reasonable allowance” for salaries. 

Here income of Kirk  (employee but not owner) increases significantly because of a bonus arrangement.  IRS says only 13x (not the 46x paid) is deductible compensation under §162.

Burden on taxpayer company (partnership) to prove reasonableness, and not proved here.

But, effective double taxation: (1) employer (no deduction) & (2) employee (all gross income).

Reasonable Compensation         p.824

§162(a)(1) provides for deduction only for “reasonable” allowance for salaries and other compensation.  What amount is (per se) too large for this purpose? 

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., a dividend to employee-shareholder)? 

What about a publicly listed company?

Special Limit - §162(m) Item 5, p.825

§162(m) limits deductible compensation for top executives of a publicly held company to $1 million per year.  Why impose such a limitation on the compensation deduction?

Note the exception to this limitation for “performance-based compensation.”  Need: (1) to establish pre-existing goals (by outside directors) and (2) shareholders approve plan.

Note even lower limits for TARP banks, etc.  §162(m)(5).

Special Limit - §162(m) Item 5, p.825, continued

§162(m) expanded in TCJA (2017):

Expansion of covered employees.

Performance based compensation is made subject to $1 million deduction limitation.

Expansion  of the definition of a “publicly-

      held corporation”

Estate of Rockefeller
p.826    

Deduction claimed for his expenses for U.S. Congressional review of his nomination to be VP (for Pres. Gerald Ford).  Were these deductible (under §162(a)) as “ordinary and necessary” expenses in carrying on a trade or business?  Is a “public servant” engaged in a “trade or business”?

What was this taxpayer’s trade or business (defined expansively or narrowly)? 

What relevance of a gap in his public service?

Other Employment Expenses

Current deduction for “headhunter” expense?

Alternative:   Capitalize the headhunter expense and amortize this cost over some period (e.g., 15 years – see §195)?

Alternative:  For politicians/judges, etc. -  contributions to public government and §170 (charitable deduction) deduction?

Expenses (Away from Home) of Legislators

P. 834

§162(a) (flush language) - $3,000 limit for U.S. Congress members (repealed TCJA 2017).

§162(h) – expenses of state legislators are deductible.

Other Employment Expenses

E.g., is the cost incurred for a “headhunter” by an individual seeking employment deductible under §162?   Tax Court agrees.  See p. 829.

Or, is this expenditure required to be capitalized if actually finding a job?

If capitalized, possible amortization of this cost (and, if so, over what time period)?

See §195 re amortization of start-up expenses.