Deductions: Business Expenses

Chapter 6



Deductions: Business Expenses


Our income tax system taxes only “net income.” Hence it is important that the Code incorporate principles that prevent taxing as income the expenses of deriving that income. Section 162 provides a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business[.]” Read § 162(a).




The Tax Formula:


(gross income)


MINUS deductions named in § 62


EQUALS (adjusted gross income (AGI))


MINUS (standard deduction or → itemized deductions)


MINUS (personal exemptions)


EQUALS (taxable income)


Compute income tax liability from tables in § 1 (indexed for inflation)


MINUS (credits against tax)





The Code does not provide a definition of “trade or business.”81 The Supreme Court observed the following when it held that a full-time gambler was engaged in a “trade or business:”



Of course, not every income-producing and profit-making endeavor constitutes a trade or business. The income tax law, almost from the beginning, has distinguished between a business or trade, on the one hand, and “transactions entered into for profit but not connected with … business or trade,” on the other. See Revenue Act of 1916, § 5(a), Fifth, 39 Stat. 759. Congress “distinguished the broad range of income or profit producing activities from those satisfying the narrow category of trade or business.” We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.82



This excerpt informs that there is a distinction between a “trade or business” and “transactions entered into for profit but not connected with” a trade or business. For most taxpayers, investing fits this description. Moreover, there is another distinction between a “trade or business” and a hobby or amusement. The Code limits deductions for an activity “not engaged in for profit” to the gross income derived from the activity.83



Congress extended the principles of § 162(a) to “expenses for the production of income” when it added § 212 to the Code. However, expenses for the production of income – as contrasted with a trade or business – are not deductible “above the line.” § 62(a)(1). In addition, § 163(a) allows a deduction for interest paid or accrued. Section 165(a) allows a deduction for losses.


Section 162 allows a deduction only for expenses of “carrying on” a trade or business. Hence, the costs of searching for a business to purchase, pre-opening organization costs, etc. are not deductible. § 195. On the other hand, an existing business that incurs the same expenses in order to expand its business may deduct them. Whether an existing business is seeking merely to expand or to enter a new trade or business “depends on the facts and circumstances of each case.”84



Taxpayer may purchase an input that enables him/her/it to earn income and immediately consume that item in the production of taxable income. We would expect that such expenditures would be immediately deductible in full. We sometimes call this treatment “expensing.”


Alternatively, taxpayer may purchase an input that enables him/her/it to earn income for more than the current tax year. For example, taxpayer might purchase a machine that will enable him/her/it to generate income for the next ten years. Taxpayer has made an “investment” rather than an expenditure on an item that he/she/it immediately consumes. A mere change in the form in which taxpayer holds wealth is not a taxable event; we implement this principle by crediting taxpayer with basis equal to the money removed from his/her/its store of property rights in order to make the investment (i.e., purchase). Taxpayer (might) then consume only a part of the item that he/she/it purchased in order to generate income, i.e., to “de-invest” it. The Code implements in several places a scheme that (theoretically) matches such consumption with the income that the expenditure actually generates. The Code permits a deduction for such partial consumption under the headings of depreciation, amortization, or more recently, cost recovery. Since such consumption represents a deinvestment, taxpayer must adjust his/her/its basis in the productive asset downward. We sometimes call this tax treatment of the purchase and use of a productive asset “capitalization.”


• The Code also implements such a matching principle when taxpayer derives gross income by selling from inventory. Taxpayer may not build up deductions by purchasing inventory in advance of the time he/she/it actually makes sales.


Yet another possibility is that taxpayer may purchase an input that enables him/her/it to produce income but never in fact consumes that input, e.g., land. There should logically be no deduction – immediately or in the future – for such expenditures. Taxpayer will have a basis in such an asset, but could only recover it for income purposes upon sale of the asset. Some of these assets may not even be capable of sale, e.g., a legal education or other investments in human capital. We sometimes also call this tax treatment of the purchase and use of such an asset “capitalization.”


Both the Commissioner and taxpayers are aware of the time value of money. For this reason, taxpayer usually wants to classify purchases of inputs that enable him/her/it to generate income in a manner that permits the greatest immediate deduction. The Commissioner of course wants the opposite result.


In the materials ahead, we very roughly consider first the placement of particular expenditures into one group or another – whether expense or capital. We then consider some of the basic principles and recurring issues in each of these groups.


I. Expense or Capital



The following cases involve the proper treatment of particular expenditures to purchase income-producing assets – whether immediately deductible, deductible over their useful life, or not deductible because taxpayer never consumes the item.


Welch v. Helvering, 290 U.S. 114 (1933)



MR. JUSTICE CARDOZO delivered the opinion of the Court.


The question to be determined is whether payments by a taxpayer, who is in business as a commission agent, are allowable deductions in the computation of his income if made to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit.


In 1922, petitioner was the secretary of the E.L. Welch Company, a Minnesota corporation, engaged in the grain business. The company was adjudged an involuntary bankrupt, and had a discharge from its debts. Thereafter the petitioner made a contract with the Kellogg Company to purchase grain for it on a commission. In order to reestablish his relations with customers whom he had known when acting for the Welch Company and to solidify his credit and standing, he decided to pay the debts of the Welch business so far as he was able. In fulfillment of that resolve, he made payments of substantial amounts during five successive years. … The Commissioner ruled that these payments were not deductible from income as ordinary and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the development of reputation and goodwill. The Board of Tax Appeals sustained the action of the Commissioner and the Court of Appeals for the Eighth Circuit affirmed. The case is here on certiorari. …


We may assume that the payments to creditors of the Welch Company were necessary for the development of the petitioner’s business, at least in the sense that they were appropriate and helpful. [citation omitted]. He certainly thought they were, and we should be slow to override his judgment. But the problem is not solved when the payments are characterized as necessary. Many necessary payments are charges upon capital. There is need to determine whether they are both necessary and ordinary. Now, what is ordinary, though there must always be a strain of constancy within it, is nonetheless a variable affected by time and place and circumstance. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. Cf. Kornhauser v. United States, 276 U.S. 145. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part. At such times, there are norms of conduct that help to stabilize our judgment, and make it certain and objective. The instance is not erratic, but is brought within a known type.


The line of demarcation is now visible between the case that is here and the one supposed for illustration. We try to classify this act as ordinary or the opposite, and the norms of conduct fail us. No longer can we have recourse to any fund of business experience, to any known business practice. Men do at times pay the debts of others without legal obligation or the lighter obligation imposed by the usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity and opulence. Indeed, if language is to be read in its natural and common meaning [citations omitted], we should have to say that payment in such circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in the stimulus evoking it, and none in the response. Here, indeed, as so often in other branches of the law, the decisive distinctions are those of degree, and not of kind. One struggles in vain for any verbal formula that will supply a ready touchstone. The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle.


The Commissioner of Internal Revenue resorted to that standard in assessing the petitioner’s income, and found that the payments in controversy came closer to capital outlays than to ordinary and necessary expenses in the operation of a business. His ruling has the support of a presumption of correctness, and the petitioner has the burden of proving it to be wrong. [citations omitted]. Unless we can say from facts within our knowledge that these are ordinary and necessary expenses according to the ways of conduct and the forms of speech prevailing in the business world, the tax must be confirmed. But nothing told us by this record or within the sphere of our judicial notice permits us to give that extension to what is ordinary and necessary. Indeed, to do so would open the door to many bizarre analogies. One man has a family name that is clouded by thefts committed by an ancestor. To add to his own standing he repays the stolen money, wiping off, it may be, his income for the year. The payments figure in his tax return as ordinary expenses. Another man conceives the notion that he will be able to practice his vocation with greater ease and profit if he has an opportunity to enrich his culture. Forthwith the price of his education becomes an expense of the business, reducing the income subject to taxation. There is little difference between these expenses and those in controversy here. Reputation and learning are akin to capital assets, like the goodwill of an old partnership. [citation omitted]. For many, they are the only tools with which to hew a pathway to success. The money spent in acquiring them is well and wisely spent. It is not an ordinary expense of the operation of a business.


Many cases in the federal courts deal with phases of the problem presented in the case at bar. To attempt to harmonize them would be a futile task. They involve the appreciation of particular situations at times with border-line conclusions. Typical illustrations are cited in the margin.85



The decree should be




Notes and Questions:


1. With this case, if not before, the word “ordinary” as used in the phrase “ordinary and necessary” provides a line of demarcation between expenditures currently deductible and those that are either never deductible or deductible only over time, i.e., through depreciation or amortization allowances.


• Since the expenses were not “ordinary,” the next question is whether taxpayer could deduct them over time through depreciation or amortization.


• What should be relevant in making this determination?


• Do you think that the expenses in Welch v. Helvering should be recoverable through depreciation or amortization allowances?


• In the second paragraph of the Court’s footnote, the Court cited several cases. Which expenditures should taxpayer be able to deduct as depreciation or amortization, and which should taxpayer not be able deduct at all – probably ever?


2. Consider these three rationales of the Court’s opinion: the expenditures were too personal to be deductible, were too bizarre to be ordinary, and were capital so not deductible.


• Personal: Welch felt a moral obligation, as many in Minnesota in such circumstances did at the time, to pay the corporation’s debts. In fact, Welch repaid the debts on the advice of bankers. This would seem to make business the motivation for repaying these debts.


• Bizarre: Others in Minnesota had done exactly the same thing, i.e., repay the debts of a bankrupt predecessor.


• Capital: The expenditures were no doubt capital in nature. However, they were arguably only an investment designed to generate income for a finite period of time. As such, the expenditures should be depreciable or amortizable.


See Joel S. Newman, The Story of Welch: The Use (and Misuse) of the “Ordinary and Necessary” Test for Deducting Business Expenses, in Tax Stories 197-224 (Paul Caron ed., 2d ed. 2009).


3. What should be the tax consequences of making payments to create goodwill? What should be the tax consequences of maintaining or repairing goodwill?


4. By paying the debts of a bankrupt, no-longer-in-existence corporation, was Thomas Welch trying to create goodwill or to maintain or repair it? Whose goodwill?


• Consider: Conway Twitty (actually Harold Jenkins) is a famous country music singer. He formed a chain of fast food restaurants (“Twitty Burger, Inc.”). He persuaded seventy-five friends in the country music business to invest with him. The venture failed. Twitty was concerned about the effect of the adverse publicity on his country music career. He repaid the investors himself.


• If Twitty were trying to protect the reputation of Twitty Burger, the expenditures would surely have been nondeductible. Twitty Burger after all was defunct.


• The court found as a fact that one’s reputation in the country music business is very important.


• Deductible? See Harold L. Jenkins v. Commissioner, T.C. Memo 1983-667, 1983 WL 14653.


5. What should be the tax treatment of expenditures incurred to acquire property that has an indefinite useful life?


Woodward v. Commissioner, 397 U.S. 572 (1970)



MR. JUSTICE MARSHALL delivered the opinion of the Court.




Taxpayers owned or controlled a majority of the common stock of the Telegraph-Herald, an Iowa publishing corporation. The Telegraph-Herald was incorporated in 1901, and its charter was extended for 20-year periods in 1921 and 1941. On June 9, 1960, taxpayers voted their controlling share of the stock of the corporation in favor of a perpetual extension of the charter. A minority stockholder voted against the extension. Iowa law requires “those stockholders voting for such renewal … [to] purchase at its real value the stock voted against such renewal.” Iowa Code § 491.25 (1966).


Taxpayers attempted to negotiate purchase of the dissenting stockholder’s shares, but no agreement could be reached on the “real value” of those shares. Consequently, in 1962, taxpayers brought an action in state court to appraise the value of the minority stock interest. The trial court fixed a value, which was slightly reduced on appeal by the Iowa Supreme Court, [citations omitted]. In July, 1965, taxpayers purchased the minority stock interest at the price fixed by the court.


During 1963, taxpayers paid attorneys’, accountants’, and appraisers’ fees of over $25,000, for services rendered in connection with the appraisal litigation. On their 1963 federal income tax returns, taxpayers claimed deductions for these expenses, asserting that they were “ordinary and necessary expenses paid … for the management, conservation, or maintenance of property held for the production of income” deductible under § 212 … The Commissioner of Internal Revenue disallowed the deduction “because the fees represent capital expenditures incurred in connection with the acquisition of capital stock of a corporation.” The Tax Court sustained the Commissioner’s determination, with two dissenting opinions, and the Court of Appeals affirmed. We granted certiorari to resolve the conflict over the deductibility of the costs of appraisal proceedings between this decision and the decision of the Court of Appeals for the Seventh Circuit in United States v. Hilton Hotels Corp., [397 U.S. 580 (1970)].86 We affirm.



Since the inception of the present federal income tax in 1913, capital expenditures have not been deductible. See § 263. Such expenditures are added to the basis of the capital asset with respect to which they are incurred, and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is sold. If an expense is capital, it cannot be deducted as “ordinary and necessary,” either as a business expense under § 162 of the Code or as an expense of “management, conservation, or maintenance” under § 212.87



It has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures. The most familiar example of such treatment is the capitalization of brokerage fees for the sale or purchase of securities, as explicitly provided by a longstanding Treasury regulation, Reg. § 1.263(a)-2(e), and as approved by this Court in Helvering v. Winmill, 305 U.S. 79 (1938), and Spreckels v. Commissioner, 315 U.S. 626 (1942). The Court recognized that brokers’ commissions are “part of the acquisition cost of the securities,” Helvering v. Winmill, supra, at 305 U.S. 84, and relied on the Treasury regulation, which had been approved by statutory reenactment, to deny deductions for such commissions even to a taxpayer for whom they were a regular and recurring expense in his business of buying and selling securities.


The regulations do not specify other sorts of acquisition costs, but rather provide generally that “[t]he cost of acquisition … of … property having a useful life substantially beyond the taxable year” is a capital expenditure. Reg. § 1.263(a)-2(a). Under this general provision, the courts have held that legal, brokerage, accounting, and similar costs incurred in the acquisition or disposition of such property are capital expenditures. See, e.g., Spangler v. Commissioner, 323 F.2d 913, 921 (C.A. 9th Cir.1963); United States v. St. Joe Paper Co., 284 F.2d 430, 432 (C.A. 5th Cir.1960). [citation omitted]. The law could hardly be otherwise, for such ancillary expenses incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it.


More difficult questions arise with respect to another class of capital expenditures, those incurred in “defending or perfecting title to property.” Reg. § 1.263(a)-2(c). In one sense, any lawsuit brought against a taxpayer may affect his title to property – money or other assets subject to lien. The courts, not believing that Congress meant all litigation expenses to be capitalized, have created the rule that such expenses are capital in nature only where the taxpayer’s “primary purpose” in incurring them is to defend or perfect title. See, e.g., Rassenfoss v. Commissioner, 158 F.2d 764 (C.A. 7th Cir.1946); Industrial Aggregate Co. v. United States, 284 F.2d 639, 645 (C.A. 8th Cir.1960). This test hardly draws a bright line, and has produced a melange of decisions which, as the Tax Court has noted, “[i]t would be idle to suggest … can be reconciled.” Ruoff v. Commissioner, 30 T.C. 204, 208 (1958).


Taxpayers urge that this “primary purpose” test, developed in the context of cases involving the costs of defending property, should be applied to costs incurred in acquiring or disposing of property as well. And if it is so applied, they argue, the costs here in question were properly deducted, since the legal proceedings in which they were incurred did not directly involve the question of title to the minority stock, which all agreed was to pass to taxpayers, but rather was concerned solely with the value of that stock.


We agree with the Tax Court and the Court of Appeals that the “primary purpose” test has no application here. That uncertain and difficult test may be the best that can be devised to determine the tax treatment of costs incurred in litigation that may affect a taxpayer’s title to property more or less indirectly, and that thus calls for a judgment whether the taxpayer can fairly be said to be “defending or perfecting title.” Such uncertainty is not called for in applying the regulation that makes the “cost of acquisition” of a capital asset a capital expense. In our view, application of the latter regulation to litigation expenses involves the simpler inquiry whether the origin of the claim litigated is in the process of acquisition itself.


A test based upon the taxpayer’s “purpose” in undertaking or defending a particular piece of litigation would encourage resort to formalism and artificial distinctions. For instance, in this case, there can be no doubt that legal, accounting, and appraisal costs incurred by taxpayers in negotiating a purchase of the minority stock would have been capital expenditures. See Atzingen-Whitehouse Dairy Inc. v. Commissioner, 36 T.C. 173 (1961). Under whatever test might be applied, such expenses would have clearly been “part of the acquisition cost” of the stock. Helvering v. Winmill, supra. Yet the appraisal proceeding was no more than the substitute that state law provided for the process of negotiation as a means of fixing the price at which the stock was to be purchased. Allowing deduction of expenses incurred in such a proceeding, merely on the ground that title was not directly put in question in the particular litigation, would be anomalous.


Further, a standard based on the origin of the claim litigated comports with this Court’s recent ruling on the characterization of litigation expenses for tax purposes in United States v. Gilmore, 372 U.S. 39 (1963). This Court there held that the expense of defending a divorce suit was a nondeductible personal expense, even though the outcome of the divorce case would affect the taxpayer’s property holdings, and might affect his business reputation. The Court rejected a test that looked to the consequences of the litigation, and did not even consider the taxpayer’s motives or purposes in undertaking defense of the litigation, but rather examined the origin and character of the claim against the taxpayer, and found that the claim arose out of the personal relationship of marriage.


The standard here pronounced may, like any standard, present borderline cases, in which it is difficult to determine whether the origin of particular litigation lies in the process of acquisition. This is not such a borderline case. Here state law required taxpayers to “purchase” the stock owned by the dissenter. In the absence of agreement on the price at which the purchase was to be made, litigation was required to fix the price. Where property is acquired by purchase, nothing is more clearly part of the process of acquisition than the establishment of a purchase price.88 Thus, the expenses incurred in that litigation were properly treated as part of the cost of the stock that the taxpayers acquired.





Notes and Questions:


1. Will taxpayers be permitted to claim depreciation or amortization deductions for the expenditures in question? Why or why not?




Start-up Expenses of a Business: No deduction is permitted for the start-up expenses of a proprietorship (§ 195), corporation (§ 248), or partnership (§ 709) – except as specifically provided. What would be the rationale of this treatment?





2. M owned certain real estate in Memphis, Tennessee. In 2011, M entered into contracts to lease the properties for a term of fifty years, and in 2011 paid commissions and fees to a real estate broker and attorney for services in obtaining the contracts.


• For tax purposes, how should M treat the real estate brokerage commissions?


See Renwick v. United States, 87 F.2d 123, 125 (7th Cir. 1936); Meyran v. Commissioner, 63 F.2d 986 (3rd Cir. 1933).


3. S owned stock in several different companies. He sold 100 shares of IBM stock for a nice profit and incurred a brokerage commission of $500. For tax purposes, how should S treat the brokerage commissions?


• Does it make any difference whether S treats the brokerage commission as an ordinary and necessary expense of investment activity or as a decrease in his “amount realized?”


See Spreckels v. Commissioner, 315 U.S. 626 (1942).


4. W purchased the IBM stock that S sold, supra. W incurred a brokerage commission of $500. For tax purposes, how should W treat the brokerage commissions?


• Does it make any difference whether W treats the brokerage commission as an ordinary and necessary expense of investment activity or as an increase in his basis?


See Helvering v. Winmill, 305 U.S. 79 (1938).


A. Expense or Capital: Cost of Constructing a Tangible Capital Asset



What should be the tax treatment of the cost of taxpayer’s self-construction of a productive asset for it to use in its own business? Should there be a parallel between such activity and the tax treatment we accord imputed income?


Commissioner v. Idaho Power Co., 418 U.S. 1 (1974)



MR. JUSTICE BLACKMUN delivered the opinion of the Court.


This case presents the sole issue whether, for federal income tax purposes, a taxpayer is entitled to a deduction from gross income, under [I.R.C.] § 167(a) …89 … for depreciation on equipment the taxpayer owns and uses in the construction of its own capital facilities, or whether the capitalization provision of § 263(a)(1) of the Code90 …, bars the deduction.



The taxpayer claimed the deduction, but the Commissioner … disallowed it. The Tax Court … upheld the Commissioner’s determination. The United States Court of Appeals for the Ninth Circuit, declining to follow a Court of Claims decision, Southern Natural Gas Co. v. United States, 412 F.2d 1222, 1264-1269 (1969), reversed. We granted certiorari in order to resolve the apparent conflict between the Court of Claims and the Court of Appeals.




… The taxpayer-respondent, Idaho Power Company, … is a public utility engaged in the production, transmission, distribution, and sale of electric energy. The taxpayer keeps its books and files its federal income tax returns on the calendar year accrual basis. The tax years at issue are 1962 and 1963.


For many years, the taxpayer has used its own equipment and employees in the construction of improvements and additions to its capital facilities. . The major work has consisted of transmission lines, transmission switching stations, distribution lines, distribution stations, and connecting facilities.


During 1962 and 1963, the tax years in question, taxpayer owned and used in its business a wide variety of automotive transportation equipment, including passenger cars, trucks of all descriptions, power-operated equipment, and trailers. Radio communication devices were affixed to the equipment, and were used in its daily operations. The transportation equipment was used in part for operation and maintenance and in part for the construction of capital facilities having a useful life of more than one year.




… [O]n its books, in accordance with Federal Power Commission-Idaho Public Utilities Commission prescribed methods, the taxpayer capitalized the construction-related depreciation, but, for income tax purposes, that depreciation increment was [computed on a composite life of ten years under straight-line and declining balance methods, and] claimed as a deduction under § 167(a).


Upon audit, the Commissioner … disallowed the deduction for the construction-related depreciation. He ruled that that depreciation was a nondeductible capital expenditure to which § 263(a)(1) had application. He added the amount of the depreciation so disallowed to the taxpayer’s adjusted basis in its capital facilities, and then allowed a deduction for an appropriate amount of depreciation on the addition, computed over the useful life (30 years or more) of the property constructed. A deduction for depreciation of the transportation equipment to the extent of its use in day-to-day operation and maintenance was also allowed. The result of these adjustments was the disallowance of depreciation, as claimed by the taxpayer on its returns, in the net amounts of $140,429.75 and $96,811.95 for 1962 and 1963, respectively. This gave rise to asserted deficiencies in taxpayer’s income taxes for those two years of $73,023.47 and $50,342.21.


The Tax Court agreed with the [Commissioner.] …


The Court of Appeals, on the other hand, perceived in the … Code … the presence of a liberal congressional policy toward depreciation, the underlying theory of which is that capital assets used in business should not be exhausted without provision for replacement. The court concluded that a deduction expressly enumerated in the Code, such as that for depreciation, may properly be taken, and that “no exception is made should it relate to a capital item.” Section 263(a)(1) … was found not to be applicable, because depreciation is not an “amount paid out,” as required by that section. …


The taxpayer asserts that its transportation equipment is used in its “trade or business,” and that depreciation thereon is therefore deductible under § 167(a)(1) … The Commissioner concedes that § 167 may be said to have a literal application to depreciation on equipment used in capital construction,91 but contends that the provision must be read in light of § 263(a)(1), which specifically disallows any deduction for an amount “paid out for new buildings or for permanent improvements or betterments.” He argues that § 263 takes precedence over § 167 by virtue of what he calls the “priority-ordering” terms (and what the taxpayer describes as “housekeeping” provisions) of § 161 of the Code92 … and that sound principles of accounting and taxation mandate the capitalization of this depreciation.



It is worth noting the various items that are not at issue here. … There is no disagreement as to the allocation of depreciation between construction and maintenance. The issue thus comes down primarily to a question of timing, … that is, whether the construction-related depreciation is to be amortized and deducted over the shorter life of the equipment or, instead, is to be amortized and deducted over the longer life of the capital facilities constructed.




Our primary concern is with the necessity to treat construction-related depreciation in a manner that comports with accounting and taxation realities. Over a period of time, a capital asset is consumed and, correspondingly over that period, its theoretical value and utility are thereby reduced. Depreciation is an accounting device which recognizes that the physical consumption of a capital asset is a true cost, since the asset is being depleted.93 As the process of consumption continues, and depreciation is claimed and allowed, the asset’s adjusted income tax basis is reduced to reflect the distribution of its cost over the accounting periods affected. The Court stated in Hertz Corp. v. United States, 364 U.S. 122, 126 (1960): [T]he purpose of depreciation accounting is to allocate the expense of using an asset to the various periods which are benefited by that asset. [citations omitted]. When the asset is used to further the taxpayer’s day-to-day business operations, the periods of benefit usually correlate with the production of income. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. It is clear, however, that different principles are implicated when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves. In this latter situation, the cost represented by depreciation does not correlate with production of current income. Rather, the cost, although certainly presently incurred, is related to the future and is appropriately allocated as part of the cost of acquiring an income-producing capital asset.



The Court of Appeals opined that the purpose of the depreciation allowance under the Code was to provide a means of cost recovery, Knoxville v. Knoxville Water Co., 212 U.S. 1, 13-14 (1909), and that this Court’s decisions, e.g., Detroit Edison Co. v. Commissioner, 319 U.S. 98, 101 (1943), endorse a theory of replacement through “a fund to restore the property.” Although tax-free replacement of a depreciating investment is one purpose of depreciation accounting, it alone does not require the result claimed by the taxpayer here. Only last Term, in United States v. Chicago, B. & Q. R. Co., 412 U.S. 401 (1973), we rejected replacement as the strict and sole purpose of depreciation:


“Whatever may be the desirability of creating a depreciation reserve under these circumstances, as a matter of good business and accounting practice, the answer is … [depreciation] reflects the cost of an existing capital asset, not the cost of a potential replacement.” Id. at 415.


Even were we to look to replacement, it is the replacement of the constructed facilities, not the equipment used to build them, with which we would be concerned. If the taxpayer now were to decide not to construct any more capital facilities with its own equipment and employees, it, in theory, would have no occasion to replace its equipment to the extent that it was consumed in prior construction.


Accepted accounting practice94 and established tax principles require the capitalization of the cost of acquiring a capital asset. In Woodward v. Commissioner, 397 U.S. 572, 575 (1970), the Court observed: “It has long been recognized, as a general matter, that costs incurred in the acquisition … of a capital asset are to be treated as capital expenditures.” This principle has obvious application to the acquisition of a capital asset by purchase, but it has been applied, as well, to the costs incurred in a taxpayer’s construction of capital facilities. [citations omitted].



There can be little question that other construction-related expense items, such as tools, materials, and wages paid construction workers, are to be treated as part of the cost of acquisition of a capital asset. The taxpayer does not dispute this. Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. § 162(a)(1) … But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized, and are then entitled to be amortized over the life of the capital asset so acquired. [citations omitted].


Construction-related depreciation is not unlike expenditures for wages for construction workers. The significant fact is that the exhaustion of construction equipment does not represent the final disposition of the taxpayer’s investment in that equipment; rather, the investment in the equipment is assimilated into the cost of the capital asset constructed. Construction-related depreciation on the equipment is not an expense to the taxpayer of its day-to-day business. It is, however, appropriately recognized as a part of the taxpayer’s cost or investment in the capital asset. … By the same token, this capitalization prevents the distortion of income that would otherwise occur if depreciation properly allocable to asset acquisition were deducted from gross income currently realized. [citations omitted].


An additional pertinent factor is that capitalization of construction-related depreciation by the taxpayer who does its own construction work maintains tax parity with the taxpayer who has its construction work done by an independent contractor. The depreciation on the contractor’s equipment incurred during the performance of the job will be an element of cost charged by the contractor for his construction services, and the entire cost, of course, must be capitalized by the taxpayer having the construction work performed. The Court of Appeals’ holding would lead to disparate treatment among taxpayers, because it would allow the firm with sufficient resources to construct its own facilities and to obtain a current deduction, whereas another firm without such resources would be required to capitalize its entire cost, including depreciation charged to it by the contractor.




[Taxpayer argued that the language of § 263(a)(1), which denies a current deduction for “new buildings or for permanent improvements or betterments,” only applies when taxpayer has “paid out” an “amount.” Depreciation, taxpayer argued, represented a decrease in value – not an “amount … paid out.” The Court rejected this limitation on § 263’s applicability. Instead, the Court accepted the IRS’s administrative construction of that phrase to mean “cost incurred.” Construction-related depreciation is such a cost.] In acquiring the transportation equipment, taxpayer “paid out” the equipment’s purchase price; depreciation is simply the means of allocating the payment over the various accounting periods affected. As the Tax Court stated in Brooks v. Commissioner, 50 T.C. at 935, “depreciation – inasmuch as it represents a using up of capital – is as much an expenditure’ as the using up of labor or other items of direct cost.”


Finally, the priority-ordering directive of § 161 – or, for that matter, … § 26195 – requires that the capitalization provision of § 263(a) take precedence, on the facts here, over § 167(a). Section 161 provides that deductions specified in Part VI of Subchapter B of the Income Tax Subtitle of the Code are “subject to the exceptions provided in part IX.” Part VI includes § 167, and Part IX includes § 263. The clear import of § 161 is that, with stated exceptions set forth either in § 263 itself or provided for elsewhere (as, for example, in § 404, relating to pension contributions), none of which is applicable here, an expenditure incurred in acquiring capital assets must be capitalized even when the expenditure otherwise might be deemed deductible under Part VI.



The Court of Appeals concluded, without reference to § 161, that § 263 did not apply to a deduction, such as that for depreciation of property used in a trade or business, allowed by the Code even though incurred in the construction of capital assets. We think that the court erred in espousing so absolute a rule, and it obviously overlooked the contrary direction of § 161. To the extent that reliance was placed on the congressional intent, in the evolvement of the 1954 Code, to provide for “liberalization of depreciation,” H.R. Rep. No. 1337, 83d Cong., 2d Sess., 22 (1954), that reliance is misplaced. The House Report also states that the depreciation provisions would “give the economy added stimulus and resilience without departing from realistic standards of depreciation accounting.” Id. at 24. To be sure, the 1954 Code provided for new and accelerated methods for depreciation, resulting in the greater depreciation deductions currently available. These changes, however, relate primarily to computation of depreciation. Congress certainly did not intend that provisions for accelerated depreciation should be construed as enlarging the class of depreciable assets to which § 167(a) has application or as lessening the reach of § 263(a). [citation omitted].


We hold that the equipment depreciation allocable to taxpayer’s construction of capital facilities is to be capitalized.


The judgment of the Court of Appeals is reversed.


It is so ordered.


MR. JUSTICE DOUGLAS, dissenting. [omitted].


Notes and Questions:


1. The Court noted that the net of taxpayer’s disallowed depreciation deductions were $140,429.75 and $96,811.95 for 1962 and 1963 respectively. The useful life of the items that taxpayer was constructing was three or more times as long as the useful life of the equipment it used to construct those items. This case is about the fraction of the figures noted here that taxpayer may deduct – after the item is placed in service.




Taxpayer’s books and taxpayer’s tax books: Distinguish between taxpayer’s books (“its books”) and taxpayer’s tax books (“for federal income tax purposes”). For what purposes does taxpayer keep each set of books? Do you think that they would ever be different? Why or why not?





2. Why do we allow deductions for depreciation? Is it that –


• “capital assets used in business should not be exhausted without provision for replacement”?


• physical consumption of a capital asset reduces its value and utility and allowing a depreciation deduction is implicit recognition of this fact?


• obsolescence may reduce the usefulness of an asset, even if the asset could still function, e.g., a twenty-year old personal computer? See the Court’s fifth footnote.


• it is necessary “to allocate the expense of using an asset to the various periods which are benefitted by that asset”?


• How does your view of depreciation apply to a case where taxpayer consumes depreciable assets in the construction of income-producing capital assets?


3. Aside from the Code’s mandate in § 1016(a)(2), why must a taxpayer reduce its adjusted basis in an asset subject to depreciation?




Sections 161 and 261: How does the language of §§ 161 and 261 create an ordering rule? What deductions do §§ 262 to 280H create?





4. How did the Court’s treatment of depreciation in this case prevent the distortion of income?


5. The case demonstrates again how important the time value of money is.


6. Why might Congress want to mismatch the timing of income and expenses and thereby distort income?


B. Expense or Capital: Cost of “Constructing” an Intangible Capital Asset



What should be the rule when taxpayer self-creates an intangible asset that it can use to generate taxable income? Are there any (obvious) difficulties to applying the rule of Idaho Power to such a situation? Identify what taxpayer in INDOPCO argued was the rule of Lincoln Savings? Would taxpayer’s statement of that rule solve those difficulties?


INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992)



JUSTICE BLACKMUN delivered the opinion of the Court.


In this case we must decide whether certain professional expenses incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as “ordinary and necessary” business expenses under § 162(a) of the Internal Revenue Code.




… Petitioner INDOPCO, Inc., formerly named National Starch and Chemical Corporation and hereinafter referred to as National Starch, … manufactures and sells adhesives, starches, and specialty chemical products. In October 1977, representatives of Unilever United States, Inc., … (Unilever), expressed interest in acquiring National Starch, which was one of its suppliers, through a friendly transaction. National Starch at the time had outstanding over 6,563,000 common shares held by approximately 3,700 shareholders. The stock was listed on the New York Stock Exchange. Frank and Anna Greenwall were the corporation’s largest shareholders and owned approximately 14.5% of the common. The Greenwalls, getting along in years and concerned about their estate plans, indicated that they would transfer their shares to Unilever only if a transaction tax free for them could be arranged.


Lawyers representing both sides devised a “reverse subsidiary cash merger” that they felt would satisfy the Greenwalls’ concerns. Two new entities would be created – National Starch and Chemical Holding Corp. (Holding), a subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Holding that would have only a transitory existence. …


In November 1977, National Starch’s directors were formally advised of Unilever’s interest and the proposed transaction. At that time, Debevoise, Plimpton, Lyons & Gates, National Starch’s counsel, told the directors that under Delaware law they had a fiduciary duty to ensure that the proposed transaction would be fair to the shareholders. National Starch thereupon engaged the investment banking firm of Morgan Stanley & Co., Inc., to evaluate its shares, to render a fairness opinion, and generally to assist in the event of the emergence of a hostile tender offer.


Although Unilever originally had suggested a price between $65 and $70 per share, negotiations resulted in a final offer of $73.50 per share, a figure Morgan Stanley found to be fair. Following approval by National Starch’s board and the issuance of a favorable private ruling from the Internal Revenue Service that the transaction would be tax free … for those National Starch shareholders who exchanged their stock for Holding preferred, the transaction was consummated in August 1978.96



Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket expenses and $18,000 for legal fees. The Debevoise firm charged National Starch $490,000, along with $15,069 for out-of-pocket expenses. National Starch also incurred expenses aggregating $150,962 for miscellaneous items – such as accounting, printing, proxy solicitation, and Securities and Exchange Commission fees – in connection with the transaction. No issue is raised as to the propriety or reasonableness of these charges.


On its federal income tax return … National Starch claimed a deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to Debevoise or the other expenses. Upon audit, the Commissioner of Internal Revenue disallowed the claimed deduction and issued a notice of deficiency. Petitioner sought redetermination in the United States Tax Court, asserting, however, not only the right to deduct the investment banking fees and expenses but, as well, the legal and miscellaneous expenses incurred.


The Tax Court, in an unreviewed decision, ruled that the expenditures were capital in nature and therefore not deductible under § 162(a) in the 1978 return as “ordinary and necessary expenses.” The court based its holding primarily on the long-term benefits that accrued to National Starch from the Unilever acquisition. The United States Court of Appeals for the Third Circuit affirmed, upholding the Tax Court’s findings that “both Unilever’s enormous resources and the possibility of synergy arising from the transaction served the long-term betterment of National Starch.” In so doing, the Court of Appeals rejected National Starch’s contention that, because the disputed expenses did not “create or enhance … a separate and distinct additional asset,” see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354 (1971), they could not be capitalized and therefore were deductible under § 162(a). We granted certiorari to resolve a perceived conflict on the issue among the Courts of Appeals.97





Section 162(a) … allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” In contrast, § 263 … allows no deduction for a capital expenditure – an “amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.” § 263(a)(1). The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer’s cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See 26 U.S.C. §§ 167(a) and 336(a); Reg. § 1.167(a) (1991). Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. See, e. g., Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 (CA ll 1982), cert. denied, 463 U.S. 1207 (1983).


In exploring the relationship between deductions and capital expenditures, this Court has noted the “familiar rule” that “an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer.” Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The notion that deductions are exceptions to the norm of capitalization finds support in various aspects of the Code. Deductions are specifically enumerated and thus are subject to disallowance in favor of capitalization. See §§ 161 and 261. Nondeductible capital expenditures, by contrast, are not exhaustively enumerated in the Code; rather than providing a “complete list of nondeductible expenditures,” Lincoln Savings, 403 U.S. at 358, § 263 serves as a general means of distinguishing capital expenditures from current expenses. See Commissioner v. Idaho Power Co., 418 U.S. at 16. For these reasons, deductions are strictly construed and allowed only “as there is a clear provision therefor.” New Colonial Ice Co. v. Helvering, 292 U.S., at 440; Deputy v. Du Pont, 308 U.S., at 493.


The Court also has examined the interrelationship between the Code’s business expense and capital expenditure provisions. In so doing, it has had occasion to parse § 162(a) and explore certain of its requirements. For example, in Lincoln Savings, we determined that, to qualify for deduction under § 162(a), “an item must (1) be ‘paid or incurred during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’ expense, and (5) be an ‘ordinary’ expense.” 403 U.S. at 352. See also Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (the term “necessary” imposes “only the minimal requirement that the expense be ‘appropriate and helpful’ for ‘the development of the [taxpayer’s] business,’” quoting Welch v. Helvering, 290 U.S. 111, 113 (1933)); Deputy v. Du Pont, 308 U.S. at 495 (to qualify as “ordinary,” the expense must relate to a transaction “of common or frequent occurrence in the type of business involved”). The Court has recognized, however, that the “decisive distinctions” between current expenses and capital expenditures “are those of degree and not of kind,” Welch v. Helvering, 290 U.S. at 114, and that because each case “turns on its special facts,” Deputy v. Du Pont, 308 U.S. at 496, the cases sometimes appear difficult to harmonize. See Welch v. Helvering, 290 U.S. at 116.


National Starch contends that the decision in Lincoln Savings changed these familiar backdrops and announced an exclusive test for identifying capital expenditures, a test in which “creation or enhancement of an asset” is a prerequisite to capitalization, and deductibility under § 162(a) is the rule rather than the exception. We do not agree, for we conclude that National Starch has overread Lincoln Savings.


In Lincoln Savings, we were asked to decide whether certain premiums, required by federal statute to be paid by a savings and loan association to the Federal Savings and Loan Insurance Corporation (FSLIC), were ordinary and necessary expenses under § 162(a), as Lincoln Savings argued and the Court of Appeals had held, or capital expenditures under § 263, as the Commissioner contended. We found that the “additional” premiums, the purpose of which was to provide FSLIC with a secondary reserve fund in which each insured institution retained a pro rata interest recoverable in certain situations, “serv[e] to create or enhance for Lincoln what is essentially a separate and distinct additional asset.” 403 U.S. at 354. “[A]s an inevitable consequence,” we concluded, “the payment is capital in nature and not an expense, let alone an ordinary expense, deductible under § 162(a).” Ibid.


Lincoln Savings stands for the simple proposition that a taxpayer’s expenditure that “serves to create or enhance … a separate and distinct” asset should be capitalized under § 263. It by no means follows, however, that only expenditures that create or enhance separate and distinct assets are to be capitalized under § 263. We had no occasion in Lincoln Savings to consider the tax treatment of expenditures that, unlike the additional premiums at issue there, did not create or enhance a specific asset, and thus the case cannot be read to preclude capitalization in other circumstances. In short, Lincoln Savings holds that the creation of a separate and distinct asset well may be a sufficient, but not a necessary, condition to classification as a capital expenditure. See General Bancshares Corp. v. Commissioner, 326 F.2d 712, 716 (CA8) (although expenditures may not “resul[t] in the acquisition or increase of a corporate asset, … these expenditures are not, because of that fact, deductible as ordinary and necessary business expenses”), cert. denied, 379 U.S. 832 (1964).


Nor does our statement in Lincoln Savings, 403 U.S. at 354, that “the presence of an ensuing benefit that may have some future aspect is not controlling” prohibit reliance on future benefit as a means of distinguishing an ordinary business expense from a capital expenditure.98 Although the mere presence of an incidental future benefit – “some future aspect” – may not warrant capitalization, a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization. See United States v. Mississippi Chemical Corp., 405 U.S. 298, 310 (1972) (expense that “is of value in more than one taxable year” is a nondeductible capital expenditure); Central Texas Savings & Loan Assn. v. United States, 731 F.2d 1181, 1183 (CA5 1984) (“While the period of the benefits may not be controlling in all cases, it nonetheless remains a prominent, if not predominant, characteristic of a capital item”). Indeed, the text of the Code’s capitalization provision, § 263(a)(1), which refers to “permanent improvements or betterments,” itself envisions an inquiry into the duration and extent of the benefits realized by the taxpayer.





In applying the foregoing principles to the specific expenditures at issue in this case, we conclude that National Starch has not demonstrated that the investment banking, legal, and other costs it incurred in connection with Unilever’s acquisition of its shares are deductible as ordinary and necessary business expenses under § 162(a).


Although petitioner attempts to dismiss the benefits that accrued to National Starch from the Unilever acquisition as “entirely speculative” or “merely incidental,” the Tax Court’s and the Court of Appeals’ findings that the transaction produced significant benefits to National Starch that extended beyond the tax year in question are amply supported by the record. For example, in commenting on the merger with Unilever, National Starch’s 1978 “Progress Report” observed that the company would “benefit greatly from the availability of Unilever’s enormous resources, especially in the area of basic technology.” (Unilever “provides new opportunities and resources”). Morgan Stanley’s report to the National Starch board concerning the fairness to shareholders of a possible business combination with Unilever noted that National Starch management “feels that some synergy may exist with the Unilever organization given a) the nature of the Unilever chemical, paper, plastics and packaging operations … and b) the strong consumer products orientation of Unilever United States, Inc.”


In addition to these anticipated resource-related benefits, National Starch obtained benefits through its transformation from a publicly held, freestanding corporation into a wholly owned subsidiary of Unilever. The Court of Appeals noted that National Starch management viewed the transaction as “‘swapping approximately 3500 shareholders for one.’” Following Unilever’s acquisition of National Starch’s outstanding shares, National Starch was no longer subject to what even it terms the “substantial” shareholder-relations expenses a publicly traded corporation incurs, including reporting and disclosure obligations, proxy battles, and derivative suits. The acquisition also allowed National Starch, in the interests of administrative convenience and simplicity, to eliminate previously authorized but unissued shares of preferred and to reduce the total number of authorized shares of common from 8,000,000 to 1,000.


Courts long have recognized that expenses such as these, “‘incurred for the purpose of changing the corporate structure for the benefit of future operations are not ordinary and necessary business expenses.’” General Bancshares Corp. v. Commissioner, 326 F. 2d, at 715 (quoting Farmers Union Corp. v. Commissioner, 300 F.2d 197, 200 (CA9), cert. denied, 371 U.S. 861 (1962)). See also B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders 5-33 to 5-36 (5th ed. 1987) (describing “well-established rule” that expenses incurred in reorganizing or restructuring corporate entity are not deductible under § 162(a)). Deductions for professional expenses thus have been disallowed in a wide variety of cases concerning changes in corporate structure.99 Although support for these decisions can be found in the specific terms of § 162(a), which require that deductible expenses be “ordinary and necessary” and incurred “in carrying on any trade or business,”100 courts more frequently have characterized an expenditure as capital in nature because “the purpose for which the expenditure is made has to do with the corporation’s operations and betterment, sometimes with a continuing capital asset, for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year.” General Bancshares Corp. v. Commissioner, 326 F. 2d at 715. See also Mills Estate, Inc. v. Commissioner, 206 F.2d 244, 246 (CA2 1953). The rationale behind these decisions applies equally to the professional charges at issue in this case.





The expenses that National Starch incurred in Unilever’s friendly takeover do not qualify for deduction as “ordinary and necessary” business expenses under § 162(a). The fact that the expenditures do not create or enhance a separate and distinct additional asset is not controlling; the acquisition-related expenses bear the indicia of capital expenditures and are to be treated as such.


The judgment of the Court of Appeals is affirmed.


It is so ordered.


Notes and Questions:


1. The INDOPCO decision was not well received in the business community. Why not?


• Should taxpayer in INDOPCO amortize the intangible that it purchased? – over what period of time?


2. Capitalization of expenditures to construct a tangible asset followed by depreciation, amortization, or cost recovery works more predictably than when expenditures are directed towards the “construction” of an intangible asset. Why do you think that this is so?


• Perhaps because a tangible asset physically deteriorates over time and so its useful life is more easily determinable.


• A marketing campaign requires current and future expenditures, but the “asset” it creates (consumer loyalty? brand recognition?) should endure past the end of the campaign. It is not even possible to know when this asset no longer generates income – as would be the case with an asset as tangible as, say, a building. A rational approach to depreciation, amortization, or cost recovery requires that we not only be able to recognize when an expenditure no longer generates income, but also be able to predict how long that would be.


• Consider expenditures for advertising. Not only do these problems emerge, but answers would be different from one taxpayer to the next.


• The compliance costs of a rule that requires taxpayer to capitalize expenditures that generate income into the future can be enormous. At least one case was litigated all the way to the Supreme Court. Cf. Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993) (at-will subscription list is not goodwill and purchaser of newspaper permitted to depreciate it upon proof of value and useful life).


• In light of these considerations, perhaps there is something to be said for National Starch’s contention that capitalization required the “creation or enhancement of a separate and distinct asset.” Moreover, its statement in the second footnote (“absent a separate-and-distinct-asset requirement for capitalization, a taxpayer will have no ‘principled basis’ upon which to differentiate business expenses from capital expenditures”) just might be accurate. The Court dismissed this argument in the next sentence of the footnote by observing that its position essentially is no worse than taxpayer’s.


• “Deduction rather than capitalization becomes more likely as the link between the outlay and a readily identifiable asset decreases, and as the asset to which the outlay is linked becomes less and less tangible.” Joseph Bankman, The Story of INDOPCO: What Went Wrong in the Capitalization v. Deduction Debate, in Tax Stories 228 (Paul Caron ed., 2d ed. 2009).


• “Deduction also becomes more likely for expenses that are recurring, or fit within a commonsense definition of ordinary and necessary.” Id.


• Lower courts gradually began to read Lincoln Savings as requiring the creation or enhancement of a separate and distinct asset. Id. at 233.


• Nevertheless, the Supreme Court was correct in its reading of Lincoln Savings to the effect “that the creation of a separate and distinct asset well may be a sufficient, but not a necessary, condition to classification as a capital expenditure.”


• On the other hand, does the Court announce that the presence of “some future benefit” is a sufficient condition to classification as a capital expenditure?


3. The INDOPCO holding called into question many long-standing positions that taxpayers had felt comfortable in taking. The cost of complete and literal compliance with every ramification of the holding would have been enormous. The IRS produced some (favorable to the taxpayer) clarifications in revenue rulings concerning the deductibility of particular expenditures. See Joseph Bankman, The Story of INDOPCO: What Went Wrong in the Capitalization v. Deduction Debate, in Tax Stories 244-45 (Paul Caron ed., 2d ed. 2009). In 2004, the IRS published final regulations. Guidance Regarding Deduction and Capitalization of Expenditures, 69 Fed. Reg. 436 (Jan. 5, 2004). The regulations represented an IRS effort to allay fears and/or provide predictability to the application of capitalization rules. In its “Explanation and Summary of Comments Concerning § 1.263(a)-4,” the IRS wrote:


The final regulations identify categories of intangibles for which capitalization is required. … [T]he final regulations provide that an amount paid to acquire or create an intangible not otherwise required to be capitalized by the regulations is not required to be capitalized on the ground that it produces significant future benefits for the taxpayer, unless the IRS publishes guidance requiring capitalization of the expenditure. If the IRS publishes guidance requiring capitalization of an expenditure that produces future benefits for the taxpayer, such guidance will apply prospectively. …


Id. at 436. This positivist approach severely limits application of the “significant future benefits” theory to require capitalization of untold numbers of expenditures.


4. The “capitalization list” appears in Regs. §§ 1.263(a)-4(b)(1) and 1.263(a)-5(a).


• an amount paid to another party to acquire an intangible;


• an amount paid to create an intangible specifically named in Reg. § 1.263(a)-4(d);


• an amount paid to create or enhance a separate and distinct intangible asset;


• an amount paid to create or enhance a future benefit that the IRS has specifically identified in published guidance;


• an amount paid to “facilitate” (as that term is specifically defined) an acquisition or creation of any of the above-named intangibles; and


• amounts paid or incurred to facilitate acquisition of a trade or business, a change in the capital structure of a business entity, and various other transactions.


5. Moreover, Reg. § 1.263(a)-4(f)(1) states a 12-month rule, i.e., that


a taxpayer is not required to capitalize … any right or benefit for the taxpayer that does not extend beyond the earlier of –


(i) 12 months after the first date on which the taxpayer realizes the right or benefit; or


(ii) The end of the taxable year following the taxable year in which the payment is made.


6. When taxpayers incur recurring expenses intended to provide future benefits – notably advertising – what is gained by strict adherence to capitalization principles?


• In Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7th Cir. 1982), Judge Posner wrote:


If one really takes seriously the concept of a capital expenditure as anything that yields income, actual or imputed, beyond the period (conventionally one year, [citation omitted]) in which the expenditure is made, the result will be to force the capitalization of virtually every business expense. It is a result courts naturally shy away from. [citation omitted]. It would require capitalizing every salesman’s salary, since his selling activities create goodwill for the company and goodwill is an asset yielding income beyond the year in which the salary expense is incurred. The administrative costs of conceptual rigor are too great. The distinction between recurring and nonrecurring business expenses provides a very crude but perhaps serviceable demarcation between those capital expenditures that can feasibly be capitalized and those that cannot be.


7. (Note 6, continued): Imagine: An author spends $5 every year for on pen and paper with which the author will write books. Each book will generate income for the author for 5 years. Let’s assume that “the rules” permit such a taxpayer to deduct $1 of that $5 expenditure in each of the succeeding five years. This tax treatment matches the author’s expenses with his income. The following table demonstrates that this taxpayer will (eventually) be deducting $5 every year.


Table No. 1


Beginning in year 5, how much does the year by year total change? Does this table suggest that there is an easier way to handle recurring capital expenditures than to require taxpayer to capitalize and depreciate each and every such expenditure?


8. You are expected to recognize a capitalization of intangibles issue – but the details of the regulations are left to a more advanced tax course.


C. Expense or Capital: Protecting Stock Investment or Protecting Employment



United States v. Generes, 405 U.S. 93 (1972)



MR. JUSTICE BLACKMUN delivered the opinion of the Court.


A debt a closely held corporation owed to an indemnifying shareholder employee became worthless in 1962. The issue in this federal income tax refund suit is whether, for the shareholder employee, that worthless obligation was a business or a nonbusiness bad debt within the meaning and reach of §§ 166(a) and (d) of the … Code101 and of the implementing Regulations § 1.166-5.102



The issue’s resolution is important for the taxpayer. If the obligation was a business debt, he may use it to offset ordinary income and for carryback purposes under § 172 of the Code … On the other hand, if the obligation is a nonbusiness debt, it is to be treated as a short-term capital loss subject to the restrictions imposed on such losses by § 166(d)(1)(B) and §§ 1211 and 1212, and its use for carryback purposes is restricted by § 172(d)(4). The debt is one or the other in its entirety, for the Code does not provide for its allocation in part to business and in part to nonbusiness.


In determining whether a bad debt is a business or a nonbusiness obligation, the Regulations focus on the relation the loss bears to the taxpayer’s business. If, at the time of worthlessness, that relation is a “proximate” one, the debt qualifies as a business bad debt and the aforementioned desirable tax consequences then ensue.


The present case turns on the proper measure of the required proximate relation. Does this necessitate a “dominant” business motivation on the part of the taxpayer, or is a “significant” motivation sufficient?


Tax in an amount somewhat in excess of $40,000 is involved. The taxpayer, Allen H. Generes, prevailed in a jury trial in the District Court. On the Government’s appeal, the Fifth Circuit affirmed by a divided vote. Certiorari was granted to resolve a conflict among the circuits.




The taxpayer, as a young man in 1909, began work in the construction business. His son-in law, William F. Kelly, later engaged independently in similar work. During World War II, the two men formed a partnership in which their participation was equal. The enterprise proved successful. In 1954, Kelly Generes Construction Co., Inc., was organized as the corporate successor to the partnership. It engaged in the heavy-construction business, primarily on public works projects.


The taxpayer and Kelly each owned 44% of the corporation’s outstanding capital stock. The taxpayer’s original investment in his shares was $38,900. The remaining 12% of the stock was owned by a son of the taxpayer and by another son-in law. Mr. Generes was president of the corporation, and received from it an annual salary of $12,000. Mr. Kelly was executive vice-president, and received an annual salary of $15,000.


The taxpayer and Mr. Kelly performed different services for the corporation. Kelly worked full time in the field, and was in charge of the day-to-day construction operations. Generes, on the other hand, devoted no more than six to eight hours a week to the enterprise. He reviewed bids and jobs, made cost estimates, sought and obtained bank financing, and assisted in securing the bid and performance bonds that are an essential part of the public project construction business. Mr. Generes, in addition to being president of the corporation, held a full-time position as president of a savings and loan association he had founded in 1937. He received from the association an annual salary of $19,000. The taxpayer also had other sources of income. His gross income averaged about $40,000 a year during 1959-1962.


Taxpayer Generes from time to time advanced personal funds to the corporation to enable it to complete construction jobs. He also guaranteed loans made to the corporation by banks for the purchase of construction machinery and other equipment. In addition, his presence with respect to the bid and performance bonds is of particular significance. Most of these were obtained from Maryland Casualty Co. That underwriter required the taxpayer and Kelly to sign an indemnity agreement for each bond it issued for the corporation. In 1958, however, in order to eliminate the need for individual indemnity contracts, taxpayer and Kelly signed a blanket agreement with Maryland whereby they agreed to indemnify it, up to a designated amount, for any loss it suffered as surety for the corporation. Maryland then increased its line of surety credit to $2,000,000. The corporation had over $14,000,000 gross business for the period 1954 through 1962.


In 1962, the corporation seriously underbid two projects and defaulted in its performance of the project contracts. It proved necessary for Maryland to complete the work. Maryland then sought indemnity from Generes and Kelly. The taxpayer indemnified Maryland to the extent of $162,104.57. In the same year, he also loaned $158,814.49 to the corporation to assist it in its financial difficulties. The corporation subsequently went into receivership and the taxpayer was unable to obtain reimbursement from it.


In his federal income tax return for 1962 the taxpayer took his loss on his direct loans to the corporation as a nonbusiness bad debt. He claimed the indemnification loss as a business bad debt and deducted it against ordinary income.103 Later, he filed claims for refund for 1959-1961, asserting net operating loss carrybacks under § 172 to those years for the portion, unused in 1962, of the claimed business bad debt deduction.



In due course, the claims were made the subject of the jury trial refund suit in the United States District Court for the Eastern District of Louisiana. At the trial, Mr. Generes testified that his sole motive in signing the indemnity agreement was to protect his $12,000-a-year employment with the corporation. The jury, by special interrogatory, was asked to determine whether taxpayer’s signing of the indemnity agreement with Maryland “was proximately related to his trade or business of being an employee” of the corporation. The District Court charged the jury, over the Government’s objection, that significant motivation satisfies the Regulations’ requirement of proximate relationship.104 The court refused the Government’s request for an instruction that the applicable standard was that of dominant, rather than significant, motivation.105



… [T]he jury found that the taxpayer’s signing of the indemnity agreement was proximately related to his trade or business of being an employee of the corporation. Judgment on this verdict was then entered for the taxpayer.


The Fifth Circuit majority approved the significant motivation standard so specified and agreed with a Second Circuit majority in Weddle v. Commissioner, 325 F.2d 849, 851 (1963), in finding comfort for so doing in the tort law’s concept of proximate cause. Judge Simpson dissented. 427 F.2d at 284. He agreed with the holding of the Seventh Circuit in Niblock v. Commissioner, 417 F.2d 1185 (1969), and with Chief Judge Lumbard, separately concurring in Weddle, 325 F.2d at 852, that dominant and primary motivation is the standard to be applied.




A. The fact responsible for the litigation is the taxpayer’s dual status relative to the corporation. Generes was both a shareholder and an employee. These interests are not the same, and their differences occasion different tax consequences. In tax jargon, Generes’ status as a shareholder was a nonbusiness interest. It was capital in nature, and it was composed initially of tax-paid dollars. Its rewards were expectative, and would flow not from personal effort, but from investment earnings and appreciation. On the other hand, Generes’ status as an employee was a business interest. Its nature centered in personal effort and labor, and salary for that endeavor would be received. The salary would consist of pre-tax dollars.


Thus, for tax purposes, it becomes important and, indeed, necessary to determine the character of the debt that went bad and became uncollectible. Did the debt center on the taxpayer’s business interest in the corporation or on his nonbusiness interest? If it was the former, the taxpayer deserves to prevail here. [citations omitted.]


B. Although arising in somewhat different contexts, two tax cases decided by the Court in recent years merit initial mention. In each of these cases, a major shareholder paid out money to or on behalf of his corporation and then was unable to obtain reimbursement from it. In each, he claimed a deduction assertable against ordinary income. In each, he was unsuccessful in this quest:


1. In Putnam v. Commissioner, 352 U. S. 82 (1956), the taxpayer was a practicing lawyer who had guaranteed obligations of a labor newspaper corporation in which he owned stock. He claimed his loss as fully deductible … The Court … held that the loss was a nonbusiness bad debt subject to short-term capital loss treatment … The loss was deductible as a bad debt or not at all. See Rev. Rul. 60-48, 1961 Cum. Bull. 112.


2. In Whipple v. Commissioner, 373 U. S. 193 (1963), the taxpayer had provided organizational, promotional, and managerial services to a corporation in which he owned approximately an 80% stock interest. He claimed that this constituted a trade or business, and, hence, that debts owing him by the corporation were business bad debts when they became worthless in 1953. The Court also rejected that contention, and held that Whipple’s investing was not a trade or business, that is, that “[d]evoting one’s time and energies to the affairs of a corporation is not, of itself, and without more, a trade or business of the person so engaged.” 373 U.S. at 202. The rationale was that a contrary conclusion would be inconsistent with the principle that a corporation has a personality separate from its shareholders, and that its business is not necessarily their business. The Court indicated its approval of the Regulations’ proximate relation test:


Moreover, there is no proof (which might be difficult to furnish where the taxpayer is the sole or dominant stockholder) that the loan was necessary to keep his job or was otherwise proximately related to maintaining his trade or business as an employee. Compare Trent v. Commissioner, [291 F.2d 669 (CA2 1961)]. 373 U.S. at 204.


The Court also carefully noted the distinction between the business and the nonbusiness bad debt for one who is both an employee and a shareholder.106



These two cases approach, but do not govern, the present one. They indicate, however, a cautious, and not a free-wheeling, approach to the business bad debt. Obviously, taxpayer Generes endeavored to frame his case to bring it within the area indicated in the above quotation from Whipple v. Commissioner.




We conclude that, in determining whether a bad debt has a “proximate” relation to the taxpayer’s trade or business, as the Regulations specify, and thus qualifies as a business bad debt, the proper measure is that of dominant motivation, and that only significant motivation is not sufficient. We reach this conclusion for a number of reasons:


A. The Code itself carefully distinguishes between business and nonbusiness items. It does so, for example, in § 165 with respect to losses, in § 166 with respect to bad debts, and in § 162 with respect to expenses. It gives particular tax benefits to business losses, business bad debts, and business expenses, and gives lesser benefits, or none at all, to nonbusiness losses, nonbusiness bad debts, and nonbusiness expenses. It does this despite the fact that the latter are just as adverse in financial consequence to the taxpayer as are the former. But this distinction has been a policy of the income tax structure ever since the Revenue Act of 1916 …


The point, however, is that the tax statutes have made the distinction, that the Congress therefore intended it to be a meaningful one, and that the distinction is not to be obliterated or blunted by an interpretation that tends to equate the business bad debt with the nonbusiness bad debt. We think that emphasis upon the significant rather, than upon the dominant, would have a tendency to do just that.


B. Application of the significant motivation standard would also tend to undermine and circumscribe the Court’s holding in Whipple, and the emphasis there that a shareholder’s mere activity in a corporation’s affairs is not a trade or business. As Chief Judge Lumbard pointed out in his separate and disagreeing concurrence in Weddle, supra, 325 F.2d at 852-853, both motives – that of protecting the investment and that of protecting the salary – are inevitably involved, and an inquiry whether employee status provides a significant motivation will always produce an affirmative answer and result in a judgment for the taxpayer.


C. The dominant motivation standard has the attribute of workability. It provides a guideline of certainty for the trier of fact. The trier then may compare the risk against the potential reward and give proper emphasis to the objective, rather than to the subjective. As has just been noted, an employee-shareholder, in making or guaranteeing a loan to his corporation, usually acts with two motivations, the one to protect his investment and the other to protect his employment. By making the dominant motivation the measure, the logical tax consequence ensues and prevents the mere presence of a business motive, however small and however insignificant, from controlling the tax result at the taxpayer’s convenience. This is of particular importance in a tax system that is so largely dependent on voluntary compliance.


D. The dominant motivation test strengthens, and is consistent with, the mandate of § 262 of the Code, … that “no deduction shall be allowed for personal, living, or family expenses” except as otherwise provided. It prevents personal considerations from circumventing this provision.


E. The dominant motivation approach to § 166(d) is consistent with that given the loss provisions in § 165(c)(1), see, for example, Imbesi v. Commissioner, 361 F.2d 640, 644 (CA3 1966), and in § 165(c)(2), see Austin v. Commissioner, 298 F.2d 583, 584 (CA2 1962). In these related areas, consistency is desirable. See also Commissioner v. Duberstein, 363 U. S. 278, 286 (1960).


F. …


G. The Regulations’ use of the word “proximate” perhaps is not the most fortunate, for it naturally tempts one to think in tort terms. The temptation, however, is best rejected, and we reject it here. In tort law, factors of duty, of foreseeability, of secondary cause, and of plural liability are under consideration, and the concept of proximate cause has been developed as an appropriate application and measure of these factors. It has little place in tax law, where plural aspects are not usual, where an item either is or is not a deduction, or either is or is not a business bad debt, and where certainty is desirable.




The conclusion we have reached means that the District Court’s instructions, based on a standard of significant, rather than dominant, motivation are erroneous, and that, at least, a new trial is required. We have examined the record, however, and find nothing that would support a jury verdict in this taxpayer’s favor had the dominant motivation standard been embodied in the instructions. Judgment n.o.v. for the United States, therefore, must be ordered. See Neely v. Eby Construction Co., 386 U. S. 317 (1967).


As Judge Simpson pointed out in his dissent, 427 F.2d at 284-285, the only real evidence offered by the taxpayer bearing upon motivation was his own testimony that he signed the indemnity agreement “to protect my job,” that “I figured, in three years’ time, I would get my money out,” and that “I never once gave it [his investment in the corporation] a thought.”


The statements obviously are self-serving. In addition, standing alone, they do not bear the light of analysis. What the taxpayer was purporting to say was that his $12,000 annual salary was his sole motivation, and that his $38,900 original investment, the actual value of which, prior to the misfortunes of 1962, we do not know, plus his loans to the corporation, plus his personal interest in the integrity of the corporation as a source of living for his son-in law and as an investment for his son and his other son-in law, were of no consequence whatever in his thinking. The comparison is strained all the more by the fact that the salary is pre-tax and the investment is tax-paid. With his total annual income about $40,000, Mr. Generes may well have reached a federal income tax bracket of 40% or more for a joint return in 1958-1962. §§ 1 and 2 of the 1954 Code … The $12,000 salary thus would produce for him only about $7,000 net after federal tax and before any state income tax. This is the figure, and not $12,000, that has any possible significance for motivation purposes, and it is less than 1/5 of the original stock investment.


We conclude on these facts that the taxpayer’s explanation falls of its own weight, and that reasonable minds could not ascribe, on this record, a dominant motivation directed to the preservation of the taxpayer’s salary as president of Kelly Generes Construction Co., Inc.


The judgment is reversed, and the case is remanded with direction that judgment be entered for the United States.


It is so ordered.


MR. JUSTICE POWELL and MR. JUSTICE REHNQUIST took no part in the consideration or decision of this case.


MR. JUSTICE MARSHALL, concurring (omitted).




While I join Parts I, II, and III of the Court’s opinion and its judgment of reversal, I would remand the case to the District Court with directions to hold a hearing on the issue of whether a jury question still exists as to whether taxpayer’s motivation was “dominantly” a business one in the relevant transactions …


MR. JUSTICE DOUGLAS, dissenting. [omitted.]


Notes and Questions:


1. What were the stakes in the outcome of the case? See §§ 1211(b) ($1000 limit at the time the Court decided Generes), 1212(b).


2. What information should be critical to the valuation of taxpayer’s stock? In a closely-held corporation in which shareholders, officers, employees, and creditors are usually the same people who wear different hats on different occasions – is it ever realistic to say that a bad debt is “one or the other in its entirety?”


D. Expense or Capital: Repair vs. Improvement



When reading the following materials do not forget some basic points. Section 263(a) denies a deduction for “[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property” and for “[a]ny amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.” The expenditures that are the subject of this section could be ordinary and necessary trade or business expenditures and so deductible under § 162, but §§ 161 and 261 make § 162 subject to and subordinate to § 263. Reg. § 1.162-4(a) restates this prioritization; it provides in part that “[a] taxpayer may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized.” The scope of what is affirmatively covered by § 263 preempts what § 162 might allow as an immediate deduction. The line between deductibility and capitalization has been the subject of dispute between taxpayers and the government in the context of a taxpayer’s trade or business. More recently, the IRS and Treasury have undertaken through regulations to articulate workable standards and procedures to assure more taxpayers predictable treatment. We will explore the high points of the portions of these regulations most relevant to this topic.


Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950)







The issue in this case is whether an expenditure for a concrete lining in petitioner’s basement to oilproof it against an oil nuisance created by a neighboring refinery is deductible as an ordinary and necessary expense under § [162(a)] … on the theory it was an expenditure for a repair …


The respondent [Commissioner] has contended, in part, that the expenditure is for a capital improvement and should be recovered through depreciation charges and is, therefore, not deductible as an ordinary and necessary business expense or as a loss.


It is none too easy to determine on which side of the line certain expenditures fall so that they may be accorded their proper treatment for tax purposes. Treasury Regulations 111, from which we quote in the margin,107 is helpful in distinguishing between an expenditure to be classed as a repair and one to be treated as a capital outlay. In Illinois Merchants Trust Co., Executor, 4 B.T.A. 103, 106, we discussed this subject in some detail and in our opinion said:



It will be noted that the first sentence of the [regulation] … relates to repairs, while the second sentence deals in effect with replacements. In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied against current earnings.


… [F]or some 25 years prior to the taxable year [(1943)] petitioner [Midland Empire] had used the basement rooms of its plant [situated in Billings near the Yellowstone River] as a place for the curing of hams and bacon and for the storage of meat and hides. The basement had been entirely satisfactory for this purpose over the entire period in spite of the fact that there was some seepage of water into the rooms from time to time. In the taxable year it was found that not only water, but oil, was seeping through the concrete walls of the basement of the packing plant and, while the water would soon drain out, the oil would not, and there was left on the basement floor a thick scum of oil which gave off a strong odor that permeated the air of the entire plant, and the fumes from the oil created a fire hazard. It appears that the oil which came from a nearby refinery [of the Yale Oil Corporation] had also gotten into the water wells which served to furnish water for petitioner’s plant, and as a result of this whole condition the Federal meat inspectors advised petitioner that it must discontinue the use of the water from the wells and oilproof the basement, or else shut down its plant.


To meet this situation, petitioner during the taxable year undertook steps to oilproof the basement by adding a concrete lining to the walls from the floor to a height of about four feet and also added concrete to the floor of the basement. It is the cost of this work[, $4,868.81,] which it seeks to deduct as a repair. The basement was not enlarged by this work [and in fact petitioner’s operating space contracted], nor did the oilproofing serve to make it more desirable for the purpose for which it had been used through the years prior to the time that the oil nuisance had occurred. The evidence is that the expenditure did not add to the value or prolong the expected life of the property over what they were before the event occurred which made the repairs necessary. It is true that after the work was done the seepage of water, as well as oil, was stopped, but, as already stated, the presence of the water had never been found objectionable. The repairs merely served to keep the property in an operating condition over its probable useful life for the purpose for which it was used.


[Midland charged the $4,868.81 to repair expense on its regular books and deducted that amount on its tax returns as an ordinary and necessary business expense for the fiscal year 1943. The Commissioner, in his notice of deficiency, determined that the cost of oilproofing was not deductible … as an ordinary and necessary expense … in 1943.]


While it is conceded on brief that the expenditure was ‘necessary,’ respondent contends that the encroachment of the oil nuisance on petitioner’s property was not an ‘ordinary’ expense in petitioner’s particular business. But the fact that petitioner had not theretofore been called upon to make a similar expenditure to prevent damage and disaster to its property does not remove that expense from the classification of ‘ordinary’ … Steps to protect a business building from the seepage of oil from a nearby refinery, which had been erected long subsequent to the time petitioner started to operate its plant, would seem to us to be a normal thing to do, and in certain sections of the country it must be a common experience to protect one’s property from the seepage of oil. Expenditures to accomplish this result are likewise normal.




[The petitioner thereafter filed suit against Yale, on April 22, 1944, in a cause of action sounding in tort … This action was to recover damages for the nuisance created by the oil seepage. … Petitioner subsequently settled its cause of action against Yale for $11,659.49 and gave Yale a complete release of all liability. This release was dated October 23, 1946.]


In our opinion, the expenditure of $4,868.81 for lining the basement walls and floor was essentially a repair and, as such, it is deductible as an ordinary and necessary business expense. …


Notes and Questions:


1. The court said: “It is none too easy to determine on which side of the line certain expenditures fall so that they may be accorded their proper treatment for tax purposes.”


• What facts convinced the court to place the expenditure on the “repair” side of the line?


2. In the fifth-to-last paragraph of the case, the court stated conclusions taken almost verbatim from the regulation. Does this give you any idea of the type of evidence that taxpayer must have presented and its relation to Reg. § 1.162-4?




War-time and shortly thereafter: During WW I and WW II, tax rates were considerably higher than they were in peacetime. In what ways did this make timing an especially important matter?





3. The Yale Oil Corporation owned a nearby oil-refining plant and storage area and its discharges caused the problems that Midland Empire had to address. Yale Oil made a payment to Midland Empire to settle the nuisance suit brought against it. May Yale Oil deduct the amount it paid to settle the case, or should it capitalize that amount? Cf. Mt. Morris Drive-In, infra?


• What tax treatment should Midland accord the $11,659.49 payment it received from Yale?


Mt. Morris Drive-In Theatre Co. v. Commissioner, 25 T.C. 272 (1955), aff’d, 238 F.2d 85 (CA6 1956)









In 1947 petitioner purchased 13 acres of farm land located on the outskirts of Flint, Michigan, upon which it proceeded to construct a drive-in or outdoor theatre. Prior to its purchase by the petitioner the land on which the theatre was built was farm land and contained vegetation. The slope of the land was such that the natural drainage of water was from the southerly line to the northerly boundary of the property and thence onto the adjacent land, owned by David and Mary D. Nickola, which was used both for farming and as a trailer park. The petitioner’s land sloped sharply from south to north and also sloped from the east downward towards the west so that most of the drainage from the petitioner’s property was onto the southwest corner of the Nickolas’ land. The topography of the land purchased by petitioner was well known to petitioner at the time it was purchased and developed. The petitioner did not change the general slope of its land in constructing the drive-in theatre, but it removed the covering vegetation from the land, slightly increased the grade, and built aisles or ramps which were covered with gravel and were somewhat raised so that the passengers in the automobiles would be able to view the picture on the large outdoor screen.


As a result of petitioner’s construction on and use of this land rain water falling upon it drained with an increased flow into and upon the adjacent property of the Nickolas. This result should reasonably have been anticipated by petitioner at the time when the construction work was done.


The Nickolas complained to the petitioner at various times after petitioner began the construction of the theatre that the work resulted in an acceleration and concentration of the flow of water which drained from the petitioner’s property onto the Nickolas’ land causing damage to their crops and roadways. On or about October 11, 1948, the Nickolas filed a suit against the petitioner … asking for an award for damages done to their property by the accelerated and concentrated drainage of the water and for a permanent injunction restraining the defendant from permitting such drainage to continue. … [T]he suit was settled by an agreement dated June 27, 1950. This agreement provided for the construction by the petitioner of a drainage system to carry water from its northern boundary across the Nickolas’ property and thence to a public drain. The cost of maintaining the system was to be shared by the petitioner and the Nickolas, and the latter granted the petitioner and its successors an easement across their land for the purpose of constructing and maintaining the drainage system. The construction of the drain was completed in October 1950 under the supervision of engineers employed by the petitioner and the Nickolas at a cost to the petitioner of $8,224, which amount was paid by it in November 1950. The performance by the petitioner on its part of the agreement to construct the drainage system and to maintain the portion for which it was responsible constituted a full release of the Nickolas’ claims against it. The petitioner chose to settle the dispute by constructing the drainage system because it did not wish to risk the possibility that continued litigation might result in a permanent injunction against its use of the drive-in theatre and because it wished to eliminate the cause of the friction between it and the adjacent landowners, who were in a position to seriously interfere with the petitioner’s use of its property for outdoor theatre purposes. A settlement based on a monetary payment for past damages, the petitioner believed, would not remove the threat of claims for future damages.


On its 1950 income and excess profits tax return the petitioner claimed a deduction of $822.40 for depreciation of the drainage system for the period July 1, 1950, to December 31, 1950. The Commissioner disallowed without itemization $5,514.60 of a total depreciation expense deduction of $19,326.41 claimed by the petitioner. In its petition the petitioner asserted that the entire amount spent to construct the drainage system was fully deductible in 1950 as an ordinary and necessary business expense incurred in the settlement of a lawsuit, or, in the alternative, as a loss, and claimed a refund of part of the $10,591.56 of income and excess profits tax paid by it for that year.


The drainage system was a permanent improvement to the petitioner’s property, and the cost thereof constituted a capital expenditure.




KERN, Judge:


When petitioner purchased, in 1947, the land which it intended to use for a drive-in theatre, its president was thoroughly familiar with the topography of this land which was such that when the covering vegetation was removed and graveled ramps were constructed and used by its patrons, the flow of natural precipitation on the lands of abutting property owners would be materially accelerated. Some provision should have been made to solve this drainage problem in order to avoid annoyance and harassment to its neighbors. If petitioner had included in its original construction plans an expenditure for a proper drainage system no one could doubt that such an expenditure would have been capital in nature.


Within a year after petitioner had finished its inadequate construction of the drive-in theatre, the need of a proper drainage system was forcibly called to its attention by one of the neighboring property owners, and under the threat of a lawsuit filed approximately a year after the theatre was constructed, the drainage system was built by petitioner who now seeks to deduct its cost as an ordinary and necessary business expenses, or as a loss.


We agree with respondent that the cost to petitioner of acquiring and constructing a drainage system in connection with its drive-in theatre was a capital expenditure.


Here was no sudden catastrophic loss caused by a ‘physical fault’ undetected by the taxpayer in spite of due precautions taken by it at the time of its original construction work as in American Bemberg Corporation, 10 T.C. 361; no unforeseeable external factor as in Midland Empire Packing Co., 14 T.C. 635; and no change in the cultivation of farm property caused by improvements in technique and made many years after the property in question was put to productive use as in J. H. Collingwood, 20 T.C. 937. In the instant case it was obvious at the time when the drive-in theatre was constructed, that a drainage system would be required to properly dispose of the natural precipitation normally to be expected, and that until this was accomplished, petitioner’s capital investment was incomplete. In addition, it should be emphasized that here there was no mere restoration or rearrangement of the original capital asset, but there was the acquisition and construction of a capital asset which petitioner had not previously had, namely, a new drainage system.


That this drainage system was acquired and constructed and that payments therefor were made in compromise of a lawsuit is not determinative of whether such payments were ordinary and necessary business expenses or capital expenditures. ‘The decisive test is still the character of the transaction which gives rise to the payment.’ Hales-Mullaly v. Commissioner, 131 F.2d 509, 511, 512.


In our opinion the character of the transaction in the instant case indicates that the transaction was a capital expenditure.


Reviewed by the Court.


Decision will be entered for the respondent.


RAUM, J. concurring:


… [I]f provision had been made in the original plans for the construction of a drainage system there could hardly be any question that its cost would have been treated as a capital outlay. The character of the expenditure is not changed merely because it is made at a subsequent time, and I think it wholly irrelevant whether the necessity for the drainage system could have been foreseen, or whether the payment therefor was made as a result of the pressure of a law suit.


FISHER, J., agrees with this concurring opinion.


RICE, J. dissenting:


… [T]he expenditure which petitioner made was an ordinary and necessary business expense, which did not improve, better, extend, increase, or prolong the useful life of its property. The expenditure did not cure the original geological defect of the natural drainage onto the Nickolas’ land, but only dealt with the intermediate consequence thereof. … I cannot agree with the majority that the expenditure here was capital in nature.


OPPER, JOHNSON, BRUCE, and MULRONEY, JJ., agree with this dissent.


Notes and Questions:


1. Upon reading Midland Empire and the three opinions in Mt. Morris Drive-In, do you get the feeling that repair vs. improvement – at least in close cases – comes down to who can argue facts that fit within certain considerations better? Notice and consider:


• The magnitude of what was done to the properties in the two cases was probably comparable.


• Neither taxpayer could continue in business without making the expenditure.


• Both taxpayers had operational businesses before making the necessary expenditures.


• Is “foreseeability” really the distinction between these two cases? “Foreseeability” of course is a very malleable term.


• Isn’t what Judge Raum wrote equally applicable to the facts of Midland Empire? Why the difference in result?


2. Does “quantitative” eventually becomes “qualitative?” Suppose taxpayer makes many discrete repairs; can they together add up to a renovation? Consider this excerpt from United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968):


In the continuing quest for formularization, the courts have superimposed upon the criteria in the repair regulation an overriding precept that an expenditure made for an item which is part of a “general plan” of rehabilitation, modernization, and improvement of the property, must be capitalized, even though, standing along, the item may appropriately be classified as one of repair. … Whether the plan exists, and whether a particular item is part of it, are usually questions of fact to be determined by the fact finder based upon a realistic appraisal of all the surrounding facts and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done, e.g., whether the work was done to suit the needs of an incoming tenant, or to adapt the property to a different use, or, in any event, whether what was done resulted in an appreciable enhancement of the property’s value.


Id. at 689 (citations and footnotes omitted). Quantity does eventually become quality. Application of the standard of Wehrli will certainly lead to disputes between taxpayers and the IRS. Generalized standards can inherently be unpredictable in application. The IRS and Treasury have worked to provide more predictability in this area through a revenue ruling and most recently rulemaking. As often happens, the difficulty that the IRS and Treasury faced in drafting regulations was to make them general enough to be applicable to a broad range of situations and a great number of taxpayers, yet specific enough to provide meaningful guidance.


3. The excerpt from Illinois Merchants Trust Co. that the court in Midland Empire quoted referenced “replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use.” On the other hand, “[a] repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition.” Id. Consider some routine (?) maintenance procedures for an automobile. If the taxpayer uses the automobile in a trade or business, should taxpayer treat them as repairs or as expenditures to be capitalized?


• changing the oil; this will certainly prolong the life of the automobile, for failure to do so will destroy the engine;


• replacing the tires warranted for 20,000 miles with tires warranted for 60,000 miles;


• equipping the automobile with a trailer hitch so that taxpayer can attach a flatbed trailer and transport large items;


• flushing the radiator and filling it with antifreeze;


• replacing an engine block that cracked on a cold winter night because taxpayer had not flushed the radiator and filled it with antifreeze.


4. In Rev. Rul. 2001-4, the IRS reviewed the statements of several courts. The following is an excerpt:


Any properly performed repair, no matter how routine, could be considered to prolong the useful life and increase the value of the property if it is compared with the situation existing immediately prior to the repair. Consequently, courts have articulated a number of ways to distinguish between deductible repairs and non-deductible capital improvements. For example, in Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103, 106 (1926), acq., V-2 C.B. 2, the court explained that repair and maintenance expenses are incurred for the purpose of keeping the property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. Capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use. In Estate of Walling v. Commissioner, 373 F.2d 192-93 (3rd Cir. 1966), the court explained that the relevant distinction between capital improvements and repairs is whether the expenditures were made to “put” or “keep” property in ordinary efficient operating condition. In Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8, the court stated that if the expenditure merely restores the property to the state it was in before the situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer-lived, then such an expenditure is usually considered a deductible repair. In contrast, a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property. …


Even if the expenditures include the replacement of numerous parts of an asset, if the replacements are a relatively minor portion of the physical structure of the asset, or of any of its major parts, such that the asset as [sic] whole has not gained materially in value or useful life, then the costs incurred may be deducted as incidental repairs or maintenance expenses. [citations omitted]. The same conclusion is true even if such minor portion of the asset is replaced with new and improved materials. [citation omitted].


If, however, a major component or a substantial structural part of the asset is replaced and, as a result, the asset as a whole has increased in value, life expectancy, or use then the costs of the replacement must be capitalized. [citations omitted].


In addition, although the high cost of work performed may be considered in determining whether an expenditure is capital in nature, cost alone is not dispositive. [citations omitted].


Similarly, the fact that a taxpayer is required by a regulatory authority to make certain repairs or to perform certain maintenance on an asset in order to continue operating the asset in its business does not mean that the work performed materially increases the value of such asset, substantially prolongs its useful life, or adapts it to a new use. [citations omitted].


The characterization of any cost as a deductible repair or capital improvement depends on the context in which the cost is incurred. Specifically, where an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expenditure must be capitalized, even though, standing alone, the item may be classified as one of repair or maintenance. United States v. Wehrli, 400 F.2d 686, 689 (10th Cir. 1968). Whether a general plan of rehabilitation exists, and whether a particular repair or maintenance item is part of it, are questions of fact to be determined based upon all the surrounding facts and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done. Id. at 690. The existence of a written plan, by itself, is not sufficient to trigger the plan of rehabilitation doctrine. [citations omitted].


In general, the courts have applied the plan of rehabilitation doctrine to require a taxpayer to capitalize otherwise deductible repair and maintenance costs where the taxpayer has a plan to make substantial capital improvements to property and the repairs are incidental to that plan. [citations omitted].


On the other hand, the courts and the Service have not applied the plan of rehabilitation doctrine to situations where the plan did not include substantial capital improvements and repairs to the same asset, the plan primarily involved repair and maintenance items, or the work was performed merely to keep the property in an ordinarily efficient operating condition. [citations omitted].


5. Consider again our servicing of an automobile.


• changing the oil “keeps” the automobile in operating condition – it does not “put” the automobile in an ordinarily efficient operating condition over its probable useful life for the uses for which it was acquired. It does not prolong the life of the automobile, materially increase its value, or make it adaptable to a different use. Deduct as repair.


• replacing worn out tires with better tires has not appreciably prolonged the life of the automobile or made it more useful. However, it may have increased the value of the automobile to more than it was, even when the 20,000 tires were new. Capitalize.


• equipping the automobile with a trailer hitch may have adapted the automobile to a different use than transporting passengers and made the automobile more useful. Capitalize.


• flushing the radiator and filling it with antifreeze should probably be treated in the same manner as changing the oil. Deduct as repair.


• replacing the engine block is the replacement of a major component or a substantial structural part of the automobile that results in increasing the value, life expectancy, or use of an otherwise permanently and completely inoperable automobile. Capitalize.


These answers are all obvious, right?


6. This revenue ruling did not put an end to disputes between the government and taxpayers. See Fedex Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6th Cir. 2005). In Fedex, the court determined that an entire aircraft rather than one of its engines on which work was performed was the appropriate unit of property to distinguish between a repair and an improvement. Id. at 712. The court considered four factors in making this determination:


First, … whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. Second, … whether the economic useful life of the component part is coextensive with the economic useful life of the larger unit of property. Third, … whether the larger unit of property and smaller unit of property can function without each other. Finally, … whether the component part can be and is maintained while affixed to the larger unit of property.


Id. at 710. The court also addressed the problem that all repairs prolong the useful life of an asset in the sense that but for certain repairs, the unit of property becomes inoperable. Rather than compare the condition of the property immediately before and immediately after the repair as the government had urged (id. at 714), the court compared the condition of the property immediately after the repair with its condition immediately after the last such repair. Id. at 716.108 The court found that the airplane was not worth more than it was immediately after the last servicing of the engine.



7. The IRS and the Treasury Department announced an intention to propose regulations to provide guidance in this area. Notice 2004-6, 2004-3 I.R.B. 308. The IRS and the Treasury Department announced proposed rules in 2006109 and 2008.110 In 2011, they issued temporary and proposed regulations.111 Finally, in September 2013, the IRS and the Treasury Department announced final rules and regulations concerning taxpayer treatment of the costs of acquisition, production, or improvement of tangible property.112 Except for the treatment of expenditures for “materials and supplies,” the focus of the regulations is to identify those expenditures that taxpayer must capitalize. This is different than regulations that define deductible “repairs” by identifying the characteristics of repairs. Cf. Reg. § 1.162-4 (2011, superseded) ((quoted supra) language closely resembling regulation that Tax Court quoted in first footnote in Midland Empire). As exceptions to such capitalizations, the regulations create so-called safe harbors; taxpayer conformance to the rules of these safe harbors assures them of a certain tax treatment. The regulations also provide that taxpayers may treat “routine maintenance” as a deductible expenditure. In many instances, taxpayers may follow their own accounting practices.



8. New buildings or permanent improvements or betterments to increase value: Reg. § 1.263(a)-1(a) denies deductions for amounts paid for new buildings or for permanent improvements or betterments to increase the value of any property or estate. It also denies deductions for amounts paid to restore property or to make good the exhaustion of property for which an allowance has been made.


• Reg. § 1.263(a)-1(f)(1)(i) now provides an elective de minimis safe harbor under which taxpayers with “applicable financial statements” may deduct expenditures of up to $5000 per invoice that it treats as an expense on its “applicable financial statement” and in accord with its written accounting procedures. There is no limit to the number of times taxpayer may rely on this safe harbor during a tax year.


• An “applicable financial statement” is – in order of preference – (1) a financial statement that taxpayer must file with the SEC, (2) a certified audited financial statement that taxpayer uses for credit purposes, reports to shareholders or the like, or for any other substantial non-tax purpose, and (3) a financial statement that taxpayer must provide to a federal or state government agency other than the SEC or the IRS. Reg. § 1.263-1(f)(4).


• Taxpayers without an applicable financial statement, but who maintain throughout the year accounting procedures that treat an item as an expense for non-tax purposes, may expense up to $500 per invoice. Reg. § 1.263(a)-1(f)(1)(ii).


• Taxpayers with both an applicable financial statement and a non-qualifying financial statement must meet the requirements applicable to taxpayers with an applicable financial statement in order to qualify for the elective de minimis safe harbor. Reg. § 1.263(a)-1(f)(1)(iii).


• These de minimis amounts may be exceeded. “[I]f examining agents and a taxpayer agree that certain amounts in excess of the de minimis safe harbor limitations are not material or otherwise should not be subject to review, that agreement should be respected.” Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property, 78 Fed. Reg. 57686, 57690 (2013).


• There are exceptions to this safe harbor for amounts paid for inventory, land, and certain spare parts. Reg. § 1.263(a)-1(f)(2).


• Taxpayer makes the election annually when filing his/her/its tax return, Reg. § 1.263(a)-1(f)(5), and must make it for all of the property eligible for such treatment. Id.


The importance of this safe harbor is that it eases the accounting burdens of taxpayers – both by not requiring capitalization of de minimis amounts and by allowing taxpayer to use the same accounting information that it uses for certain parties other than the IRS.


9. Unit of property: The new regulations provide a definition of a “unit of property,” i.e., “all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.” Reg. 1.263-3(e)(3)(i).


• There as some exceptions.


• Focus on a “unit of property” often goes far to resolve questions of deductible repair versus capitalized improvement. The larger the “unit of property,” the more substantial may be the components on which work is merely a “repair.” See e.g., Fedex Corp. v. United States, 291 F. Supp. 2d 699, 712 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6th Cir. 2005) (entire aircraft rather than engine was unit of property; cost of servicing engine deductible).


9a. Buildings as units of property: The regulations provide that each building and each structural component are separate single units of property. Reg. § 1.263(a)-3(e)(2)(i). The structural components of a building include HVAC systems, plumbing systems, electrical systems, all escalators, all elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other components identified in published guidance in the Federal Register or the Internal Revenue Bulletin. Reg. § 1.263(a)-3(e)(2)(B).


10. Acquired or produced tangible property: Reg. § 1.263(a)-2(d) provides in part: “Acquired or produced tangible property – (1) Requirement to capitalize. Except [for maintenance and supplies and for the de minimis safe harbor,] a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property … including leasehold improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. … Amounts paid to acquire or produce a unit of real or personal property include the invoice price, transaction costs …, and costs for work performed prior to the date that the unit of property is placed in service by the taxpayer (without regard to any applicable convention under section 168(d). A taxpayer also must capitalize amounts paid to acquire real or personal property for resale.”


11. Improvements. Reg. § 1.263(a)-3(d) provides in part: “Requirement to capitalize amounts paid for improvements. Except [for “small taxpayers,” reliance on taxpayer’s own accounting treatment of expenditures, and de minimis expenditures,] … a taxpayer generally must capitalize the related amounts …paid to improve a unit of property owned by the taxpayer. … For purposes of this section, a unit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer –


(1) Are for a betterment to the unit of property …;


(2) Restore the unit of property …; or


(3) Adapt the unit of property to a new or different use …”


11a. A “betterment”


“(i) Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;


(ii) Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component … to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or


(iii) Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.”


Reg. § 1.263(a)-3(j)(1). Would the improvement in Mr. Morris Drive-In be a betterment?


11b. A “restoration”


“(i) Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss …;


(ii) Is for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;


(iii) Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss … or relating to a casualty event …;


(iv) Returns the unit to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;


(v) Results in the rebuilding of the unit of property to a like-new condition after the end of its class life …; or


(vi) Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property …”


Reg. § 1.263(a)-3(k)(1). Whether “a part or a combination of parts … comprise a major component or a substantial structural part of a unit of property” depends on all of the facts and circumstances, including “the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.” Reg. § 1.263(a)-3(k)(6)(i). Application of this regulation will require distinguishing between parts that are “a major component or a substantial structural part of a unit of property” and those that are not.


11c. An adaptation adapts “a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.” Reg. § 1.263(a)-3(l)(1). In the case of a building, the adaptation adapts the building to a “new or different use.” Reg. § 1.263(a)-3(l)(2).


11d. The regulations provide some safe harbors to the regulation governing improvements.


• A “small taxpayer” – one whose average gross receipts for the three preceding taxable years does not exceed $10M – may elect not to apply the improvements provision to building property “if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the … building property does not exceed the lesser of” 2% of the unadjusted basis [of $1M or less] of the building property or $10,000. Reg. § 1.263(a)-3(h)(1, 3, and 4).


• “Routine maintenance” does not improve property. Reg. § 1.263(a)-3(i)(1). “Routine maintenance” is recurring activities that a taxpayer expects to perform in order to keep the building or each building system in “ordinarily efficient operating condition.” In order to be “routine” in the case of a building, taxpayer must expect to perform the activities more than once during the 10-year period following placement in service. In order to be “routine” in the case of other property, taxpayer must expect at the time of placement into service to perform the activities more than once during the class life of the property. Reg. § 1.263(a)-3(i)(i, ii).


• A taxpayer may elect to capitalize all repair and maintenance costs as improvements consistent with the manner in which it keeps its own books and records. § 1.263(a)-3(n)(1). This permits taxpayers who conservatively capitalized all repair and maintenance costs to elect not to undertake the burden of changing their practices.


12. Reg. § 1.162-4(a) permits expensing of residual amounts as “repairs and maintenance.” Additionally, Reg. § 1.162-3 establishes rules for the timing and deductibility of incidental and non-incidental “materials and supplies.” “Materials and supplies” are tangible property that taxpayer uses or consumes in its operations that is not inventory that


• is a component that taxpayer acquires to maintain, repair, or improve a unit of tangible property and that is not acquired as a part of any single unit of tangible property,


• is fuel, lubricants, water, and the like – that taxpayer reasonably expects to consume in 12 months or less, beginning when taxpayer uses the items in its operations,


• is a unit of property with an “economic useful life” (i.e., the period over which taxpayer may reasonably expect the property to be useful and relying on taxpayer’s assessment in its “applicable financial statement” if it has one, Reg. § 1.162-3(c)(4)) of 12 months or less, beginning when the taxpayer uses or consumes the item in its operations,


• is a unit of property whose acquisition cost or production cost is $200 or less, or


• is identified in the Federal Register or the Internal Revenue Bulletin as “materials and supplies.”


Reg. § 1.162-3(c)(1).


“Incidental materials and supplies” are those that taxpayer keeps on hand and of which taxpayer keeps no record of consumption or takes no physical inventory at the beginning and end of the taxable year. Taxpayer may deduct the costs of “incidental materials and supplies” in the year in which it pays for them, provided that its income is clearly reflected. Reg. § 1.162-3(a)(2). “Non-incidental materials and supplies” are, presumably, all other materials and supplies. Taxpayer may deduct their costs when it first uses or consumes them in its operations. Reg. § 1.162-3(a)(1).


“Materials and supplies” are neither a capital asset under § 1221 nor “property used in the trade or business” under § 1231. Reg. § 1.162-3(g). There is no provision to capitalize “materials and supplies” except for rotable spare parts, temporary spare parts, and standby emergency spare parts. Taxpayer must deduct expenditures for other “materials and supplies” at the appropriate time.


The regulation provides special rules for “rotable spare parts,” “temporary spare parts,” and “standby emergency spare parts.” Such parts are all deemed to be “materials and supplies.” Reg. § 1.162-3(c)(2, 3).


• “Rotable spare parts” are parts that taxpayer acquires for installation on a unit of property. They are removable and subject to repair and improvement. Taxpayer may either reinstall the parts or store them for later installation. Reg. § 1.162-3(c)(2).


• “Temporary spare parts” are parts that taxpayer acquires for temporary use until a new or repaired part can be installed. The temporary spare part is removed and stored for later installation. Reg. § 1.162-3(c)(2).


• “Standby emergency spare parts” are parts that taxpayer acquires for particular machinery or equipment that it sets aside to avoid substantial time lost due to emergencies. Taxpayer keeps such parts near the site of the machinery or equipment to which they directly relate so that they are readily available. The parts are normally expensive and available only on special order. The parts are not subject to normal periodic replacement. The parts are not interchangeable with the parts in other machines and equipment. Taxpayer does not acquire them in quantity and does not repair or reuse them. Reg. § 1.162-3(c)(3).


In the case of rotable and temporary spare parts, taxpayer’s first use or consumption is deemed to be the taxable year of disposal of the parts. Reg. § 1.162-3(a)(3). Disposal of rotable and temporary spare parts is an event that may be far into the future for a taxpayer, and taxpayers should hope that they never have to use or consume emergency spare parts. The regulations give taxpayer the option of electing to capitalize and depreciate such assets. The election applies to the taxable year in which taxpayer acquired or produced such parts. Reg. § 1.162-3(d).


• Such an election is not available to the taxpayer if the part’s reasonably expected useful life is 12 months or less beginning with the taxpayer’s use or consumption of the item, if the part’s production or acquisition cost is $200 or less, or if guidance in the Federal Register or in the Internal Revenue Bulletin provides that the item is materials and supplies. Reg. § 1.162-3(d). An election also is not available if the part is a component acquired to maintain, repair, or improve a unit of tangible property that taxpayer owns, leases, or services and not as part of any single unit of tangible property. Id.


• Taxpayer makes the election when filing a tax return for the taxable year in which the asset was placed in service.


With respect to rotable and temporary spare parts, taxpayer may use an optional method of accounting. Under the optional method, taxpayer deducts the amount paid to acquire or produce the part in the taxable year that the part is first installed on a unit of property for use in taxpayer’s operations. Reg. § 1.162-3(e)(2)(i). Upon removal of the part, taxpayer must recapture as gross income the deduction, and the recaptured income subject to tax becomes the basis of the part. Reg. § 1.162-3(e)(2)(ii). Taxpayer must add repair and maintenance expenses of the part to the part’s basis. Reg. § 1.162-3(e)(2)(iii). Upon reinstallation, taxpayer deducts both the costs of reinstallation and the basis of the part. Reg. § 1.162-3(e)(2)(iv). Upon disposal of the part, taxpayer deducts any remaining basis in the part. Reg. § 1.162-3(e)(2)(v). A taxpayer who uses the optional method must use it for all of its pools of rotable and temporary spare parts in the same trade or business and consistently with taxpayer’s accounting method for its own books and records. Reg. § 1.162-3(e)(1).


13. Examples and hypotheticals:


13a. In Year 1, A purchases 10 printers at $250 each for a total cost of $2500 as indicated by the invoice. Assume that each printer is a unit of property. A does not have an AFS. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property that costs less than $500, and A treats the amounts paid for the printers as an expense on its books and records. May A deduct the cost of the printers? See Reg. § 1.263(a)-1(i)(7), Example 1.


• Same facts, except that the printers cost $600 each. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $1000, and A treats the amounts paid for the printers as an expense on its books and records. May A deduct the cost of the printers? See Reg. § 1.263(a)-1(i)(7), Example 2.


13b. A purchases new cash registers for use in its retail store located in leased space in a shopping mall that cost $6000 each. Assume each cash register is a unit of property and is not a material or supply. May A deduct the cost of the cash registers? See Reg. § 1.263(a)-2(d)(2), Example 1.


13c. H owns locomotives that it uses in its railroad business. Each locomotive consists of various components, such as an engine, generators, batteries, and trucks. H acquired a locomotive with all its components. Is the locomotive a single unit of property? See Reg. § 1.263(a)-3(e)(6), Example 8.


13d. J provides legal services to its clients. J purchases a laptop computer and a printer for its employees to use in providing legal services. Are the computer and printer a single unit of property or separate units of property? See Reg. § 1.263(a)-3(e)(6), Example 9.


13e. E is a towboat operator that owns and leases a fleet of towboats. Each towboat is equipped with two diesel-powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. At the time that E places its towboats into service, E is aware that approximately every three to four years E will need to perform scheduled maintenance on the two towboat engines to keep the engines in their ordinarily efficient operating condition. This maintenance is completed while the engines are attached to the towboat and involves the cleaning and inspecting of the engines to determine which parts are within acceptable operating tolerances and can continue to be used, which parts must be reconditioned to be brought back to acceptable tolerances, and which parts must be replaced. Engine parts replaced during these procedures are replaced with comparable and commercially available replacement parts. Assume the towboat engines are not rotable spare parts. In Year 1, E acquired a new towboat, including its two engines, and placed the towboat into service. In Year 5, E pays amounts to perform scheduled maintenance on both engines in the towboat. Should E be permitted to deduct these expenses as routine maintenance? See Reg. § 1.263(a)-3(i)(6), Example 9.


13f. Consider the following: In Year 1, X purchased a store located on a parcel of land that contained underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the unit of property. The tanks had leaked, causing soil contamination. X was not aware of the contamination at the time of purchase. In Year 2, X discovered the contamination and incurred costs to remediate the soil. May X deduct the expenses of soil remediation, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 1.


13g. X owns an office building that was constructed with insulation that contained asbestos. The health dangers of asbestos were not widely known when the building was constructed. Several years after X places the building into service, B determines that certain areas of asbestos-containing insulation had begun to deteriorate and could eventually pose a health risk to employees. Therefore, X decided to remove the asbestos-containing insulation from the building and replace it with new insulation that was safer to employees, but no more efficient or effective than the asbestos insulation. May X deduct the expenses of removal of the asbestos and replacement with safer insulation, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 2.


13h. X acquires a building for use in its business of providing assisted living services. Before and after the purchase, the building functioned as an assisted living facility. However, at the time of the purchase, X was aware that the building was in a condition below the standards that it requires for facilities used in its business. Immediately after the acquisition and during the following two years, while X continued to use the building as an assisted living facility, X incurred costs for extensive repairs and maintenance, and the acquisition of new property to bring the facility into the high-quality condition for which X’s facilities are known. The work included repairing damaged drywall; repainting and re-wallpapering; replacing flooring materials, windows, and tiling and fixtures in bathrooms; replacing window treatments, furniture, and cabinets; and repairing or replacing roofing materials, heating and cooling systems. May X deduct the expenses of bringing the facility into high-quality condition, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 5 (i and ii).


13i. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. May G deduct the expenses of replacing the existing engine, cab, and petroleum tank with a new engine, cab, and tank? See § 1.263(a)-3(k)(7), Example 10.


13j. D owns a parcel of land on which it previously operated a manufacturing facility. Assume that the land is the unit of property. During the course of D’s operation of the manufacturing facility, the land became contaminated with wastes from its manufacturing processes. D discontinues manufacturing operations at the site and decides to develop the property for residential housing. In anticipation of building residential property, D pays an amount to remediate the contamination caused by D’s manufacturing process. In addition, D pays an amount to regrade the land so that it can be used for residential purposes. May D deduct the amounts it paid to clean up the waste? What about the amounts it paid to regrade the land? See Reg. § 1.263(a)-3(l)(3), Example 4.


II. Deductibility Under §§ 162 or 212



After determining that an expense is not a capital expenditure, § 162 (and § 212), coupled with § 274 define and delimit the precise scope of expenses of generating income that taxpayer may deduct. Read § 162(a). How many types of trade or business expenses are deductible?


• We will consider several § 162 issues, but we will not consider them in the sequence in which they appear in the Code.


A. Travel Expenses



Read § 162(a)(2).


Commissioner v. Flowers, 326 U.S. 465 (1946)



MR. JUSTICE MURPHY delivered the opinion of the Court.


This case presents a problem as to the meaning and application of the provision of § [162(a)(2)] of the Internal Revenue Code, allowing a deduction for income tax purposes of “traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business.”


The taxpayer, a lawyer, has resided with his family in Jackson, Mississippi, since 1903. There, he has paid taxes, voted, schooled his children, and established social and religious connections. He built a house in Jackson nearly thirty years ago, and at all times has maintained it for himself and his family. He has been connected with several law firms in Jackson, one of which he formed and which has borne his name since 1922.


In 1906, the taxpayer began to represent the predecessor of the Gulf, Mobile & Ohio Railroad, his present employer. He acted as trial counsel for the railroad throughout Mississippi. From 1918 until 1927, he acted as special counsel for the railroad in Mississippi. He was elected general solicitor in 1927, and continued to be elected to that position each year until 1930, when he was elected general counsel. Thereafter, he was annually elected general counsel until September, 1940, when the properties of the predecessor company and another railroad were merged and he was elected vice-president and general counsel of the newly formed Gulf, Mobile & Ohio Railroad.


The main office of the Gulf, Mobile & Ohio Railroad is in Mobile, Alabama, as was also the main office of its predecessor. When offered the position of general solicitor in 1927, the taxpayer was unwilling to accept it if it required him to move from Jackson to Mobile. He had established himself in Jackson both professionally and personally, and was not desirous of moving away. As a result, an arrangement was made between him and the railroad whereby he could accept the position and continue to reside in Jackson on condition that he pay his traveling expenses between Mobile and Jackson and pay his living expenses in both places. This arrangement permitted the taxpayer to determine for himself the amount of time he would spend in each of the two cities, and was in effect during 1939 and 1940, the taxable years in question.


The railroad company provided an office for the taxpayer in Mobile, but not in Jackson. When he worked in Jackson, his law firm provided him with office space, although he no longer participated in the firm’s business or shared in its profits. He used his own office furniture and fixtures at this office. The railroad, however, furnished telephone service and a typewriter and desk for his secretary. It also paid the secretary’s expenses while in Jackson. Most of the legal business of the railroad was centered in or conducted from Jackson, but this business was handled by local counsel for the railroad. The taxpayer’s participation was advisory only, and was no different from his participation in the railroad’s legal business in other areas.


The taxpayer’s principal post of business was at the main office in Mobile. However, during the taxable years of 1939 and 1940, he devoted nearly all of his time to matters relating to the merger of the railroads. Since it was left to him where he would do his work, he spent most of his time in Jackson during this period. In connection with the merger, one of the companies was involved in certain litigation in the federal court in Jackson, and the taxpayer participated in that litigation.


During 1939, he spent 203 days in Jackson and 66 in Mobile, making 33 trips between the two cities. During 1940, he spent 168 days in Jackson and 102 in Mobile, making 40 trips between the two cities. The railroad paid all of his traveling expenses when he went on business trips to points other than Jackson or Mobile. But it paid none of his expenses in traveling between these two points or while he was at either of them.


The taxpayer deducted $900 in his 1939 income tax return and $1,620 in his 1940 return as traveling expenses incurred in making trips from Jackson to Mobile and as expenditures for meals and hotel accommodations while in Mobile.113 The Commissioner disallowed the deductions, which action was sustained by the Tax Court. But the Fifth Circuit Court of Appeals reversed the Tax Court’s judgment, and we granted certiorari because of a conflict between the decision below and that reached by the Fourth Circuit Court of Appeals in Barnhill v. Commissioner, 148 F.2d 913.



The portion of § [162(a)(2)] authorizing the deduction of “traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business” is one of the specific examples given by Congress in that section of “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” It is to be contrasted with the provision of § [262(a)] of the Internal Revenue Code, disallowing any deductions for “personal, living, or family expenses.” … In pertinent part, [the applicable regulation] states that “Traveling expenses, as ordinarily understood, include railroad fares and meals and lodging. If the trip is undertaken for other than business purposes, the railroad fares are personal expenses, and the meals and lodging are living expenses. If the trip is solely on business, the reasonable and necessary traveling expenses, including railroad fares, meals, and lodging, are business expenses. … Only such expenses as are reasonable and necessary in the conduct of the business and directly attributable to it may be deducted. … Commuters’ fares are not considered as business expenses, and are not deductible.”


Three conditions must thus be satisfied before a traveling expense deduction may be made under § [162(a)(2)]:


(1) The expense must be a reasonable and necessary traveling expense, as that term is generally understood. This includes such items as transportation fares and food and lodging expenses incurred while traveling.


(2) The expense must be incurred “while away from home.”


(3) The expense must be incurred in pursuit of business. This means that there must be a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer. Moreover, such an expenditure must be necessary or appropriate to the development and pursuit of the business or trade.


Whether particular expenditures fulfill these three conditions so as to entitle a taxpayer to a deduction is purely a question of fact in most instances. See Commissioner v. Heininger, 320 U. S. 467, 475. And the Tax Court’s inferences and conclusions on such a factual matter, under established principles, should not be disturbed by an appellate court. Commissioner v. Scottish American Co., 323 U. S. 119; Dobson v. Commissioner, 320 U. S. 489.


In this instance, the Tax Court, without detailed elaboration, concluded that “The situation presented in this proceeding is, in principle, no different from that in which a taxpayer’s place of employment is in one city and, for reasons satisfactory to himself, he resides in another.” It accordingly disallowed the deductions on the ground that they represent living and personal expenses, rather than traveling expenses incurred while away from home in the pursuit of business. The court below accepted the Tax Court’s findings of fact, but reversed its judgment on the basis that it had improperly construed the word “home” as used in the second condition precedent to a traveling expense deduction under § [162(a)(2)] The Tax Court, it was said, erroneously construed the word to mean the post, station, or place of business where the taxpayer was employed – in this instance, Mobile – and thus erred in concluding that the expenditures in issue were not incurred “while away from home.” The Court below felt that the word was to be given no such “unusual” or “extraordinary” meaning in this statute, that it simply meant “that place where one in fact resides” or “the principal place of abode of one who has the intention to live there permanently.” Since the taxpayer here admittedly had his home, as thus defined, in Jackson, and since the expenses were incurred while he was away from Jackson, the deduction was permissible.


The meaning of the word “home” in § [162(a)(2)] with reference to a taxpayer residing in one city and working in another has engendered much difficulty and litigation. 4 Mertens, Law of Federal Income Taxation (1942) § 25.82. The Tax Court and the administrative rulings114 have consistently defined it as the equivalent of the taxpayer’s place of business. See Barnhill v. Commissioner, supra. On the other hand, the decision below and Wallace v. Commissioner, 144 F.2d 407, have flatly rejected that view, and have confined the term to the taxpayer’s actual residence. [citation omitted].



We deem it unnecessary here to enter into or to decide this conflict. The Tax Court’s opinion, as we read it, was grounded neither solely nor primarily upon that agency’s conception of the word “home.” Its discussion was directed mainly toward the relation of the expenditures to the railroad’s business, a relationship required by the third condition of the deduction. Thus, even if the Tax Court’s definition of the word “home” was implicit in its decision, and even if that definition was erroneous, its judgment must be sustained here if it properly concluded that the necessary relationship between the expenditures and the railroad’s business was lacking. Failure to satisfy any one of the three conditions destroys the traveling expense deduction.


Turning our attention to the third condition, this case is disposed of quickly. …


The facts demonstrate clearly that the expenses were not incurred in the pursuit of the business of the taxpayer’s employer, the railroad. Jackson was his regular home. Had his post of duty been in that city, the cost of maintaining his home there and of commuting or driving to work concededly would be nondeductible living and personal expenses lacking the necessary direct relation to the prosecution of the business. The character of such expenses is unaltered by the circumstance that the taxpayer’s post of duty was in Mobile, thereby increasing the costs of transportation, food, and lodging. Whether he maintained one abode or two, whether he traveled three blocks or three hundred miles to work, the nature of these expenditures remained the same.


The added costs in issue, moreover, were as unnecessary and inappropriate to the development of the railroad’s business as were his personal and living costs in Jackson. They were incurred solely as the result of the taxpayer’s desire to maintain a home in Jackson while working in Mobile, a factor irrelevant to the maintenance and prosecution of the railroad’s legal business. The railroad did not require him to travel on business from Jackson to Mobile, or to maintain living quarters in both cities. Nor did it compel him, save in one instance, to perform tasks for it in Jackson. It simply asked him to be at his principal post in Mobile as business demanded and as his personal convenience was served, allowing him to divide his business time between Mobile and Jackson as he saw fit. Except for the federal court litigation, all of the taxpayer’s work in Jackson would normally have been performed in the headquarters at Mobile. The fact that he traveled frequently between the two cities and incurred extra living expenses in Mobile, while doing much of his work in Jackson, was occasioned solely by his personal propensities. The railroad gained nothing from this arrangement except the personal satisfaction of the taxpayer.


Travel expenses in pursuit of business within the meaning of § [162(a)(2)] could arise only when the railroad’s business forced the taxpayer to travel and to live temporarily at some place other than Mobile, thereby advancing the interests of the railroad. Business trips are to be identified in relation to business demands and the traveler’s business headquarters. The exigencies of business, rather than the personal conveniences and necessities of the traveler, must be the motivating factors. Such was not the case here.


It follows that the court below erred in reversing the judgment of the Tax Court.




MR. JUSTICE JACKSON took no part in the consideration or decision of this case.




I think the judgment of the Court of Appeals should be affirmed. When Congress used the word “home” in § [162] of the Code, I do not believe it meant “business headquarters.” And, in my opinion, this case presents no other question.


Congress allowed the deduction for “traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business.” [A Treasury Regulation] also provides: “Commuters’ fares are not considered as business expenses and are not deductible.” By this decision, the latter regulation is allowed, in effect, to swallow up the deduction for many situations where the regulation has no fit application.




… It seems questionable whether … the Tax Court has not confused the taxpayer’s principal place of employment with his employer’s. For, on the facts, Jackson, rather than Mobile, would seem more appropriately to be found his business headquarters. …




[The majority treats taxpayer as a commuter. The word “commuter”] has limitations unless it also is made a tool for rewriting the Act. The ordinary, usual connotation, [citation omitted], does not include irregular, although frequent journeys of 350 miles, requiring Pullman accommodations and some twelve to fifteen hours, one way.


Congress gave the deduction for traveling away from home on business. The commuter’s case, rightly confined, does not fall in this class. One who lives in an adjacent suburb or City and by usual modes of commutation can work within a distance permitting the daily journey and return, with time for the day’s work and a period at home, clearly can be excluded from the deduction on the basis of the section’s terms equally with its obvious purpose. … If the line may be extended somewhat to cover doubtful cases, it need not be lengthened to infinity or to cover cases as far removed from the prevailing connotation of commuter as this one. Including it pushes “commuting” too far, even for these times of rapid transit.115



Administrative construction should have some bounds. It exceeds what are legitimate when it reconstructs the statute to nullify or contradict the plain meaning of nontechnical terms not artfully employed. …


By construing “home” as “business headquarters;” by reading “temporarily” as “very temporarily” into § [162]; by bringing down “ordinary and necessary” from its first sentence into its second;116 by finding “inequity” where Congress has said none exists; by construing “commuter” to cover long distance, irregular travel, and by conjuring from the “statutory setting” a meaning at odds with the plain wording of the clause, the Government makes over understandable ordinary English into highly technical tax jargon. …



Notes and Questions:


1. Reg. § 1.162-2 is now the regulation covering “traveling expenses” whose provisions have not materially changed those quoted by the Court in Flowers.




Reimbursement of Non-deductible Expenditures: Taxpayer paid his expenses and tried to deduct them. What result if taxpayer’s employer had paid for taxpayer’s train tickets, hotels, and meals while in Mobile? Would (should) that have solved taxpayer’s problems – or made them worse? See discussion of Brandl v. Commissioner, infra.





2. Can commuting expenses ever meet the third requirement of deductibility, i.e., “a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer?”


3. Does Justice Rutledge have a point? After all, the Court later construed the word “gift” in its ordinary sense in Duberstein.


4. Upon application of the Court’s standards, why will taxpayer’s home usually be the “post, station, or place of business where the taxpayer [is] employed?”


5. Robert Rosenspan was a jewelry salesman who worked on a commission basis and paid his own traveling expenses without reimbursement. In 1964 he was the employee of two New York City jewelry manufacturers. For 300 days during the year he traveled by automobile through an extensive sales territory in the Middle West. He stayed at hotels and motels and ate at restaurants. Five times during the year he returned to New York and spent several days at his employers’ offices. There he performed a variety of services essential to his work, i.e., cleaned up his sample case, checked orders, discussed customers’ credit problems, recommended changes in stock, attended annual staff meetings, and the like. He used his brother’s Brooklyn home as a personal residential address. He kept some clothing and other belongings there. He voted, and filed his income tax returns from that address. On his trips to New York City, “out of a desire not to abuse his welcome at his brother’s home, he stayed more often” at an inn near the John F. Kennedy Airport.


• What tax issue(s) do these facts raise? How should they be resolved?


See Rosenspan v. United States, 438 F.2d 905 (2d Cir.), cert. denied, 404 U.S. 864 (1971).


5a. Folkman, an airline pilot, was stationed in San Francisco International Airport as an employee of Pan American World Airways. He flew infrequently as a pilot with Pan American because of his low seniority. His principal work was that of navigator. This work gave him little opportunity to keep up basic flying skills. To maintain his proficiency as a jet pilot, and to earn extra income, Folkman enlisted in a military reserve program. The closest Air National Guard unit that had openings for pilots of jet aircraft was in Reno, Nevada, about 250 miles from San Francisco. As a condition of membership, the Nevada Air National Guard required all pilots to reside in the Reno area. Folkman and his family moved from their home near the San Francisco airport, to Reno. Folkman divided his time between flying with Pan American from his San Francisco base and flying for the Nevada Air National Guard. During an average month Folkman spent 10 to 13 days performing services for Pan American and four to seven days fulfilling his military reserve flying obligations. Whether or not he was scheduled to fly for the National Guard on a given day, Folkman routinely returned to Reno immediately after his Pan American flights. Folkman spent more time in Reno than in San Francisco, but derived approximately 85% of his earnings from his Pan American employment.


• What tax issue(s) do these facts raise? How do you think they should be resolved and why?


See Folkman v. United States, 615 F.2d 493 (9th Cir. 1980).


5b. Taxpayer Brandl was employed by Strong Electric Co. as a traveling technical representative of the marketing department. His duties consisted of visiting, assisting and selling to Strong dealers throughout the United States. Taxpayer did a great deal of traveling. Strong’s headquarters are in Toledo, Ohio. Taxpayer neither owned nor rented an apartment or house in Toledo. When Taxpayer was in Toledo he either stayed at a motel or with his brother and sister-in-law. When Taxpayer stayed with his brother he paid no rent but did help pay for groceries and household items, and worked around the house doing maintenance and remodeling. Generally he was away from Toledo visiting customers from four to six weeks at a time, but on occasion up to three months. When Taxpayer traveled he stayed in hotels. When Taxpayer was at Strong headquarters in Toledo he took care of paper work, wrote letters to customers he had visited, and helped with general office work of the marketing department. During the tax year, Taxpayer spent a total of three months in Toledo. Taxpayer received personal mail at his brother’s home in Toledo, and he had an Ohio driver’s license. For the tax year in question, Strong paid Taxpayer $8,288.68 for his travel expenses. Taxpayer did not include that amount in income. Taxpayer did not claim a deduction for traveling expenses while away from home.


• Must Taxpayer Brandl include the $8288.68 in his taxable income?


• If so, may he deduct that amount as a “travel expense” under § 162(a)(2)?


See Brandl v. Commissioner, T.C. Memo 1974-160 (1974).




Reimbursement or Other Expense Allowance Arrangement: An employee may deduct his/her trade or business expenses. However, the employee may only claim that deduction if s/he itemizes deductions, and trade or business deductions of an employee are subject to the 2% floor for “miscellaneous deductions.” See § 67. The effect of this treatment is to reduce, if not deny, an employee’s trade or business expense deduction. Employee must include any employer reimbursement in his/her gross income.


However, § 62(a)(2)(A) permits taxpayer to reduce his/her agi by trade or business expenditures (i.e., deduct “above-the-line”) if his/her employer (or the employer’s agent or a third party) has a “reimbursement or other expense allowance arrangement.” See also Reg. § 1.62-2. The net effect of such employer reimbursement of employee trade or business expenses is a wash. The arrangement must require substantiation of deductible expenditures so that such arrangements do not become a means by which employees can receive compensation without paying income tax on it.


How is a “reimbursement or other expense allowance arrangement” advantageous to both employer and employee?





5c. Taxpayers were employees at the Nevada Test Site, a nuclear testing facility. Las Vegas, Nevada, the closest habitable community to the Test Site, is 65 miles south of the Camp Mercury control point, located at the southernmost boundary of the Test Site, and 130 miles from the northernmost boundary of the Test Site. Because of the potential dangers arising out of the activities conducted at the Test Site, the government chose this location precisely because of its remoteness from populated areas. All of the taxpayers assigned to the Test Site received, in addition to their regular wages, a per diem allowance for each day they reported for work at the Test Site. The amount of the allowance varied. Employees reporting to Camp Mercury received $5 per day; those reporting to any forward area received $7.50 per day. Employees received these allowances without regard to the actual costs incurred by them for transportation, meals, or lodging. A private contractor maintained meal and lodging facilities onsite. Employees were responsible for procuring transportation, meals, and occasionally overnight lodging when they had to work overtime.


• Should Taxpayers be permitted to exclude their per diem allowances? See Commissioner v. Kowalski, 434 U.S. 77 (1977), supra.


• Should Taxpayers be permitted to deduct the cost of their travel?


• Should Taxpayers be permitted to deduct the cost of their meals?


• Should Taxpayers be permitted to deduct the cost of their lodging?


See Coombs v. Commissioner, 608 F.2d 1269 (9th Cir. 1979).


United States v. Correll, 389 U.S. 299 (1967)



MR. JUSTICE STEWART delivered the opinion of the Court.


The Commissioner of Internal Revenue has long maintained that a taxpayer traveling on business may deduct the cost of his meals only if his trip requires him to stop for sleep or rest. The question presented here is the validity of that rule.


The respondent in this case was a traveling salesman for a wholesale grocery company in Tennessee. He customarily left home early in the morning, ate breakfast and lunch on the road, and returned home in time for dinner. In his income tax returns for 1960 and 1961, he deducted the cost of his morning and noon meals as “traveling expenses” incurred in the pursuit of his business “while away from home” under [I.R.C.] § 162(a)(2) …117 Because the respondent’s daily trips required neither sleep nor rest, the Commissioner disallowed the deductions, ruling that the cost of the respondent’s meals was a “personal, living” expense under § 262 , rather than a travel expense under § 162(a)(2). The respondent paid the tax, sued for a refund in the District Court, and there received a favorable jury verdict.118 The Court of Appeals for the Sixth Circuit affirmed, holding that the Commissioner’s sleep or rest rule is not “a valid regulation under the present statute.” In order to resolve a conflict among the circuits on this recurring question of federal income tax administration, we granted certiorari.



Under § 162(a)(2), taxpayers “traveling … away from home in the pursuit of trade or business” may deduct the total amount “expended for meals and lodging.”119 As a result, even the taxpayer who incurs substantial hotel and restaurant expenses because of the special demands of business travel receives something of a windfall, for at least part of what he spends on meals represents a personal living expense that other taxpayers must bear without receiving any deduction at all.120 Not surprisingly, therefore, Congress did not extend the special benefits of § 162(a)(2) to every conceivable situation involving business travel. It made the total cost of meals and lodging deductible only if incurred in the course of travel that takes the taxpayer “away from home.” The problem before us involves the meaning of that limiting phrase.



In resolving that problem, the Commissioner has avoided the wasteful litigation and continuing uncertainty that would inevitably accompany any purely case-by-case approach to the question of whether a particular taxpayer was “away from home” on a particular day. Rather than requiring “every meal-purchasing taxpayer to take pot luck in the courts,” the Commissioner has consistently construed travel “away from home” to exclude all trips requiring neither sleep nor rest,121 regardless of how many cities a given trip may have touched, how many miles it may have covered,122 or how many hours it may have consumed. By so interpreting the statutory phrase, the Commissioner has achieved not only ease and certainty of application, but also substantial fairness, for the sleep or rest rule places all one-day travelers on a similar tax footing, rather than discriminating against intracity travelers and commuters, who, of course, cannot deduct the cost of the meals they eat on the road. See Commissioner v. Flowers, 326 U.S. 465.



Any rule in this area must make some rather arbitrary distinctions , but at least the sleep or rest rule avoids the obvious inequity of permitting the New Yorker who makes a quick trip to Washington and back, missing neither his breakfast nor his dinner at home, to deduct the cost of his lunch merely because he covers more miles than the salesman who travels locally and must finance all his meals without the help of the Federal Treasury. And the Commissioner’s rule surely makes more sense than one which would allow the respondent in this case to deduct the cost of his breakfast and lunch simply because he spends a greater percentage of his time at the wheel than the commuter who eats breakfast on his way to work and lunch a block from his office.


The Court of Appeals nonetheless found in the “plain language of the statute” an insuperable obstacle to the Commissioner’s construction. We disagree. The language of the statute – “meals and lodging … away from home” – is obviously not self-defining. And to the extent that the words chosen by Congress cut in either direction, they tend to support, rather than defeat, the Commissioner’s position, for the statute speaks of “meals and lodging” as a unit, suggesting – at least arguably – that Congress contemplated a deduction for the cost of meals only where the travel in question involves lodging as well. Ordinarily, at least, only the taxpayer who finds it necessary to stop for sleep or rest incurs significantly higher living expenses as a direct result of his business travel,123 and Congress might well have thought that only taxpayers in that category should be permitted to deduct their living expenses while on the road.124 …



Alternatives to the Commissioner’s sleep or rest rule are, of course, available. Improvements might be imagined. But we do not sit as a committee of revision to perfect the administration of the tax laws. Congress has delegated to the Commissioner, not to the courts, the task of prescribing “all needful rules and regulations for the enforcement” of the Internal Revenue Code. 26 U.S.C. § 7805(a). In this area of limitless factual variations, “it is the province of Congress and the Commissioner, not the courts, to make the appropriate adjustments.” Commissioner v. Stidger, 386 U.S. 287, 296. The role of the judiciary in cases of this sort begins and ends with assuring that the Commissioner’s regulations fall within his authority to implement the congressional mandate in some reasonable manner. Because the rule challenged here has not been shown deficient on that score, the Court of Appeals should have sustained its validity. The judgment is therefore




MR. JUSTICE MARSHALL took no part in the consideration or decision of this case.


MR. JUSTICE DOUGLAS, with whom MR. JUSTICE BLACK and MR. JUSTICE FORTAS concur, dissenting.


The statutory words “while away from home,” § 162(a)(2), may not, in my view, be shrunken to “overnight” by administrative construction or regulations. “Overnight” injects a time element in testing deductibility, while the statute speaks only in terms of geography. As stated by the Court of Appeals:


“In an era of supersonic travel, the time factor is hardly relevant to the question of whether or not travel and meal expenses are related to the taxpayer’s business, and cannot be the basis of a valid regulation under the present statute.” Correll v. United States, 369 F.2d 87, 89-90.


I would affirm the judgment below.


Notes and Questions:


1. Is this an appropriate area for a bright line rule that may unfairly “catch” some taxpayers?


2. Read the instruction that the federal district court gave to the jury (in a footnote). Does it seem that the standard resembles the standard that the Court later adopted for § 119?


3. Under § 162(a)(2), how strong must the nexus be between the meals and a business purpose? See the Court’s last footnote. Does your answer make the approach of the commissioner seem more reasonable?


4. Did the majority’s statement of the Commissioner’s rule require an “overnight” stay – as Justice Douglas claimed in his dissent?


6. F.M. Williams was a railroad conductor with more than forty years of service with the Atlanta and West Point Railroad and the Western Railway of Alabama. Every other day Williams got up shortly after five in the morning, left his house in Montgomery, Alabama, in time to arrive at the railroad station about 6:45 a.m., attended to duties at the station, left Montgomery on the Crescent at 7:40 a.m., arrived in Atlanta, Georgia, at 12:15 p.m., took six hours off, returned to duty in time to leave Atlanta at 6:15 p.m. on the Piedmont, pulled in to Montgomery at 10:15 p.m., left the Piedmont, and reached home about midnight. It is a long, hard day. The railroad never ordered Williams to rent a room in Atlanta, nor required him to sleep during the layover period. For years, however, because he felt he needed sleep and rest in Atlanta before his return run, Williams rented a reasonably priced room in the Gordon Hotel, a small hotel near the railroad station. At the hotel he had lunch and dinner, rested and slept, bathed and freshened up before boarding the Piedmont. He had the same room for eight years. His superiors knew that he could always be reached in Atlanta at the Gordon Hotel; taxpayer was subject to call at all times. In 1955 Captain Williams incurred expenses of $796 for meals, lodging, and tips at the Gordon Hotel during his layover in Atlanta.


• Should Williams be permitted to deduct the expenses that he incurred at the Gordon Hotel?


• What issues (sub-issues) do these facts raise?


See Williams v. Patterson, 286 F.2d 333 (5th Cir. 1961).


4a. Taxpayer B was a ferryboat captain. He worked in the Puget Sound area of Washington State. During the summer months, he typically worked 18-hour days for seven consecutive days. Then he would have seven consecutive days off. His schedule was the same in the winter, except that he would typically captain a ship from Seattle to Victoria. The return voyage would be six hours later. During the six-hour layover, he would take a nap on a cot provided by his employer. He would also purchase one or two meals.


• Should taxpayer B be permitted to deduct the cost of his meals?


See Bissonnette v. Commissioner, 127 T.C. 124 (2006).


Hantzis v. Commissioner, 638 F.2d 248 (1st Cir.), cert. denied, 452 U.S. 962 (1981)



LEVIN H. CAMPBELL, Circuit Judge.


The Commissioner of Internal Revenue (Commissioner) appeals a decision of the United States Tax Court that allowed a deduction under § 162(a)(2) (1976) for expenses incurred by a law student in the course of her summer employment. …


In the fall of 1973 Catharine Hantzis (taxpayer), formerly a candidate for an advanced degree in philosophy at the University of California at Berkeley, entered Harvard Law School in Cambridge, Massachusetts, as a full-time student. During her second year of law school she sought unsuccessfully to obtain employment for the summer of 1975 with a Boston law firm. She did, however, find a job as a legal assistant with a law firm in New York City, where she worked for ten weeks beginning in June 1975. Her husband, then a member of the faculty of Northeastern University with a teaching schedule for that summer, remained in Boston and lived at the couple’s home there. At the time of the Tax Court’s decision in this case, Mr. and Mrs. Hantzis still resided in Boston.


On their joint income tax return for 1975, Mr. and Mrs. Hantzis reported the earnings from taxpayer’s summer employment ($3,750) and deducted the cost of transportation between Boston and New York, the cost of a small apartment rented by Mrs. Hantzis in New York and the cost of her meals in New York ($3,204). The deductions were taken under § 162(a)(2), which provides:


“§ 162. Trade or business expenses


(a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including


(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business ….”


The Commissioner disallowed the deduction on the ground that taxpayer’s home for purposes of § 162(a)(2) was her place of employment and the cost of traveling to and living in New York was therefore not “incurred … while away from home.” The Commissioner also argued that the expenses were not incurred “in the pursuit of a trade or business.” Both positions were rejected by the Tax Court, which found that Boston was Mrs. Hantzis’ home because her employment in New York was only temporary and that her expenses in New York were “necessitated” by her employment there. The court thus held the expenses to be deductible under § 162(a)(2).


In asking this court to reverse the Tax Court’s allowance of the deduction, the Commissioner has contended that the expenses were not incurred “in the pursuit of a trade or business.” We do not accept this argument; nonetheless, we sustain the Commissioner and deny the deduction, on the basis that the expenses were not incurred “while away from home.”




Section 262 of the Code, declares that “except as otherwise provided in this chapter, no deductions shall be allowed for personal, living, or family expenses.” Section 162 provides less of an exception to this rule than it creates a separate category of deductible business expenses. This category manifests a fundamental principle of taxation: that a person’s taxable income should not include the cost of producing that income. [citation omitted]; Commissioner v. Flowers, 326 U.S. 465, 469 (1946); [citation omitted].


The test by which “personal” travel expenses subject to tax under § 262 are distinguished from those costs of travel necessarily incurred to generate income is embodied in the requirement that, to be deductible under § 162(a)(2), an expense must be “incurred … in the pursuit of a trade or business.” In Flowers the Supreme Court read this phrase to mean that “(t)he exigencies of business rather than the personal conveniences and necessities of the traveler must be the motivating factors.” 326 U.S. at 474.125 Of course, not every travel expense resulting from business exigencies rather than personal choice is deductible; an expense must also be “ordinary and necessary” and incurred “while away from home.” § 162(a)(2); Flowers, 326 U.S. at 470. But the latter limitations draw also upon the basic concept that only expenses necessitated by business, as opposed to personal, demands may be excluded from the calculation of taxable income.



With these fundamentals in mind, we proceed to ask whether the cost of taxpayer’s transportation to and from New York, and of her meals and lodging while in New York, was incurred “while away from home in the pursuit of a trade or business.”




The Commissioner has directed his argument at the meaning of “in pursuit of a trade or business.” He interprets this phrase as requiring that a deductible traveling expense be incurred under the demands of a trade or business which predates the expense, i.e., an “already existing” trade or business. [The court rejected the commissioner’s contention.]




In other contexts the phrase “in the pursuit of a trade or business” may permit the interpretation urged upon us by the Commissioner,126 but to require under § 162(a)(2) that a travel expense be incurred in connection with a preexisting trade or business is neither necessary nor appropriate to effectuating the purpose behind the use of that phrase in the provision. Accordingly, we turn to the question whether, in the absence of the Commissioner’s proposed threshold limit on deductibility, the expenses at issue here satisfy the requirements of § 162(a)(2) as interpreted in Flowers v. Commissioner.





As already noted, Flowers construed § 162(a)(2) to mean that a traveling expense is deductible only if it is (1) reasonable and necessary, (2) incurred while away from home, and (3) necessitated by the exigencies of business. Because the Commissioner does not suggest that Mrs. Hantzis’ expenses were unreasonable or unnecessary, we may pass directly to the remaining requirements. Of these, we find dispositive the requirement that an expense be incurred while away from home. As we think Mrs. Hantzis’ expenses were not so incurred, we hold the deduction to be improper.


The meaning of the term “home” in the travel expense provision is far from clear. When Congress enacted the travel expense deduction now codified as § 162(a)(2), it apparently was unsure whether, to be deductible, an expense must be incurred away from a person’s residence or away from his principal place of business. [citation omitted] This ambiguity persists and courts, sometimes within a single circuit, have divided over the issue. Compare Six v. United States, 450 F.2d 66 (2d Cir. 1971) (home held to be residence) and Rosenspan v. United States, 438 F.2d 905 (2d Cir.), cert. denied, 404 U.S. 864 (1971) and Burns v. Gray, 287 F.2d 698 (6th Cir. 1961) and Wallace v. Commissioner, 144 F.2d 407 (9th Cir. 1944) with Markey v. Commissioner, 490 F.2d 1249 (6th Cir. 1974) (home held to be principal place of business) and Curtis v. Commissioner, 449 F.2d 225 (5th Cir. 1971) and Wills v. Commissioner, 411 F.2d 537 (9th Cir. 1969).127 It has been suggested that these conflicting definitions are due to the enormous factual variety in the cases. [citations omitted]. We find this observation instructive, for if the cases that discuss the meaning of the term “home” in § 162(a)(2) are interpreted on the basis of their unique facts as well as the fundamental purposes of the travel expense provision, and not simply pinioned to one of two competing definitions of home, much of the seeming confusion and contradiction on this issue disappears and a functional definition of the term emerges.



We begin by recognizing that the location of a person’s home for purposes of § 162(a)(2) becomes problematic only when the person lives one place and works another. Where a taxpayer resides and works at a single location, he is always home, however defined; and where a taxpayer is constantly on the move due to his work, he is never “away” from home. (In the latter situation, it may be said either that he has no residence to be away from, or else that his residence is always at his place of employment. See Rev. Rul. 60-16.) However, in the present case, the need to determine “home” is plainly before us, since the taxpayer resided in Boston and worked, albeit briefly, in New York.


We think the critical step in defining “home” in these situations is to recognize that the “while away from home” requirement has to be construed in light of the further requirement that the expense be the result of business exigencies. The traveling expense deduction obviously is not intended to exclude from taxation every expense incurred by a taxpayer who, in the course of business, maintains two homes. Section 162(a)(2) seeks rather “to mitigate the burden of the taxpayer who, because of the exigencies of his trade or business, must maintain two places of abode and thereby incur additional and duplicate living expenses.” [citations omitted]. Consciously or unconsciously, courts have effectuated this policy in part through their interpretation of the term “home” in § 162(a)(2). Whether it is held in a particular decision that a taxpayer’s home is his residence or his principal place of business, the ultimate allowance or disallowance of a deduction is a function of the court’s assessment of the reason for a taxpayer’s maintenance of two homes. If the reason is perceived to be personal, the taxpayer’s home will generally be held to be his place of employment rather than his residence and the deduction will be denied. [citations omitted]. If the reason is felt to be business exigencies, the person’s home will usually be held to be his residence and the deduction will be allowed. See, e.g., Frederick v. United States, 603 F.2d 1292 (8th Cir. 1979); [citations omitted]. We understand the concern of the concurrence that such an operational interpretation of the term “home” is somewhat technical and perhaps untidy, in that it will not always afford bright line answers, but we doubt the ability of either the Commissioner or the courts to invent an unyielding formula that will make sense in all cases. The line between personal and business expenses winds through infinite factual permutations; effectuation of the travel expense provision requires that any principle of decision be flexible and sensitive to statutory policy.


Construing in the manner just described the requirement that an expense be incurred “while away from home,” we do not believe this requirement was satisfied in this case. Mrs. Hantzis’ trade or business did not require that she maintain a home in Boston as well as one in New York. Though she returned to Boston at various times during the period of her employment in New York, her visits were all for personal reasons. It is not contended that she had a business connection in Boston that necessitated her keeping a home there; no professional interest was served by maintenance of the Boston home as would have been the case, for example, if Mrs. Hantzis had been a lawyer based in Boston with a New York client whom she was temporarily serving. The home in Boston was kept up for reasons involving Mr. Hantzis, but those reasons cannot substitute for a showing by Mrs. Hantzis that the exigencies of her trade or business required her to maintain two homes.128 Mrs. Hantzis’ decision to keep two homes must be seen as a choice dictated by personal, albeit wholly reasonable, considerations and not a business or occupational necessity. We therefore hold that her home for purposes of § 162(a)(2) was New York and that the expenses at issue in this case were not incurred “while away from home.”129



We are not dissuaded from this conclusion by the temporary nature of Mrs. Hantzis’ employment in New York. Mrs. Hantzis argues that the brevity of her stay in New York excepts her from the business exigencies requirement of § 162(a)(2) under a doctrine supposedly enunciated by the Supreme Court in Peurifoy v. Commissioner, 358 U.S. 59 (1958) (per curiam).130 The Tax Court here held that Boston was the taxpayer’s home because it would have been unreasonable for her to move her residence to New York for only ten weeks. At first glance these contentions may seem to find support in the court decisions holding that, when a taxpayer works for a limited time away from his usual home, § 162(a)(2) allows a deduction for the expense of maintaining a second home so long as the employment is “temporary” and not “indefinite” or “permanent.” [citations omitted]. This test is an elaboration of the requirements under § 162(a)(2) that an expense be incurred due to business exigencies and while away from home. Thus it has been said,



“Where a taxpayer reasonably expects to be employed in a location for a substantial or indefinite period of time, the reasonable inference is that his choice of a residence is a personal decision, unrelated to any business necessity. Thus, it is irrelevant how far he travels to work. The normal expectation, however, is that the taxpayer will choose to live near his place of employment. Consequently, when a taxpayer reasonable (sic) expects to be employed in a location for only a short or temporary period of time and travels a considerable distance to the location from his residence, it is unreasonable to assume that his choice of a residence is dictated by personal convenience. The reasonable inference is that he is temporarily making these travels because of a business necessity.”


Frederick, supra, 603 F.2d at 1294-95 (citations omitted).


The temporary employment doctrine does not, however, purport to eliminate any requirement that continued maintenance of a first home have a business justification. We think the rule has no application where the taxpayer has no business connection with his usual place of residence. If no business exigency dictates the location of the taxpayer’s usual residence, then the mere fact of his taking temporary employment elsewhere cannot supply a compelling business reason for continuing to maintain that residence. Only a taxpayer who lives one place, works another and has business ties to both is in the ambiguous situation that the temporary employment doctrine is designed to resolve. In such circumstances, unless his employment away from his usual home is temporary, a court can reasonably assume that the taxpayer has abandoned his business ties to that location and is left with only personal reasons for maintaining a residence there. Where only personal needs require that a travel expense be incurred, however, a taxpayer’s home is defined so as to leave the expense subject to taxation. See supra. Thus, a taxpayer who pursues temporary employment away from the location of his usual residence, but has no business connection with that location, is not “away from home” for purposes of § 162(a)(2). [citations omitted].


On this reasoning, the temporary nature of Mrs. Hantzis’ employment in New York does not affect the outcome of her case. She had no business ties to Boston that would bring her within the temporary employment doctrine. By this holding, we do not adopt a rule that “home” in § 162(a)(2) is the equivalent of a taxpayer’s place of business. Nor do we mean to imply that a taxpayer has a “home” for tax purposes only if he is already engaged in a trade or business at a particular location. Though both rules are alluringly determinate, we have already discussed why they offer inadequate expressions of the purposes behind the travel expense deduction. We hold merely that for a taxpayer in Mrs. Hantzis’ circumstances to be “away from home in the pursuit of a trade or business,” she must establish the existence of some sort of business relation both to the location she claims as “home” and to the location of her temporary employment sufficient to support a finding that her duplicative expenses are necessitated by business exigencies. This, we believe, is the meaning of the statement in Flowers that “(b)usiness trips are to be identified in relation to business demands and the traveler’s business headquarters.” 326 U.S. at 474 254 (emphasis added). On the uncontested facts before us, Mrs. Hantzis had no business relation to Boston; we therefore leave to cases in which the issue is squarely presented the task of elaborating what relation to a place is required under § 162(a)(2) for duplicative living expenses to be deductible.




KEETON, District Judge, concurring in the result.


Although I agree with the result reached in the court’s opinion, and with much of its underlying analysis, I write separately because I cannot join in the court’s determination that New York was the taxpayer’s home for purposes of § 162(a)(2). In so holding, the court adopts a definition of “home” that differs from the ordinary meaning of the term and therefore unduly risks causing confusion and misinterpretation of the important principle articulated in this case.


In adopting § 162(a)(2), Congress sought “to mitigate the burden of the taxpayer who, because of the exigencies of his trade or business, must maintain two places of abode and thereby incur additional and duplicate living expenses.” [citations omitted]. In the present case, the taxpayer does not contend that she maintained her residence in Boston for business reasons. Before working in New York, she had attended school near her home in Boston, and she continued to do so after she finished her summer job. In addition, her husband lived and worked in Boston. Thus, on the facts in this case, I am in agreement with the court that the taxpayer’s deductions must be disallowed because she was not required by her trade or business to maintain both places of residence. However rather than resting its conclusion on an interpretation of the language of § 162(a)(2) taken as a whole, which allows a deduction for ordinary and necessary expenses incurred “while away from home in the pursuit of trade or business,” the court reaches the same result by incorporating the concept of business-related residence into the definition of “home,” thereby producing sometimes, but not always, a meaning of “home” quite different from ordinary usage.




… I read the opinion as indicating that in a dual residence case, the Commissioner must determine whether the exigencies of the taxpayer’s trade or business require her to maintain both residences. If so, the Commissioner must decide that the taxpayer’s principal residence is her “home” and must conclude that expenses associated with the secondary residence were incurred “while away from home,” and are deductible. If not, as in the instant case, the Commissioner must find that the taxpayer’s principal place of business is her “home” and must conclude that the expenses in question were not incurred “while away from home.” The conclusory nature of these determinations as to which residence is her “home” reveals the potentially confusing effect of adopting an extraordinary definition of “home.”


A word used in a statute can mean, among the cognoscenti, whatever authoritative sources define it to mean. Nevertheless, it is a distinct disadvantage of a body of law that it can be understood only by those who are expert in its terminology. Moreover, needless risks of misunderstanding and confusion arise, not only among members of the public but also among professionals who must interpret and apply a statute in their day-to-day work, when a word is given an extraordinary meaning that is contrary to its everyday usage.


The result reached by the court can easily be expressed while also giving “home” its ordinary meaning, and neither Congress nor the Supreme Court has directed that “home” be given an extraordinary meaning in the present context. See Flowers, supra, Stidger, supra, and Peurifoy, supra. In Rosenspan v. United States, supra, Judge Friendly, writing for the court, rejected the Commissioner’s proposed definition of home as the taxpayer’s business headquarters, concluding that in § 162(a)(2) “‘home’ means ‘home.’” Id. at 912.


When Congress uses a non-technical word in a tax statute, presumably it wants administrators and courts to read it in the way that ordinary people would understand, and not “to draw on some unexpressed spirit outside the bounds of the normal meaning of words.” Addison v. Holly Hill Fruit Prods., Inc., 322 U.S. 607, 617 (1944).


Id. at 911. [citation omitted].


In analyzing dual residence cases, the court’s opinion advances compelling reasons that the first step must be to determine whether the taxpayer has business as opposed to purely personal reasons for maintaining both residences. This must be done in order to determine whether the expenses of maintaining a second residence were, “necessitated by business, as opposed to personal, demands,” and were in this sense incurred by the taxpayer “while away from home in pursuit of trade or business.” Necessarily implicit in this proposition is a more limited corollary that is sufficient to decide the present case: When the taxpayer has a business relationship to only one location, no traveling expenses the taxpayer incurs are “necessitated by business, as opposed to personal demands,” regardless of how many residences the taxpayer has, where they are located, or which one is “home.”


In the present case, although the taxpayer argues that her employment required her to reside in New York, that contention is insufficient to compel a determination that it was the nature of her trade or business that required her to incur the additional expense of maintaining a second residence, the burden that § 162(a)(2) was intended to mitigate. Her expenses associated with maintaining her New York residence arose from personal interests that led her to maintain two residences rather than a single residence close to her work.131 While traveling from her principal residence to a second place of residence closer to her business, even though “away from home,” she was not “away from home in pursuit of business.” Thus, the expenses at issue in this case were not incurred by the taxpayer “while away from home in pursuit of trade or business.”



In the contrasting case in which a taxpayer has established that both residences were maintained for business reasons, § 162(a)(2) allows the deduction of expenses associated with travel to, and maintenance of, one of the residences if they are incurred for business reasons and that abode is not the taxpayer’s home. A common sense meaning of “home” works well to achieve the purpose of this provision.


In summary, the court announces a sound principle that, in dual residence cases, deductibility of traveling expenses depends upon a showing that both residences were maintained for business reasons. If that principle is understood to be derived from the language of § 162(a)(2) taken as a whole, “home” retains operative significance for determining which of the business-related residences is the one the expense of which can be treated as deductible. In this context, “home” should be given its ordinary meaning to allow a deduction only for expenses relating to an abode that is not the taxpayer’s principal place of residence. On the undisputed facts in this case, the Tax Court found that Boston was the taxpayer’s “home” in the everyday sense, i.e., her principal place of residence. Were the issue relevant to disposition of the case, I would uphold the Tax Court’s quite reasonable determination on the evidence before it. However, because the taxpayer had no business reason for maintaining both residences, her deduction for expenses associated with maintaining a second residence closer than her principal residence to her place of employment must be disallowed without regard to which of her two residences was her “home” under § 162(a)(2).


Notes and Questions:


1. Obviously, the meaning of “home” is not to be determined by the ordinary use of the term.


2. Does the court’s opinion conflate the second and third requirements of Flowers?


3. On which of the Flowers requirements does Judge Keeton rely to deny taxpayers a deduction?


4. Taxpayer owned and operated a very successful swimming pool construction business in Lynnfield, Massachusetts. He also owned and operated a very successful horse breeding and racing business in Lighthouse Point, Florida. From November through April, he resided in Florida. From May through October, he resided in Massachusetts. Taxpayer owned a home in both Florida and Massachusetts and traveled between them in order to tend to his businesses.


• Does Taxpayer have two tax homes so that he may deduct the travel expenses associated with neither of them?


• What guidance do the opinions in Hantzis offer in answering this question?


See Andrews v. Commissioner, 931 F.2d 132 (1St Cir. 1991) (“major” post of duty; “minor” post of duty).


4a. For the past five years, Taxpayers (Mr. and Mrs. Chwalow) have maintained a residence in Bala Cynwyd, Pennsylvania. Mrs. Chwalow is a teacher in the Philadelphia public school system and specializes in working with deaf children. Dr. Chwalow is a physicist whose specialty is military optics and electrooptics encompassing areas such as night vision, laser range finding, missile guidance, aerial reconnaissance, etc. Dr. Chwalow works for IBM in Washington, D.C., where he rents an apartment. He uses public transportation to get to his job. Mrs. Chwalow continues to live in Bala Cynwyd, Pennsylvania.


• May either Mr. or Mrs. Chwalow deduct meal and lodging expenses as “travel expenses” under § 162(a)(2)?


See Chwalow v. Commissioner, 470 F.2d 475 (3rd Cir. 1972).


4b. Taxpayer Dews was a coach on the staff of the Atlanta Braves baseball team. He and his wife lived in Albany, Georgia. In the course of over 20 years in professional baseball, Dews had 37 different assignments, including as a manager of farm teams in the Atlanta organization. During one 4-year period, he was a coach for the Atlanta team. He maintained an apartment in Atlanta.


• May Dews deduct the expenses of traveling between Albany and Atlanta? May he deduct the expenses of living in Atlanta?


See Dews v. Commissioner, T.C. Memo. 1987-353, available at 1987 WL 40405.


CALI Lesson Logo


5. Read the second sentence of the carryout paragraph that ends § 162(a). It refers to § 162(a)(2). Also read § 274(m)(3). Then do the following CALI Lesson: Basic Federal Income Taxation: Deductions: Traveling Expenses.


B. Reasonable Salaries



Read § 162(a)(1). How would you determine the reasonableness of salaries? What constraints exist outside of the Code that prevent payment of excessive salaries or other compensation? What conditions make it more (or less) likely that a taxpayer is paying a greater-than-reasonable salary?


• Notice that the approach of the Code is to deny a deduction to the one who pays an excessive salary. Hence, both the recipient of the salary and the employer would pay tax on the amount paid in salary that the employer may not deduct.


Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999)



POSNER, Chief Judge.


This appeal from a judgment by the Tax Court, requires us to interpret and apply § 162(a)(1), which allows a business to deduct from its income its “ordinary and necessary” business expenses, including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” In 1993 and 1994, Exacto Spring Corporation, a closely held corporation engaged in the manufacture of precision springs, paid its cofounder, chief executive, and principal owner, William Heitz, $1.3 and $1.0 million, respectively, in salary. The Internal Revenue Service thought this amount excessive, that Heitz should not have been paid more than $381,000 in 1993 or $400,000 in 1994, with the difference added to the corporation’s income, and it assessed a deficiency accordingly, which Exacto challenged in the Tax Court. That court found that the maximum reasonable compensation for Heitz would have been $900,000 in the earlier year and $700,000 in the later one – figures roughly midway between his actual compensation and the IRS’s determination – and Exacto has appealed.


In reaching its conclusion, the Tax Court applied a test that requires the consideration of seven factors, none entitled to any specified weight relative to another. The factors are, in the court’s words, “(1) the type and extent of the services rendered; (2) the scarcity of qualified employees; (3) the qualifications and prior earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer’s business.” It is apparent that this test, though it or variants of it (one of which has the astonishing total of 21 factors, Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-79 (1981)), are encountered in many cases, see, e.g. Edwin’s Inc. v. United States, 501 F.2d 675, 677 (7th Cir.1974); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323 (5th Cir.1987); Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.1949); 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts ¶ 22.2.2, p. 22-21 (3d ed.1999), leaves much to be desired – being, like many other multi-factor tests, “redundant, incomplete, and unclear.” Palmer v. City of Chicago, 806 F.2d 1316, 1318 (7th Cir.1986).


To begin with, it is nondirective. No indication is given of how the factors are to be weighed in the event they don’t all line up on one side. And many of the factors, such as the type and extent of services rendered, the scarcity of qualified employees, and the peculiar characteristics of the employer’s business, are vague.


Second, the factors do not bear a clear relation either to each other or to the primary purpose of § 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. E.g., Rapco, Inc. v. Commissioner, 85 F.3d 950, 954 n. 2 (2d Cir.1996). Suppose that an employee who let us say was, like Heitz, a founder and the chief executive officer and principal owner of the taxpayer rendered no services at all but received a huge salary. It would be absurd to allow the whole or for that matter any part of his salary to be deducted as an ordinary and necessary business expense even if he were well qualified to be CEO of the company, the company had substantial net earnings, CEOs of similar companies were paid a lot, and it was a business in which high salaries are common. The multi-factor test would not prevent the Tax Court from allowing a deduction in such a case even though the corporation obviously was seeking to reduce its taxable income by disguising earnings as salary. The court would not allow the deduction, but not because of anything in the multi-factor test; rather because it would be apparent that the payment to the employee was not in fact for his services to the company. Reg. § 1.162-7(a); 1 Bittker & Lokken, supra, ¶ 22.2.1, p. 22-19.


Third, the seven-factor test invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts, as we have repeatedly noted in the Title VII context, e.g., Jackson v. E.J. Brach Corp., 176 F.3d 971, 984 (7th Cir. 1999), and as the Delaware Chancery Court has noted in the more germane context of derivative suits alleging excessive compensation of corporate employees. Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 (Del. Ch. 1996). The test – the irruption of “comparable worth” thinking (see, e.g., American Nurses’ Ass’n v. Illinois, 783 F.2d 716 (7th Cir. 1986)) in a new context – invites the court to decide what the taxpayer’s employees should be paid on the basis of the judges’ own ideas of what jobs are comparable, what relation an employee’s salary should bear to the corporation’s net earnings, what types of business should pay abnormally high (or low) salaries, and so forth. The judges of the Tax Court are not equipped by training or experience to determine the salaries of corporate officers; no judges are.




Irruption: a breaking or bursting in; a violent incursion or invasion.





Fourth, since the test cannot itself determine the outcome of a dispute because of its nondirective character, it invites the making of arbitrary decisions based on uncanalized discretion or unprincipled rules of thumb. The Tax Court in this case essentially added the IRS’s determination of the maximum that Mr. Heitz should have been paid in 1993 and 1994 to what he was in fact paid, and divided the sum by two. It cut the baby in half. One would have to be awfully naive to believe that the seven-factor test generated this pleasing symmetry.


Fifth, because the reaction of the Tax Court to a challenge to the deduction of executive compensation is unpredictable, corporations run unavoidable legal risks in determining a level of compensation that may be indispensable to the success of their business.


The drawbacks of the multi-factor test are well illustrated by its purported application by the Tax Court in this case. With regard to factor (1), the court found that Heitz was “indispensable to Exacto’s business” and “essential to Exacto’s success.” Heitz is not only Exacto’s CEO; he is also the company’s chief salesman and marketing man plus the head of its research and development efforts and its principal inventor. The company’s entire success appears to be due on the one hand to the research and development conducted by him and on the other hand to his marketing of these innovations (though he receives some additional compensation for his marketing efforts from a subsidiary of Exacto). The court decided that factor (1) favored Exacto.


Likewise factor (2), for, as the court pointed out, the design of precision springs, which is Heitz’s specialty, is “an extremely specialized branch of mechanical engineering, and there are very few engineers who have made careers specializing in this area,” let alone engineers like Heitz who have “the ability to identify and attract clients and to develop springs to perform a specific function for that client…. It would have been very difficult to replace Mr. Heitz.” Notice how factors (1) and (2) turn out to be nearly identical.


Factors (3) and (4) also supported Exacto, the court found. “Mr Heitz is highly qualified to run Exacto as a result of his education, training, experience, and motivation. Mr. Heitz has over 40 years of highly successful experience in the field of spring design.” And his “efforts were of great value to the corporation.” So factor (4) duplicated (2), and so the first four factors turn out to be really only two.


With regard to the fifth factor – the employer’s (Exacto’s) net earnings – the Tax Court was noncommittal. Exacto had reported a loss in 1993 and very little taxable income in 1994. But it conceded having taken some improper deductions in those years unrelated to Heitz’s salary. After adjusting Exacto’s income to remove these deductions, the court found that Exacto had earned more than $1 million in each of the years at issue net of Heitz’s supposedly inflated salary.


The court was noncommital with regard to the sixth factor – earnings of comparable employees – as well. The evidence bearing on this factor had been presented by expert witnesses, one on each side, and the court was critical of both. The taxpayer’s witness had arrived at his estimate of Heitz’s maximum reasonable compensation in part by aggregating the salaries that Exacto would have had to pay to hire four people each to wear one of Heitz’s “hats,” as chief executive officer, chief manufacturing executive, chief research and development officer, and chief sales and marketing executive. Although the more roles or functions an employee performs the more valuable his services are likely to be, Dexsil Corp. v. Commissioner, 147 F.3d 96, 102-03 (2d Cir.1998); Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-46 (9th Cir.1983), an employee who performs four jobs, each on a part-time basis, is not necessarily worth as much to a company as four employees each working full time at one of those jobs. It is therefore arbitrary to multiply the normal full-time salary for one of the jobs by four to compute the reasonable compensation of the employee who fills all four of them. Anyway salaries are determined not by the method of comparable worth but, like other prices, by the market, which is to say by conditions of demand and supply. Especially in the short run, salaries may vary by more than any difference in the “objective” characteristics of jobs. An individual who has valuable skills that are in particularly short supply at the moment may command a higher salary than a more versatile, better-trained, and more loyal employee whose skills are, however, less scarce.


The Internal Revenue Service’s expert witness sensibly considered whether Heitz’s compensation was consistent with Exacto’s investors’ earning a reasonable return (adjusted for the risk of Exacto’s business), which he calculated to be 13%. But in concluding that Heitz’s compensation had pushed the return below that level, he neglected to consider the concessions of improper deductions, which led to adjustments to Exacto’s taxable income. The Tax Court determined that with those adjustments the investors’ annual return was more than 20% despite Heitz’s large salary. The government argues that the court should not have calculated the investors’ return on the basis of the concessions of improper deductions, because when Heitz’s compensation was determined the corporation was unaware that the deductions would be disallowed. In other words, the corporation thought that its after-tax income was larger than it turned out to be. But if the ex ante perspective is the proper one, as the government contends, it favors the corporation if when it fixed Heitz’s salary it thought there was more money in the till for the investors than has turned out to be the case.


What is puzzling is how disallowing deductions and thus increasing the taxpayer’s tax bill could increase the investors’ return. What investors care about is the corporate income available to pay dividends or be reinvested; obviously money paid in taxes to the Internal Revenue Service is not available for either purpose. The reasonableness of Heitz’s compensation thus depends not on Exacto’s taxable income but on the corporation’s profitability to the investors, which is reduced by the disallowance of deductions – if a corporation succeeds in taking phantom deductions, shareholders are better off because the corporation’s tax bill is lower. But the government makes nothing of this. Its only objection is to the Tax Court’s having taken account of adjustments made after Heitz’s salary was fixed. Both parties, plus the Tax Court, based their estimates of investors’ returns on the after-tax income shown on Exacto’s tax returns, which jumped after the deductions were disallowed, rather than on Exacto’s real profits, which declined. The approach is inconsistent with a realistic assessment of the investors’ rate of return, but as no one in the case questions it we shall not make an issue of it.


Finally, under factor (7) (“peculiar characteristics”), the court first and rightly brushed aside the IRS’s argument that the low level of dividends paid by Exacto (zero in the two years at issue, but never very high) was evidence that the corporation was paying Heitz dividends in the form of salary. The court pointed out that shareholders may not want dividends. They may prefer the corporation to retain its earnings, causing the value of the corporation to rise and thus enabling the shareholders to obtain corporate earnings in the form of capital gains taxed at a lower rate than ordinary income. The court also noted that while Heitz, as the owner of 55% of Exacto’s common stock, obviously was in a position to influence his salary, the corporation’s two other major shareholders, each with 20% of the stock, had approved it. They had not themselves been paid a salary or other compensation, and are not relatives of Heitz; they had no financial or other incentive to allow Heitz to siphon off dividends in the form of salary.


Having run through the seven factors, all of which either favored the taxpayer or were neutral, the court reached a stunning conclusion: “We have considered the factors relevant in deciding reasonable compensation for Mr. Heitz. On the basis of all the evidence, we hold that reasonable compensation for Mr. Heitz” was much less than Exacto paid him. The court’s only effort at explaining this result when Exacto had passed the seven-factor test with flying colors was that “we have balanced Mr. Heitz’ unique selling and technical ability, his years of experience, and the difficulty of replacing Mr. Heitz with the fact that the corporate entity would have shown a reasonable return for the equity holders, after considering petitioners’ concessions.” Id. But “the fact that the corporate entity would have shown a reasonable return for the equity holders” after the concessions is on the same side of the balance as the other factors; it does not favor the Internal Revenue Service’s position. The government’s lawyer was forced to concede at the argument of the appeal that she could not deny the possibility that the Tax Court had pulled its figures for Heitz’s allowable compensation out of a hat.


The failure of the Tax Court’s reasoning to support its result would alone require a remand. But the problem with the court’s opinion goes deeper. The test it applied does not provide adequate guidance to a rational decision. We owe no deference to the Tax Court’s statutory interpretations, its relation to us being that of a district court to a court of appeals, not that of an administrative agency to a court of appeals. 26 U.S.C. § 7482(a)(1); [citations omitted]. The federal courts of appeals, whose decisions do of course have weight as authority with us even when they are not our own decisions, have been moving toward a much simpler and more purposive test, the “independent investor” test. Dexsil Corp. v. Commissioner, supra; Elliotts, Inc. v. Commissioner, supra, 716 F.2d at 1245-48; Rapco, Inc. v. Commissioner, supra, 85 F.3d at 954-55. We applaud the trend and join it.


Because judges tend to downplay the element of judicial creativity in adapting law to fresh insights and changed circumstances, the cases we have just cited prefer to say (as in Dexsil and Rapco) that the “independent investor” test is the “lens” through which they view the seven (or however many) factors of the orthodox test. But that is a formality. The new test dissolves the old and returns the inquiry to basics. The Internal Revenue Code limits the amount of salary that a corporation can deduct from its income primarily in order to prevent the corporation from eluding the corporate income tax by paying dividends but calling them salary because salary is deductible and dividends are not. (Perhaps they should be, to avoid double taxation of corporate earnings, but that is not the law.) In the case of a publicly held company, where the salaries of the highest executives are fixed by a board of directors that those executives do not control, the danger of siphoning corporate earnings to executives in the form of salary is not acute. The danger is much greater in the case of a closely held corporation, in which ownership and management tend to coincide; unfortunately, as the opinion of the Tax Court in this case illustrates, judges are not competent to decide what business executives are worth.


There is, fortunately, an indirect market test, as recognized by the Internal Revenue Service’s expert witness. A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner’s investment. The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid, for it will be implausible that if he quit if his salary was cut, and he was replaced by a lower-paid manager, the owner would be better off; it would be killing the goose that lays the golden egg. The Service’s expert believed that investors in a firm like Exacto would expect a 13% return on their investment. Presumably they would be delighted with more. They would be overjoyed to receive a return more than 50% greater than they expected – and 20%, the return that the Tax Court found that investors in Exacto had obtained, is more than 50% greater than the benchmark return of 13%.


When, notwithstanding the CEO’s “exorbitant” salary (as it might appear to a judge or other modestly paid official), the investors in his company are obtaining a far higher return than they had any reason to expect, his salary is presumptively reasonable. We say “presumptively” because we can imagine cases in which the return, though very high, is not due to the CEO’s exertions. Suppose Exacto had been an unprofitable company that suddenly learned that its factory was sitting on an oil field, and when oil revenues started to pour in its owner raised his salary from $50,000 a year to $1.3 million. The presumption of reasonableness would be rebutted. There is no suggestion of anything of that sort here and likewise no suggestion that Mr. Heitz was merely the titular chief executive and the company was actually run by someone else, which would be another basis for rebuttal.


The government could still have prevailed by showing that while Heitz’s salary may have been no greater than would be reasonable in the circumstances, the company did not in fact intend to pay him that amount as salary, that his salary really did include a concealed dividend though it need not have. This is material (and the “independent investor” test, like the multi-factor test that it replaces, thus incomplete, though invaluable) because any business expense to be deductible must be, as we noted earlier, a bona fide expense as well as reasonable in amount. The fact that Heitz’s salary was approved by the other owners of the corporation, who had no incentive to disguise a dividend as salary, goes far to rebut any inference of bad faith here, which in any event the Tax Court did not draw and the government does not ask us to draw.


The judgment is reversed with directions to enter judgment for the taxpayer. Reversed.


Notes and Questions:


1. Judge Posner is right in describing what is probably still the prevailing standard as a multi-factor test – with all of the problems that go with it. See E.L. Kellett, Annot., Reasonableness of Compensation Paid to Officers or Employees, so as to Warrant Deduction Thereof in Computing Employer’s Income Tax, 10 A.L.R. Fed.3d 125.


2. For what reasons would a taxpayer “pay,” i.e., compensate, an employee more than a reasonable amount of salary?


• The court observed that a shareholder derivative suit is a “more germane context” in which to evaluate excessive compensation? Why would this be true?




What’s at stake? A corporation pays its shareholders dividends from the profits it has earned over and above its (deductible) expenses. A corporation may not deduct the amount of dividends that it pays to shareholders. Shareholders who receive dividends must pay income tax on them. Thus, corporate profits that a corporation distributes to shareholders are subject to income taxation twice – once at the corporate level and once at the shareholder level.


A corporation may deduct salaries that it pays. § 162(a)(1). Thus, a salary is subject to tax only at the employee level.


What is the tax treatment of a gift that a corporation gives to an employee? See Duberstein, supra; §§ 102(c), 274(b).





CALI Lesson Logo


3. Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Reasonable Compensation, Miscellaneous Business Deductions, and Business Losses. You will find that the law involves “comparable” salaries.


• Read §§ 274(a), (l), (n), 162(e), 165(a and b).


• Do not worry about whether you get the correct answer to the two questions involving a “golden parachute,” § 280G, i.e., questions 3 and 4, but do not be afraid of learning something. Also, do not worry about the costs of military clothing. Do not worry about § 280B, but you should still get the right answer to question 17.


C. Ordinary and Necessary Expenses



Section 162(a) allows taxpayer to deduct all ordinary and necessary expenses paid or incurred in carrying on any trade or business. Sections 162 and 274 also limit trade or business deductions incurred for certain purposes.


Section 212 allows a similar deduction for the ordinary and necessary expenses that taxpayer pays or incurs –


• for the production or collection of income,


• for the management, conservation, or maintenance of property held for the production of income, or


• in connection with the determination, collection, or refund of any tax.


CALI Lesson Logo


Do the CALI Lesson, Basic Federal Income Taxation: Deductions for Income-Producing Activities after reading §§ 212, 215, 62(a)(10).


We consider here a few recurring issues.


1. Personal vs. Trade or Business


We have already seen that § 162(a)(2) implicitly treats taxpayer’s choice of where to live as a personal one. Hence, taxpayer may not deduct expenditures associated with that choice. The Code also implicitly treats certain other choices as “personal.”


Smith v. Commissioner, 40 B.T.A. 1038 (1939), aff’d 113 F.2d 114 (2d Cir. 1940)







Respondent determined a deficiency of $23.62 in petitioner’s 1937 income tax. This was due to the disallowance of a deduction claimed by petitioners, who are husband and wife, for sums spent by the wife in employing nursemaids to care for petitioners’ young child, the wife, as well as the husband, being employed. …


Petitioners would have us apply the ‘but for’ test. They propose that but for the nurses the wife could not leave her child; but for the freedom so secured she could not pursue her gainful labors; and but for them there would be no income and no tax. This thought evokes an array of interesting possibilities. The fee to the doctor, but for whose healing service the earner of the family income could not leave his sickbed; the cost of the laborer’s raiment, for how can the world proceed about its business unclothed; the very home which gives us shelter and rest and the food which provides energy, might all by an extension of the same proposition be construed as necessary to the operation of business and to the creation of income. Yet these are the very essence of those ‘personal’ expenses the deductibility of which is expressly denied. [citation omitted]


We are told that the working wife is a new phenomenon. This is relied on to account for the apparent inconsistency that the expenses in issue are now a commonplace, yet have not been the subject of legislation, ruling, or adjudicated controversy. But if that is true it becomes all the more necessary to apply accepted principles to the novel facts. We are not prepared to say that the care of children, like similar aspects of family and household life, is other than a personal concern. The wife’s services as custodian of the home and protector of its children are ordinarily rendered without monetary compensation. There results no taxable income from the performance of this service and the correlative expenditure is personal and not susceptible of deduction. [citation omitted] Here the wife has chosen to employ others to discharge her domestic function and the services she performs are rendered outside the home. They are a source of actual income and taxable as such. But that does not deprive the same work performed by others of its personal character nor furnish a reason why its cost should be treated as an offset in the guise of a deductible item.


We are not unmindful that, as petitioners suggest, certain disbursements normally personal may become deductible by reason of their intimate connection with an occupation carried on for profit. In this category fall entertainment [citation omitted], and traveling expenses [citation omitted], and the cost of an actor’s wardrobe [citation omitted]. The line is not always an easy one to draw nor the test simple to apply. But we think its principle is clear. It may for practical purposes be said to constitute a distinction between those activities which, as a matter of common acceptance and universal experience, are ‘ordinary’ or usual as the direct accompaniment of business pursuits, on the one hand; and those which, though they may in some indirect and tenuous degree relate to the circumstances of a profitable occupation, are nevertheless personal in their nature, of a character applicable to human beings generally, and which exist on that plane regardless of the occupation, though not necessarily of the station in life, of the individuals concerned. See Welch v. Helvering, 290 U.S. 111.


In the latter category, we think, fall payments made to servants or others occupied in looking to the personal wants of their employers. [citation omitted]. And we include in this group nursemaids retained to care for infant children.


Decision will be entered for the respondent.


Notes and Questions:


1. The B.T.A. says that the expenses of a nursemaid “are the very essence of those ‘personal expenses the deductibility of which is expressly denied.’”


• What was the personal choice that taxpayer made in this case that made these expenses non-deductible?


2. We have already noted §§ 21 and 129. These provisions reverse the result of Smith, but not its construction of § 162.


• What do these provisions say about the underlying rationale of Smith, in particular the role of the wife and mother?


CALI Lesson Logo


3. Do the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax Computation: Dependent Care Credit.


2. Limitations on Deductibility of Ordinary and Necessary Expenses


Consider the sources of limitation on the deductibility of expenses that taxpayer incurs in order to generate income that the following cases consider:


Commissioner v. Tellier, 383 U.S. 687 (1966)



MR. JUSTICE STEWART delivered the opinion of the Court.


The question presented in this case is whether expenses incurred by a taxpayer in the unsuccessful defense of a criminal prosecution may qualify for deduction from taxable income under § 162(a), which allows a deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. …” The respondent Walter F. Tellier was engaged in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers. In 1956, he was brought to trial upon a 36-count indictment that charged him with violating the fraud section of the Securities Act of 1933 and the mail fraud statute, and with conspiring to violate those statutes. He was found guilty on all counts, and was sentenced to pay an $18,000 fine and to serve four and a half years in prison. The judgment of conviction was affirmed on appeal. In his unsuccessful defense of this criminal prosecution, the respondent incurred and paid $22,964.20 in legal expenses in 1956. He claimed a deduction for that amount on his federal income tax return for that year. The Commissioner disallowed the deduction, and was sustained by the Tax Court. The Court of Appeals for the Second Circuit reversed in a unanimous en banc decision, and we granted certiorari. We affirm the judgment of the Court of Appeals.


There can be no serious question that the payments deducted by the respondent were expenses of his securities business under the decisions of this Court, and the Commissioner does not contend otherwise. In United States v. Gilmore, 372 U.S. 39, we held that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal’” within the meaning of § 162(a). Cf. Kornhauser v. United States, 276 U.S. 145; Deputy v. du Pont, 308 U.S. 488. The criminal charges against the respondent found their source in his business activities as a securities dealer. The respondent’s legal fees, paid in defense against those charges, therefore clearly qualify under Gilmore as “expenses paid or incurred … in carrying on any trade or business” within the meaning of § 162(a).


The Commissioner also concedes that the respondent’s legal expenses were “ordinary” and “necessary” expenses within the meaning of § 162(a). Our decisions have consistently construed the term “necessary” as imposing only the minimal requirement that the expense be “appropriate and helpful” for “the development of the [taxpayer’s] business.” Welch v. Helvering, 290 U.S. 111; cf. Kornhauser v. United States, supra, at 276 U.S. 152; Lilly v. Commissioner, 343 U.S. 90, 93-94; Commissioner v. Heininger, 320 U.S. 467, 320 U.S. 471; McCulloch v. Maryland, 4 Wheat. 316, 17 U.S. 413-415. The principal function of the term “ordinary” in § 162(a) is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset. Welch v. Helvering, supra, at 290 U.S. 113-116. The legal expenses deducted by the respondent were not capital expenditures. They were incurred in his defense against charges of past criminal conduct, not in the acquisition of a capital asset. Our decisions establish that counsel fees comparable to those here involved are ordinary business expenses, even though a “lawsuit affecting the safety of a business may happen once a lifetime.” Welch v. Helvering, supra, at 290 U.S. 114. Kornhauser v. United States, supra, at 276 U.S. 152-153; cf. Trust of Bingham v. Commissioner, 325 U.S. 365, 376.


It is therefore clear that the respondent’s legal fees were deductible under § 162(a) if the provisions of that section are to be given their normal effect in this case. The Commissioner and the Tax Court determined, however, that, even though the expenditures meet the literal requirements of § 162(a), their deduction must nevertheless be disallowed on the ground of public policy. That view finds considerable support in other administrative and judicial decisions.132 It finds no support, however, in any regulation or statute or in any decision of this Court, and we believe no such “public policy” exception to the plain provisions of § 162(a) is warranted in the circumstances presented by this case.



We start with the proposition that the federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources. “[T]he fact that a business is unlawful [does not] exempt it from paying the taxes that if lawful it would have to pay.” United States v. Sullivan, 274 U.S. 259. See James v. United States, 366 U.S. 213.


With respect to deductions, the basic rule, with only a few limited and well defined exceptions, is the same. During the Senate debate in 1913 on the bill that became the first modern income tax law, amendments were rejected that would have limited deductions for losses to those incurred in a “legitimate” or “lawful” trade or business. Senator Williams, who was in charge of the bill, stated on the floor of the Senate that


“[T]he object of this bill is to tax a man’s net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men’s moral characters; that is not the object of the bill at all. The tax is not levied for the purpose of restraining people from betting on horse races or upon ‘futures,’ but the tax is framed for the purpose of making a man pay upon his net income, his actual profit during the year. The law does not care where he got it from, so far as the tax is concerned, although the law may very properly care in another way.” 50 Cong. Rec. 3849.133



The application of this principle is reflected in several decisions of this Court. As recently as Commissioner v. Sullivan, 356 U.S. 27, we sustained the allowance of a deduction for rent and wages paid by the operators of a gambling enterprise, even though both the business itself and the specific rent and wage payments there in question were illegal under state law. In rejecting the Commissioner’s contention that the illegality of the enterprise required disallowance of the deduction, we held that, were we to “enforce as federal policy the rule espoused by the Commissioner in this case, we would come close to making this type of business taxable on the basis of its gross receipts, while all other business would be taxable on the basis of net income. If that choice is to be made, Congress should do it.” Id. at 356 U.S. 29. In Lilly v. Commissioner, 343 U.S. 90, the Court upheld deductions claimed by opticians for amounts paid to doctors who prescribed the eyeglasses that the opticians sold, although the Court was careful to disavow “approval of the business ethics or public policy involved in the payments. …” 343 U.S. at 97. And in Commissioner v. Heininger, 320 U.S. 467, a case akin to the one before us, the Court upheld deductions claimed by a dentist for lawyer’s fees and other expenses incurred in unsuccessfully defending against an administrative fraud order issued by the Postmaster General.


Deduction of expenses falling within the general definition of § 162(a) may, to be sure, be disallowed by specific legislation, since deductions “are a matter of grace and Congress can, of course, disallow them as it chooses.” Commissioner v. Sullivan, 356 U.S. at 28.134 The Court has also given effect to a precise and longstanding Treasury Regulation prohibiting the deduction of a specified category of expenditures; an example is lobbying expenses, whose nondeductibility was supported by considerations not here present. Textile Mills Securities Corp. v. Commissioner, 314 U.S. 326; Cammarano v. United States, 358 U.S. 498. But where Congress has been wholly silent, it is only in extremely limited circumstances that the Court has countenanced exceptions to the general principle reflected in the Sullivan, Lilly, and Heininger decisions. Only where the allowance of a deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct” have we upheld its disallowance. Commissioner v. Heininger, 320 U.S. at 473. Further, the “policies frustrated must be national or state policies evidenced by some governmental declaration of them.” Lilly v. Commissioner, 343 U.S. at 97. (Emphasis added.) Finally, the “test of nondeductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction.” Tank Truck Rentals v. Commissioner, 356 U.S. 30, 35. In that case, as in Hoover Motor Express Co. v. United States, 356 U.S. 38, we upheld the disallowance of deductions claimed by taxpayers for fines and penalties imposed upon them for violating state penal statutes; to allow a deduction in those circumstances would have directly and substantially diluted the actual punishment imposed.



The present case falls far outside that sharply limited and carefully defined category. No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense. That is not “proscribed conduct.” It is his constitutional right. Chandler v. Fretag, 348 U.S. 3. See Gideon v. Wainwright, 372 U.S. 335. In an adversary system of criminal justice, it is a basic of our public policy that a defendant in a criminal case have counsel to represent him.


Congress has authorized the imposition of severe punishment upon those found guilty of the serious criminal offenses with which the respondent was charged and of which he was convicted. But we can find no warrant for attaching to that punishment an additional financial burden that Congress has neither expressly nor implicitly directed.135 To deny a deduction for expenses incurred in the unsuccessful defense of a criminal prosecution would impose such a burden in a measure dependent not on the seriousness of the offense or the actual sentence imposed by the court, but on the cost of the defense and the defendant’s particular tax bracket. We decline to distort the income tax laws to serve a purpose for which they were neither intended nor designed by Congress.



The judgment is






Deductibility of Legal Expenses: In both Woodward, supra, and Tellier, the Court cited United States v. Gilmore, 372 U.S. 39 (1963). In Gilmore, taxpayer and his wife cross-claimed for divorce. Taxpayer owned the controlling stock interests of three corporations, each of which owned a General Motors dealership. He received a substantial income from these corporations. His wife made sensational allegations, and had she prevailed, she could receive more than half of the stock and/or GM would terminate the corporations’ franchises. Fearing such consequences of losing, taxpayer expended large sums to fight his wife’s allegations and eventually prevailed. Taxpayer sought to deduct his legal expenses attributable to successful resistance of his wife’s claims under § 212 (expenses of conserving property held for production of income). The Commissioner argued that such expenses were personal or family expenses. The court of claims allocated 20% of the fees to the divorce and 80% to conservation of property. The CIR argued that deductibility under either § 162 or § 212 turned “not upon the consequences to respondent of a failure to defeat his wife’s community property claims, but upon the origin and nature of the claims themselves.” The Court agreed: “[T]he characterization, as ‘business’ or ‘personal,’ of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer’s profit-seeking activities. It does not depend on the consequences that might result to a taxpayer’s income-producing property from a failure to defeat the claim[.]” The Court stated its “origin of the claim” test thus: “[T]he origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal[.]’” None of taxpayer’s legal expenses were deductible. “It is enough to say that … the wife’s claims stemmed entirely from the marital relationship, and not, under any tenable view of things, from income-producing activity.”





Notes and Questions:


1. Why should the standard of “necessary” under § 162 be a minimal one, i.e., appropriate and helpful? Are there forces other than the rules of § 162 that will provide controls on the amounts that a taxpayer spends to further his/her/its business?


• Recall the statement in Welch v. Helvering: Taxpayer “certainly thought [payments to creditors of a bankrupt corporation were necessary], and we should be slow to override his judgment.”


2. The income tax is a tax only on net income. The one exception to this – explicitly stated in the Code – is § 280E. The expenses of carrying on the trade or business of trafficking in controlled substances are not deductible.


• Is § 280E constitutional?


• Who would want to know?


3. What norms does a refusal to incorporate public policy into the Code further?


• A refusal to incorporate public policy into the Code hardly means that there is no public policy limitation on deductibility under § 162. Rather, those limitations must be explicitly stated in the statute itself.


See Court’s discussion of the point and its third footnote.


• Note the topics covered in §§ 162(b, c, e, f, g, k, l, and m).


4. The term “ordinary” has a relatively special meaning as used in § 162. What is it?


5. In Tellier, taxpayer was a criminal. He nevertheless could deduct the “ordinary and necessary” trade or business expenses arising from this character flaw.


• Should taxpayer be permitted to deduct the ordinary and necessary expenses associated with mental “flaws?” Is Gilliam distinguishable from Tellier?


Gilliam v. Commissioner, 51 T.C. Memo. 515 (1986), available at 1986 WL 21482











[Taxpayer] Gilliam is, and was at all material periods, a noted artist. His works have been exhibited in numerous art galleries throughout the United States and Europe … In addition, Gilliam is, and was at all material periods, a teacher of art. On occasion, Gilliam lectured and taught art at various institutions.


Gilliam accepted an invitation to lecture and teach for a week at the Memphis Academy of Arts in Memphis, Tennessee. On Sunday, February 23, 1975, he flew to Memphis to fulfill this business obligation.


Gilliam had a history of hospitalizations for mental and emotional disturbances and continued to be under psychiatric care until the time of his trip to Memphis. In December 1963, Gilliam was hospitalized in Louisville; Gilliam had anxieties about his work as an artist. For periods of time in both 1965 and 1966, Gilliam suffered from depression and was unable to work. In 1970, Gilliam was again hospitalized. In 1973, while Gilliam was a visiting artist at a number of university campuses in California, he found it necessary to consult an airport physician; however, when he returned to Washington, D.C., Gilliam did not require hospitalization.


Before his Memphis trip, Gilliam created a 225-foot painting for the Thirty-fourth Biennial Exhibition of American Painting at the Corcoran Gallery of Art (hereinafter sometimes referred to as ‘the Exhibition’). The Exhibition opened on Friday evening, February 21, 1975. In addition, Gilliam was in the process of preparing a giant mural for an outside wall of the Philadelphia Museum of Art for the 1975 Spring Festival in Philadelphia. The budget plans for this mural were due on Monday, February 24, 1975.


On the night before his Memphis trip, Gilliam felt anxious and unable to rest. On Sunday morning, Gilliam contacted Ranville Clark (hereinafter sometimes referred to as ‘Clark’), a doctor Gilliam had been consulting intermittently over the years, and asked Clark to prescribe some medication to relieve his anxiety. Clark arranged for Gilliam to pick up a prescription of the drug Dalmane on the way to the airport. Gilliam had taken medication frequently during the preceding 10 years. Clark had never before prescribed Dalmane for Gilliam.


On Sunday, February 23, 1975, Gilliam got the prescription and at about 3:25 p.m., he boarded American Airlines flight 395 at Washington National Airport, Washington, D.C., bound for Memphis. Gilliam occupied a window seat. He took the Dalmane for the first time shortly after boarding the airplane.


About one and one-half hours after the airplane departed Washington National Airport, Gilliam began to act in an irrational manner. He talked of bizarre events and had difficulty in speaking. According to some witnesses, he appeared to be airsick and held his head. Gilliam began to feel trapped, anxious, disoriented, and very agitated. Gilliam said that the plane was going to crash and that he wanted a life raft. Gilliam entered the aisle and, while going from one end of the airplane to the other, he tried to exit from three different doors. Then Gilliam struck Seiji Nakamura (hereinafter sometimes referred to as ‘Nakamura’), another passenger, several times with a telephone receiver. Nakamura was seated toward the rear of the airplane, near one of the exits. Gilliam also threatened the navigator and a stewardess, called for help, and cried. As a result of the attack, Nakamura sustained a one-inch laceration above his left eyebrow which required four sutures. Nakamura also suffered ecchymosis of the left arm and pains in his left wrist. Nakamura was treated for these injuries at Methodist Hospital in Memphis.


On arriving in Memphis, Gilliam was arrested by Federal officials. On March 10, 1975, Gilliam was indicted. He was brought to trial in the United States District Court for the Western District of Tennessee, Western Division, on one count of violation of 49 U.S.C. § 1472(k) (relating to certain crimes aboard an aircraft in flight) and two counts of violation 49 U.S.C. § 1472(j) (relating to interference with flight crew members or flight attendants). Gilliam entered a plea of not guilty to the criminal charges. … After Gilliam presented all of his evidence, the district court granted Gilliam’s motion for a judgment of acquittal by reason of temporary insanity.


Petitioners paid $8250 and $8600 for legal fees in 1975 and 1976, respectively, in connection with both the criminal trial and Nakamura’s civil claim. In 1975, petitioners also paid $3800 to Nakamura in settlement of the civil claim.


Petitioners claimed deductions for the amounts paid in 1975 and 1976 on the appropriate individual income tax returns. Respondent disallowed the amounts claimed in both years attributable to the incident on the airplane. .


* * *


Gilliam’s trip to Memphis was a trip in furtherance of his trades or businesses.






Petitioners contend that they are entitled to deduct the amounts paid in defense of the criminal prosecution and in settlement of the related civil claim under § 162. . Petitioners maintain that the instant case is directly controlled by our decision in Dancer v. Commissioner, 73 T.C. 1103 (1980). According to petitioners, ‘[t]he clear holding of Dancer is *** that expenses for litigation arising out of an accident which occurs during a business trip are deductible as ordinary and necessary business expenses.’ Petitioners also contend that Clark v. Commissioner, 30 T.C. 1330 (1958), is to the same effect as Dancer.


Respondent maintains that Dancer and Clark are distinguishable. Respondent contends that the legal fees paid are not deductible under either § 162 or § 212 because the criminal charges against Gilliam were neither directly connected with nor proximately resulted from his trade or business and the legal fees were not paid for the production of income. Respondent maintains that ‘the criminal charges which arose as a result of *** (the incident on the airplane), could hardly be deemed ‘ordinary,’ given the nature of (Gilliam’s) profession.’ Respondent contends ‘that the provisions of § 262 control this situation.’ As to the settlement of the related civil claim, respondent asserts that since Gilliam committed an intentional tort, the settlement of the civil claim constitutes a nondeductible personal expense.


We agree with respondent that the expenses are not ordinary expenses of Gilliam’s trade or business.


Section 162(a) allows a deduction for all the ordinary and necessary expenses of carrying on a trade or business. In order for the expense to be deductible by a taxpayer, it must be an ordinary expense, it must be a necessary expense, and it must be an expense of carrying on the taxpayer’s trade or business. If any one of these requirements is not met, the expense is not deductible under § 162(a). Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933); Kornhauser v. United States, 276 U.S. 145 (1928). In Deputy v. du Pont, the Supreme Court set forth a guide for application of the statutory requirement that the expense be ‘ordinary’, as follows (308 U.S. at 494-497):


[…] Ordinary has the connotation of normal, usual, or customary. To be sure, an expense may be ordinary though it happens but once in the taxpayer’s lifetime. Cf. Kornhauser v. United States, supra. Yet the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved. Welch v. Helvering, supra, 114. Hence, the fact that a particular expense would be an ordinary or common one in the course of one business and so deductible under [§ 162(a)] does not necessarily make it such in connection with another business. *** As stated in Welch v. Helvering, supra, pp. 113-114: ‘… What is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance.’ 22 F. Supp. 589, 597.


One of the extremely relevant circumstances is the nature and scope of the particular business out of which the expense in question accrued. The fact that an obligation to pay has arisen is not sufficient. It is the kind of transaction out of which the obligation arose and its normalcy in the particular business which are crucial and controlling.


Review of the many decided cases is of little aid since each turns on its special facts. But the principle is clear. […] [T]he fact that the payments might have been necessary … is of no aid. For Congress has not decreed that all necessary expenses may be deducted. Though plainly necessary they cannot be allowed unless they are also ordinary. Welch v. Helvering, supra.


… It undoubtedly is ordinary for people in Gilliam’s trades or businesses to travel (and to travel by air) in the course of such trades or businesses; however, we do not believe it is ordinary for people in such trades or businesses to be involved in altercations of the sort here involved in the course of any such travel. The travel was not itself the conduct of Gilliam’s trades or businesses. Also, the expenses here involved are not strictly a cost of Gilliam’s transportation. Finally, it is obvious that neither the altercation nor the expenses were undertaken to further Gilliam’s trades or businesses.


We conclude that Gilliam’s expenses are not ordinary expenses of his trades or businesses.


It is instructive to compare the instant case with Dancer v. Commissioner, supra, upon which petitioners rely. In both cases, the taxpayer was traveling on business. In both cases, the expenses in dispute were not the cost of the traveling, but rather were the cost of an untoward incident that occurred in the course of the trip. In both cases, the incident did not facilitate the trip or otherwise assist the taxpayer’s trade or business. In both cases, the taxpayer was responsible for the incident; in neither case was the taxpayer willful. In Dancer, the taxpayer was driving an automobile; he caused an accident which resulted in injuries to a child. The relevant expenses were the taxpayer’s payments to settle the civil claims arising from the accident. 73 T.C. at 1105. In the instant case, Gilliam was a passenger in an airplane; he apparently committed acts which would have been criminal but for his temporary insanity, and he injured a fellow passenger. Gilliam’s expenses were the costs of his successful legal defense, and his payments to settle Nakamura’s civil claim.


In Dancer, we stated as follows (73 T.C. at 1108-1109):


It is true that the expenditure in the instant case did not further petitioner’s business in any economic sense; nor is it, we hope, the type of expenditure that many businesses are called upon to pay. Nevertheless, neither factor lessens the direct relationship between the expenditure and the business. Automobile travel by petitioner was an integral part of this business. As rising insurance rates suggest, the cost of fuel and routine servicing are not the only costs one can expect in operating a car. As unfortunate as it may be, lapses by drivers seem to be an inseparable incident of driving a car. Anderson v. Commissioner (81 F.2d 457 (CA10 1936)). Costs incurred as a result of such an incident are just as much a part of overall business expenses as the cost of fuel. (Emphasis supplied.)


Dancer is distinguishable.


In Clark v. Commissioner, supra, also relied on by petitioners, the expenses consisted of payments of (a) legal fees in defense of a criminal prosecution and (b) amounts to settle a related civil claim. In this regard, the instant case is similar to Clark. In Clark, however, the taxpayer’s activities that gave rise to the prosecution and civil claim were activities directly in the conduct of Clark’s trade or business. In the instant case, Gilliam’s activities were not directly in the conduct of his trades or businesses. Rather, the activities merely occurred in the course of transportation connected with Gilliam’s trades or businesses. And, as we noted in Dancer v. Commissioner, 73 T.C. at 1106, ‘in cases like this, where the cost is an adjunct of and not a direct cost of transporting an individual, we have not felt obliged to routinely allow the expenditure as a transportation cost deduction.’


Petitioners also rely on Commissioner v. Tellier, 383 U.S. 687 (1966), in which the taxpayer was allowed to deduct the cost of an unsuccessful criminal defense to securities fraud charges. The activities that gave rise to the criminal prosecution in Tellier were activities directly in the conduct of Tellier’s trade or business. Our analysis of the effect of Clark v. Commissioner, applies equally to the effect of Commissioner v. Tellier.


In sum, Gilliam’s expenses were of a kind similar to those of the taxpayers in Tellier and Clark; however the activities giving rise to Gilliam’s expenses were not activities directly in the conduct of his trades or businesses, while Tellier’s and Clark’s activities were directly in the conduct of their respective trades or businesses. Gilliam’s expenses were related to his trades or businesses in a manner similar to those of the taxpayer in Dancer; however Gilliam’s actions giving rise to the expenses were not shown to be ordinary, while Dancer’s were shown to be ordinary. Tellier, Clark, and Dancer all have similarities to the instant case; however, Tellier, Clark, and Dancer are distinguishable in important respects. The expenses are not deductible under § 162(a). .


We hold for respondent.


Notes and Questions:


1. Were the expenses incurred by taxpayer “necessary?”




If not “ordinary” …: In Welch, the opposite of an “ordinary” expense was a capital expense. What is the opposite of “ordinary” in Gilliam?





2. By what means did the court in fact implement a public policy limitation on taxpayer’s trade or business expense? Why were the deductions that taxpayer claimed denied?


• because they were “extraordinary” in light of taxpayer’s trade or business?


• If so, are there trades or businesses in which such expenditures would not be extraordinary?


• What if airline employees hit taxpayer and incurred tort damages and legal expenses? These expenses would be the very type of expenses that Gilliam could not deduct.


3. Even when taxpayer incurs ordinary and necessary trade or business expense, taxpayer might not be entitled to deduct them.


Walliser v. Commissioner, 72 T.C. 433 (1979)











During the taxable years 1973 and 1974, James [Walliser] was vice president and branch manager of the First Federal Savings & Loan Association (First Federal) of Dallas, Tex., Richardson branch office. James began his career at First Federal as a trainee in mortgage lending and an appraiser. He later became a branch manager and a loan production officer. Subsequent to the taxable years at issue, James was made the head of the interim loan department of First Federal. Prior to his initial association with First Federal in 1964, James was primarily engaged in the business of home building in Dallas County, Tex.


As branch manager of the Richardson office of First Federal, James supervised all aspects of the branch’s operations, but his primary responsibility was the marketing of permanent and interim loans. James was assigned loan production quotas, and he expected to receive annual raises in his salary if he met his yearly quotas, although First Federal was under no commitment to give James a raise in salary or a bonus if a quota was met. … James met his quotas and received salary raises at the end of 1973 and 1974.


During the taxable years at issue, petitioners traveled abroad in tour groups organized primarily for people involved in the building industry. In 1973, petitioners took two such trips. The first was to Rio de Janeiro and was sponsored by General Electric Co. (General Electric). It began on March 23, 1973, and ended on March 31, 1973. Their second trip, to London and Copenhagen, was sponsored by Fedders Co. (Fedders) and ran from October 3, 1973, to October 15, 1973.


In 1974, petitioners went to Santo Domingo on a tour organized by Fedders which began on September 27, 1974, and ended on October 4, 1974.




The majority of the people on a General Electric or Fedders builders’ tour were builders and developers from Texas and their spouses. The group also included lenders, title company personnel, and other users and distributors of the sponsor’s product. The dealers and builders who participated in the Fedders builders’ tours did so as part of the Fedders incentive program through which they were able to earn the cost of the tours in whole or in part by purchasing or selling a certain amount of central air conditioning equipment in a particular year. Fedders presented awards during the tours to some people it considered outstanding in its sales and promotional programs but conducted no business meetings.


The builders’ tours were arranged as guided vacation trips, with sightseeing and other recreational activities. Petitioners, however, went on the tours because James found that they provided an unusual opportunity to associate with many potential and actual customers and believed that the tours would generate business, thereby helping him to meet his loan production quotas and obtain salary raises. He spent as much time as possible talking with builders whom he already knew and getting acquainted with builders he had not previously met to make them aware of First Federal’s services and of his own skills. His conversations frequently centered on conditions in the building industry and the availability of loans for builders, but he did not negotiate specific business transactions on the tours or conduct formal business meetings. Social relationships formed or renewed on the tours between petitioners and builders and their spouses resulted in a substantial amount of loan business for First Federal.




Prior to 1973, First Federal had paid for James to participate in builders’ tours. During 1973 and 1974, First Federal stopped reimbursing employees for a variety of previously reimbursed expenses as part of a program of overall budget cutbacks. During the taxable years in issue, First Federal’s policy was to pay entertainment costs directly, or to provide reimbursement for expenses, when an officer of First Federal entertained current customers of the company at civic, social, or business meetings. The company did not customarily reimburse officers for the costs of goodwill meetings or trips for current customers along with prospective customers; however, the board of directors expected the officers, especially vice presidents in charge of marketing activities, to be active in cultivating new customers. First Federal did not reimburse petitioners for any travel expenses incurred in connection with the Fedders and General Electric tours taken by them in 1973 and 1974. James was, however, given leave with pay, in addition to his normal 2-week paid vacation, in order to participate in the tours.




On their 1973 and 1974 tax returns, petitioners deducted, as employee business expenses, one-half of the price of each of the tours (the portion attributable to James’ travel) …




Initially, we must determine whether petitioners are entitled, under § 162, to deduct as employee business expenses costs incurred by James in connection with his travel on tours for builders organized by General Electric and Fedders. If we hold that the requirements of that section are satisfied, then we must face the further question as to the extent to which the limitations of § 274 apply.


Section 162(a)(2) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses incurred while away from home in the pursuit of a trade or business. The question is essentially one of fact. [citations omitted] Petitioners must show that the expenses were incurred primarily for business rather than social reasons and that there was a proximate relation between the cost of the builders’ tours and James’ business as an officer of First Federal. [citations omitted].


James’ primary responsibility as an officer of First Federal was marketing loans. He was assigned loan production quotas and considered yearly increases in his salary to be contingent upon meeting those quotas. The participants in the General Electric and Fedders tours were not a random group of Texas vacationers. On the contrary, they were largely builders and developers from Texas, the area in which First Federal operated. Thus, the tours were a useful means of maintaining relations with existing customers of First Federal and reaching prospective customers. Indeed, the record indicated that some of the participants considered the social relationships with James, including their association with him on the tours, as an influencing factor in their decisions to seek loans from First Federal.


The fact that, during the years at issue, First Federal did not reimburse James for the costs of his travel does not render his expenses nondeductible. Where a corporate officer personally incurs expenditures which enable him to better perform his duties to the corporation and which have a direct bearing on the amount of his compensation or his chances for advancement, unreimbursed expenses may be deductible under § 162. [citations omitted].136



First Federal expected its officers in charge of marketing activities to participate in public or social functions without reimbursement and examined their performance in this regard when evaluating their compensation and overall value to the company. [citation omitted]. James met his loan quotas in 1973 and 1974 and received raises in his salary at the end of those years. In a later year, he became head of First Federal’s interim loan department.


Moreover, the evidence tends to show that First Federal considered the trips valuable in generating goodwill. Although First Federal, which was in the midst of a program of budget cutbacks in 1973 and 1974, did not reimburse James for the tours as it had done in prior years, it continued to grant him additional leave with pay for the time he was on the tours.


Finally, the testimony of petitioners, and particularly of Carol, which we found straightforward and credible, tended to show that the tours were strenuous, and not particularly enjoyable, experiences because of the amount of time expended in cultivating business and, therefore, that petitioners did not undertake the tours for primarily personal reasons. [They took family vacations to other destinations.]


We conclude that, under the circumstances of this case, the requisite proximate relation has been shown to constitute James’ travel expenses as “ordinary and necessary” business expenses within the meaning of § 162(a)(2).


We now turn our attention to the applicability of § 274, the issue on which respondent has concentrated most of his fire. That section disallows a deduction in certain instances for expenses which would otherwise be deductible under § 162. Respondent argues that the requirements of § 274 are applicable here and have not been satisfied in that petitioners have failed: (1) To show that James’ trips were “directly related” to the active conduct of his business (§ 274(a)) …


Section 274(a) provides in part:




(1) IN GENERAL. – No deduction otherwise allowable under this chapter shall be allowed for any item—


(A) ACTIVITY. – With respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, unless the taxpayer establishes that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that such item was associated with, the active conduct of the taxpayer’s trade or business, ***


and such deduction shall in no event exceed the portion of such item directly related to, or, in the case of an item described in subparagraph (A) directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), the portion of such item associated with, the active conduct of the taxpayer’s trade or business.


Petitioners urge that the “directly related” test of § 274(a) is not applicable because the expenditures at issue were incurred for travel, not entertainment. We disagree.


Section 274(a) relates to activities of a type generally considered to constitute “entertainment, amusement, or recreation.” Reg. § 1.274-2(b) defines “entertainment, amusement, or recreation” as follows:


(b) Definitions – (1) Entertainment defined – (i) In general. For purposes of this section, the term “entertainment” means any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family. ***


(ii) Objective test. An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of this section and § 274(a) regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone. This objective test precludes arguments such as that “entertainment” means only entertainment of others or that an expenditure for entertainment should be characterized as an expenditure for advertising or public relations.


(Emphasis added.)


This regulation is squarely based on the language of the legislative history of § 274 and we find it to be valid as it relates to the issue herein.137



This regulation and the Congressional committee reports from which it is derived leave no doubt that the deductibility of an expenditure for travel, on what would objectively be considered a vacation trip, is subject to the limitations of subsection 274(a), even where the expenditure relates solely to the taxpayer himself. [citations omitted]. Furthermore, Reg. § 1.274-2(b)(1)(iii) provides that “any expenditure which might generally be considered *** either for travel or entertainment, shall be considered an expenditure for entertainment rather than for *** travel.” This regulation too has a solid foundation in the statute, which provides, in [§ 274(o)], authority for the promulgation of regulations necessary to carry out the purpose of § 274 and in the committee reports, which provide that rules be prescribed for determining whether § 274(a) should govern where another section is also applicable. H. Rept. 1447, supra; S. Rept. 1881, supra.


Although the participants in the tours that petitioners took were drawn, for the most part, from the building industry, their activities – sightseeing, shopping, dining – were the same as those of other tourists. Fedders presented some awards to persons considered outstanding in its sales or promotional programs on the tours but did not conduct any business meetings. Nor is there any evidence that any business meetings were conducted on the 1973 General Electric tour; on the itinerary for the 1974 tour, for which petitioners canceled their reservation, only 1 hour out of 10 days of guided tours, dinners, and cocktail parties, was set aside for a business meeting. Under the objective test set forth in the regulations, it is irrelevant that petitioners did not regard the trips as vacations or did not find them relaxing. Clearly, the tours were of a type generally considered vacation trips and, thus, under the objective test, constituted entertainment for the purposes of § 274(a). Therefore, the requirements of that section must be satisfied.


For a deduction to be allowed for any item under § 274(a)(1)(A), the taxpayer must establish that the item was directly related to the active conduct of the taxpayer’s trade or business or, in the case of an item directly preceding or following a substantial and bona fide business discussion, that such item was associated with the active conduct of the taxpayer’s trade or business.


The “directly related” test requires that a taxpayer show a greater degree of proximate relationship between an expenditure and the taxpayer’s trade or business than that required by § 162. [citations omitted]. Reg. § 1.274-2(c)(3) provides that, for an expenditure to be directly related to the active conduct of the taxpayer’s trade or business, it must be shown that the taxpayer had more than a general expectation of deriving some income or business benefit from the expenditure, other than the goodwill of the person or persons entertained. While the language of this regulation is awkward and not completely apt in a situation where the entertainment expenditure relates to the taxpayer alone, it is clear, nevertheless, that more than a general expectation of deriving some income at some indefinite future time is necessary for an expenditure to be deductible under § 274(a). [citations omitted].


The record shows that petitioners participated in the builders’ tours because they provided an opportunity for James to meet new people who might be interested in the services he, and First Federal, had to offer and to maintain good personal relations with people already using those services. While James discussed business continually during the tours, his wife testified that this was typical of his behavior during all social activities. He engaged in general discussions about business conditions and the services he could provide to a builder but did not engage in business meetings or negotiations on the tours. James could not directly connect particular business transactions with specific discussions which occurred during the trips. . In short, petitioners’ purpose in taking the trips was to create or maintain goodwill for James and First Federal, his employer, in order to generate some future business. Although the evidence tends to indicate that the trips did, in fact, enhance goodwill and contribute to James’ success in loan production and otherwise constituted ordinary and necessary business expenses deductible under § 162, we hold, nevertheless, that Congress intended, by means of the more stringent standard of the “directly related” test in § 274(a), to disallow deductions for this type of activity, which involves merely the promotion of goodwill in a social setting. [citation omitted].


We also hold that the petitioners’ trips do not qualify as entertainment “associated with” the active conduct of a trade or business. To be deductible, entertainment “associated with” the active conduct of a trade or business must directly precede or follow a substantial business discussion. In St. Petersburg Bank & Trust Co. v. United States, [362 F. Supp. 674 (M.D. Fla. 1973), aff’d in an unpublished order, 503 F.2d 1402 (5th Cir. 1974)], a decision affirmed by the Fifth Circuit, the District Court concluded that the phrase “directly preceding or following” in § 274(a)(1)(A) should be read restrictively in cases in which entertainment expenditures are related to the taxpayer’s trade or business only in that they promote goodwill. . In view of the legislative history, which reveals that the “associated with” test is an exception to the general rule intended to limit deductions for entertainment which has as its sole business purpose the promotion of goodwill , we agree with the District Court’s conclusion. Accordingly, we do not consider the costs of the vacation trips to be deductible under § 274(a)(1)(A) as entertainment directly preceded or followed by a substantial and bona fide business discussion merely because James had general discussions of a business nature intended to promote goodwill during the course of the trips. [citation omitted].


We conclude that § 274(a) bars a deduction for the costs of James’ trips. …


Decision will be entered for the respondent.


Notes and Questions:


1. Is it appropriate that § 274 denies this taxpayer a deduction when § 162 permits it?


2. Suppose that taxpayer Walliser could prove that he actually closed a lending deal (except for documentary formalities) with a person he met and conversed with extensively about his bank’s lending services. The borrower came by the bank three days after the end of the tour and signed the necessary documents. Would (should) the result be different?


• Suppose that at the end of the signing formalities, Walliser gave the borrower two tickets which cost $25 each to that night’s baseball game. The borrower happily accepted. Walliser did not attend the game with the borrower. Should Walliser be permitted to deduct the cost of the baseball tickets?


• Would it make any difference if the tickets cost $60 each?


Moss v. Commissioner, 758 F.2d 211 (7th Cir. 1985)



POSNER, Circuit Judge


The taxpayers, a lawyer named Moss and his wife, appeal from a decision of the Tax Court disallowing federal income tax deductions of a little more than $1,000 in each of two years, representing Moss’s share of his law firm’s lunch expense at the Café Angelo in Chicago. The Tax Court’s decision in this case has attracted some attention in tax circles because of its implications for the general problem of the deductibility of business meals. See, e.g., McNally, Vulnerability of Entertainment and Meal Deductions Under the Sutter Rule, 62 Taxes 184 (1984).


Moss was a partner in a small trial firm specializing in defense work, mostly for one insurance company. Each of the firm’s lawyers carried a tremendous litigation caseload, averaging more than 300 cases, and spent most of every working day in courts in Chicago and its suburbs. The members of the firm met for lunch daily at the Café Angelo near their office. At lunch the lawyers would discuss their cases with the head of the firm, whose approval was required for most settlements, and they would decide which lawyer would meet which court call that afternoon or the next morning. Lunchtime was chosen for the daily meeting because the courts were in recess then. The alternatives were to meet at 7:00 a.m. or 6:00 p.m., and these were less convenient times. There is no suggestion that the lawyers dawdled over lunch, or that the Café Angelo is luxurious.


The framework of statutes and regulations for deciding this case is simple, but not clear. Section 262 of the Internal Revenue Code disallows, “except as otherwise expressly provided in this chapter,” the deduction of “personal, family, or living expenses.” Section 119 excludes from income the value of meals provided by an employer to his employees for his convenience, but only if they are provided on the employer’s premises; and § 162(a) allows the deduction of “‘all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including – … (2) traveling expenses (including amounts expended for meals …) while away from home….’” Since Moss was not an employee but a partner in a partnership not taxed as an entity, since the meals were not served on the employer’s premises, and since he was not away from home (that is, on an overnight trip away from his place of work, see United States v. Correll, 389 U.S. 299 (1967)), neither § 119 nor § 162(a)(2) applies to this case. The Internal Revenue Service concedes, however, that meals are deductible under § 162(a) when they are ordinary and necessary business expenses (provided the expense is substantiated with adequate records, see § 274(d)) even if they are not within the express permission of any other provision and even though the expense of commuting to and from work, a traveling expense but not one incurred away from home, is not deductible. Reg. § 1.262-1(b)(5); Fausner v. Commissioner, 413 U.S. 838 (1973) (per curiam).


The problem is that many expenses are simultaneously business expenses in the sense that they conduce to the production of business income and personal expenses in the sense that they raise personal welfare. This is plain enough with regard to lunch; most people would eat lunch even if they didn’t work. Commuting may seem a pure business expense, but is not; it reflects the choice of where to live, as well as where to work. Read literally, § 262 would make irrelevant whether a business expense is also a personal expense; so long as it is ordinary and necessary in the taxpayer’s business, thus bringing § 162(a) into play, an expense is (the statute seems to say) deductible from his income tax. But the statute has not been read literally. There is a natural reluctance, most clearly manifested in the regulation disallowing deduction of the expense of commuting, to lighten the tax burden of people who have the good fortune to interweave work with consumption. To allow a deduction for commuting would confer a windfall on people who live in the suburbs and commute to work in the cities; to allow a deduction for all business-related meals would confer a windfall on people who can arrange their work schedules so they do some of their work at lunch.


Although an argument can thus be made for disallowing any deduction for business meals, on the theory that people have to eat whether they work or not, the result would be excessive taxation of people who spend more money on business meals because they are business meals than they would spend on their meals if they were not working. Suppose a theatrical agent takes his clients out to lunch at the expensive restaurants that the clients demand. Of course he can deduct the expense of their meals, from which he derives no pleasure or sustenance, but can he also deduct the expense of his own? He can, because he cannot eat more cheaply; he cannot munch surreptitiously on a peanut butter and jelly sandwich brought from home while his client is wolfing down tournedos Rossini followed by souffle au grand marnier. No doubt our theatrical agent, unless concerned for his longevity, derives personal utility from his fancy meal, but probably less than the price of the meal. He would not pay for it if it were not for the business benefit; he would get more value from using the same money to buy something else; hence the meal confers on him less utility than the cash equivalent would. The law could require him to pay tax on the fair value of the meal to him; this would be (were it not for costs of administration) the economically correct solution. But the government does not attempt this difficult measurement; it once did, but gave up the attempt as not worth the cost, see United States v. Correll, supra, 389 U.S. at 301 n. 6. The taxpayer is permitted to deduct the whole price, provided the expense is “‘different from or in excess of that which would have been made for the taxpayer’s personal purposes.’” Sutter v. Commissioner, 21 T.C. 170, 173 (1953).


Because the law allows this generous deduction, which tempts people to have more (and costlier) business meals than are necessary, the Internal Revenue Service has every right to insist that the meal be shown to be a real business necessity. This condition is most easily satisfied when a client or customer or supplier or other outsider to the business is a guest. Even if Sydney Smith was wrong that “‘soup and fish explain half the emotions of life,’” it is undeniable that eating together fosters camaraderie and makes business dealings friendlier and easier. It thus reduces the costs of transacting business, for these costs include the frictions and the failures of communication that are produced by suspicion and mutual misunderstanding, by differences in tastes and manners, and by lack of rapport. A meeting with a client or customer in an office is therefore not a perfect substitute for a lunch with him in a restaurant. But it is different when all the participants in the meal are coworkers, as essentially was the case here (clients occasionally were invited to the firm’s daily luncheon, but Moss has made no attempt to identify the occasions). They know each other well already; they don’t need the social lubrication that a meal with an outsider provides – at least don’t need it daily. If a large firm had a monthly lunch to allow partners to get to know associates, the expense of the meal might well be necessary, and would be allowed by the Internal Revenue Service. See Wells v. Commissioner, 36 T.C.M. 1698, 1699 (1977), aff’d without opinion, 626 F.2d 868 (9th Cir. 1980). But Moss’s firm never had more than eight lawyers (partners and associates), and did not need a daily lunch to cement relationships among them.


It is all a matter of degree and circumstance (the expense of a testimonial dinner, for example, would be deductible on a morale-building rationale); and particularly of frequency. Daily – for a full year – is too often, perhaps even for entertainment of clients, as implied by Hankenson v. Commissioner, 47 T.C.M. 1567, 1569 (1984), where the Tax Court held nondeductible the cost of lunches consumed three or four days a week, 52 weeks a year, by a doctor who entertained other doctors who he hoped would refer patients to him, and other medical personnel.


We may assume it was necessary for Moss’s firm to meet daily to coordinate the work of the firm, and also, as the Tax Court found, that lunch was the most convenient time. But it does not follow that the expense of the lunch was a necessary business expense. The members of the firm had to eat somewhere, and the Café Angelo was both convenient and not too expensive. They do not claim to have incurred a greater daily lunch expense than they would have incurred if there had been no lunch meetings. Although it saved time to combine lunch with work, the meal itself was not an organic part of the meeting, as in the examples we gave earlier where the business objective, to be fully achieved, required sharing a meal.


The case might be different if the location of the courts required the firm’s members to eat each day either in a disagreeable restaurant, so that they derived less value from the meal than it cost them to buy it, cf. Sibla v. Commissioner, 611 F.2d 1260, 1262 (9th Cir. 1980); or in a restaurant too expensive for their personal tastes, so that, again, they would have gotten less value than the cash equivalent. But so far as appears, they picked the restaurant they liked most. Although it must be pretty monotonous to eat lunch the same place every working day of the year, not all the lawyers attended all the lunch meetings and there was nothing to stop the firm from meeting occasionally at another restaurant proximate to their office in downtown Chicago; there are hundreds.


An argument can be made that the price of lunch at the Café Angelo included rental of the space that the lawyers used for what was a meeting as well as a meal. There was evidence that the firm’s conference room was otherwise occupied throughout the working day, so as a matter of logic Moss might be able to claim a part of the price of lunch as an ordinary and necessary expense for work space. But this is cutting things awfully fine; in any event Moss made no effort to apportion his lunch expense in this way.




Notes and Questions:


1. Walliser was a § 274 case. Moss was not. Why not?


2. What requirement of deductibility under § 162 did taxpayer fail to meet?


3. If this firm had only monthly lunches, the court seems to say that the cost of those lunches might have been deductible. Why should such meals be treated differently than the daily lunches at Café Angelo?


4. Another limitation on §§ 162 and 212 is § 280A, which limits taxpayer’s deductions for business use of a home.


Section 280A limits deductions for business use of a dwelling unit that taxpayer (individual or S corporation) uses as a residence. Section 280A(a) provides taxpayer is entitled to no deduction for such use “[e]xcept as otherwise provided in” § 280A itself. Section 280A(c) provides those exceptions.


• Section 280A(c)(1) permits deductions when taxpayer regularly uses a portion of the dwelling “exclusively”


• as a principal place of business, including a place that taxpayer uses for administrative or management activities of taxpayer’s trade or business, and there is no other fixed location where taxpayer conducts substantial management or administrative activities,


• as a place of business that patients, clients, or customers use to meet with taxpayer “in the normal course of his trade or business,” OR


• in connection with taxpayer’s trade or business “in the case of a separate structure which is not attached to the dwelling unit.”


• Section 280A(c)(2) permits deductions when taxpayer regularly uses space in the dwelling unit to store inventory or product samples that taxpayer sells at retail or wholesale, provided the dwelling unit is the only fixed location of taxpayer’s trade or business.


• Section 280A(c)(3) permits deductions when they are attributable to rental of the dwelling unit.


• Section 280A(c)(4) permits deductions attributable to use of a portion of the dwelling unit for licensed child or dependent care services.


Section 280A(c)(5) limits the amount of any deductions attributable to business use of the home to the gross income that taxpayer derives from such use. § 280A(c)(5)(A). Section 280A(c)(5) and Prop. Reg. § 1-280A(i) provide a sequence in which taxpayer may claim deductions attributable to the business activity.


1. the gross income that taxpayer derives from use of a dwelling unit in a trade or business does not include “expenditures required for the activity but not allocable to use of the unit itself, such as expenditures for supplies and compensation paid to other persons.” Prop. Reg. § 1.280A-2(i)(2)(iii).


2. deductions attributable to such trade or business and allocable to the portion of the dwelling unit that taxpayer uses that the Code would allow taxpayer even if he/she/it did not conduct a trade or business in the dwelling unit, e.g., real property taxes, § 164(a)(1), mortgage interest, § 163(h)(2)(D).


3. deductions attributable to such trade or business use that do not reduce basis, e.g., utilities, homeowners’ insurance.


4. basis-reducing deductions, i.e., depreciation.


If taxpayer’s deductions exceed his/her/its gross income derived from the business use of the dwelling unit that he/she/it uses as a home, taxpayer may carry those deductions forward to succeeding years.


• Notice that unless taxpayer operates a trade or business in the home that is genuine, in the sense that it is profitable, it is unlikely that taxpayer will ever be able to exploit all of the deductions that business use of a home would generate. A taxpayer who does not carry on a profitable trade or business in the home will likely carry forward unused deductions forever.


• Notice also that the sequence of deductions that § 280A(c)(5) and Prop. Reg. § 1.280A-2(i) mandate requires taxpayer to “use up” the deductions to which he/she/it would be entitled – even if taxpayer did not use his/her/its dwelling unit for business activities, i.e., direct expenses of the business itself followed by deductions to which taxpayer is entitled in any event.


• The deductions that might motivate taxpayer to claim business use of a home are the ones to which he/she/it would not otherwise be entitled to claim, e.g., a portion of homeowners’ insurance, utilities, other expenses of home ownership, and (perhaps most importantly) depreciation. Those deductions may be effectively out of reach.


CALI Lesson Logo


5. Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Trade or Business Deductions. Hopefully, you will find some of it to be in the nature of review.


3. Education Expenses


CALI Lesson Logo


Do CALI Lesson, Basic Federal Income Taxation: Deductions: Education Expenses


• Read Reg. § 1.162-5.


• Read §§ 274(m)(2), 274(n).


A taxpayer may incur expenses for various educational activities, e.g., training, that he/she/it may deduct as ordinary and necessary business expenses. Recall that in Welch v. Helvering, the Court indicated that investment in one’s basic education is a nondeductible investment in human capital. Not surprisingly, then, the regulations draw lines around education undertaken to meet the minimum requirements of a particular trade or business or to qualify for a new trade or business. Reg. § 1.162-5 implements these distinctions.


Reg. § 1.162-5(a) states the general rule that expenditures made for education are deductible, even when those expenditures may lead to a degree, if the education –


“(1) Maintains or improves skills required by the individual in his employment or other trade or business, or


(2) Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship status, or rate of compensation.”


Id. However, even expenditures that meet one of these two conditions are nevertheless not deductible if –


• the expenditures are “made by an individual for education which is required of him in order to meet the minimum educational requirements for qualification in his employment or other trade or business. … The fact that an individual is already performing service in an employment status does not establish that he has met the minimum educational requirements for qualification in that employment. Once an individual has met the minimum educational requirements for qualification in his employment or other trade or business (as in effect when he enters the employment or trade or business), he shall be treated as continuing to meet those requirements even though they are changed.” Reg. § 1.162-5(b)(2)(i). OR


• the expenditures are “made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.” Reg. § 1.162-5(b)(3)(i).




Pere Alegal works for a downtown Memphis law firm. He works under the supervision of attorneys, but in many respects he does the same type of work that attorneys do. The firm’s partners advise Alegal that if he does not obtain a law license, he will not be retained. Alegal therefore enrolled in one of the nation’s best-value law schools. Pere will continue to work for the firm. Alegal incurs costs for tuition, books, etc. At the end of the educational program, Alegal passed the bar examination and obtained a license to practice law. Alegal continues to work for the firm and in fact his job functions did not change at all.


• If Alegal sought to deduct the expenses of his legal education, could he argue that his job functions did not change at all once he obtained his law license?


• Is it relevant that a law license did not cause Alegal to take up a new trade or business?


4. Section 172


The costs of earning taxable income are offset against that income. Ours is a system that taxes only “net income.” The Tax Code requires an annual accounting of income and deductible expenses. A taxpayer’s income may fluctuate between losses and profitability from one year to the next. This could raise serious problems of fairness if losses cannot offset gross income. Section 172 permits some netting of business gains and losses between different tax years.


• Read § 172(c). It defines a “net operating loss” (NOL) to be the excess of deductions allowed over gross income.


• Read § 172(d). Its effect is to limit the deductions that would “take taxpayer’s taxable income negative” to essentially trade or business expenses. For individual taxpayers, capital losses are deductible only to the extent of capital gains, § 172(d)(2)(A); no deduction is allowed for personal exemptions, § 172(d)(3); nonbusiness deductions are allowed only to the extent of taxpayer’s non-trade or business income, § 172(d)(4); the § 199 domestic production deduction is not allowed, § 172(d)(7).


• Section 172(a) permits NOL carryovers and carrybacks to reduce taxpayer’s taxable income.


• An NOL carryback is first allowed against the taxable income of each of the two taxable years preceding the taxable year of the net loss. § 172(b)(1)(A)(i).


• An NOL carryover is allowed against the taxable income of each of the 20 years following the taxable year of the net loss. § 172(b)(1)(A)(ii).138



• A taxpayer must use carrybacks and carryovers beginning with the earliest taxable year and then apply them to each succeeding year. § 172(b)(2). The taxable income against which an NOL may be used is computed without regard to capital losses or personal exemptions. § 172(b)(2)(A). A taxpayer may waive the entire carryback period. § 172(b)(3).


• The carryback period is extended to three years in the case of NOLs caused by casualties, federally declared disasters, and certain farming losses. § 172(b)(1)(F).


• The effect of any extension of the carryback period is to get money into the pockets of the affected taxpayer(s) quickly. A casualty or natural disaster likely causes significant losses to the affected taxpayer in the year of the disaster. A carryforward deduction will only benefit such taxpayers in the future. Such taxpayers may have been (quite) profitable in the immediately preceding years and paid a significant amount in federal income tax. An extension of the carryback period permits affected taxpayers to recoup more of such income taxes paid sooner.


• One measure to deal with the economic crisis is § 172(b)(1)(H). This provision permits a taxpayer to extend the carryback period to 3, 4, or 5 years for an operating loss occurring in 2008 or 2009. § 172(b)(1)(H)(i and ii). Taxpayer may make this election only with respect to one taxable year. § 172(b)(1)(H)(iii)(I).


• A 5-year carryback is limited to 50% of the taxpayer’s taxable income as of the carryback year, computed without regard to the NOL for the loss year or any other succeeding loss year whose NOL would be carried back. § 172(b)(2)(H)(iv)(I).


• Presumably, a taxpayer would choose a carryback period that would maximize his/her refund.




In 2011, taxpayer had net losses of $500,000. Redetermine taxpayer’s taxable income under the rules of § 172 if taxpayer’s taxable income would otherwise have been the following amounts for the years in question.


• 2009: $50,000


• 2010: $75,000


• 2011: ?


• 2012: $110,000


• 2013: $165,000


• 2014: $200,000


• 2015: $100,000


• 2016: $60,000


D. Special Rules to Encourage Manufacturing and Exploitation of Natural Resources



1. Section 199: Income Attributable to Domestic Production Activities


In order to encourage taxpayers to engage in manufacturing trades or businesses in the United States, Congress enacted § 199. Section 199(a) allows a deduction of 9% of a taxpayer’s “qualified production activities income” or the taxpayer’s taxable income determined without regard to § 199 – whichever is less. A taxpayer’s “qualified production activities income” is taxpayer’s net (§ 199(c)(1)) income derived from “any lease, rental, license, sale, exchange, or other disposition of” (§ 199(c)(4)(A)(i))


• tangible personal property, computer software, or sound recording, § 199(c)(5),


• a film if at least 50% of the compensation relating to its production is for services performed in the United States, §§ 199(c)(A)(i)(II), 199(c)(6), or


• “electricity, natural gas, or potable water produced by the taxpayer in the United States. § 199(c)(4)(A)(i)(III).


Such income also includes income derived from –


• “construction of real property performed in the United States by the taxpayer in the ordinary course of” his/her/its trade or business, § 199(c)(4)(A)(ii), or


• engineering or architectural services performed in the United States by the taxpayer in the ordinary course of his/her/its trade or business, § 199(c)(4)(iii).


A § 199 deduction is limited to 50% of the taxpayer’s W-2 wages paid during the taxable year.


Section 199 is not part of the Code’s methods for determining a taxpayer’s net income. Rather, it is a reward for doing something that Congress wants taxpayers to do, i.e., to engage in manufacturing activities in the United States. And: the more profit a taxpayer can derive from engaging in manufacturing activities, the greater his/her/its deduction. But taxpayer is only entitled to a § 199 deduction in an amount up to half what he/she/it paid in W-2 [i.e., U.S.] wages.


Section 199 represents an effort to make U.S. manufacturers more competitive vis-a-vis foreign competition. It is also intended to encourage exports. By rewarding successful manufacturers, Congress is (likely to be) rewarding exporters.


Congress has pursued this objective in other legislation, but the World Trade Organization found that such legislation violated the General Agreement on Tariffs and Trade.


2. Section 611: The Depletion Deduction


Section 611(a) provides for a deduction in computing taxable income for depletion. This deduction is available for “mines, oil and gas wells, other natural deposits, and timber[.]”139 The depletion allowance deduction is similar to the depreciation deduction, infra, in that both deductions are a form of cost recovery of capital investments. Unlike the depreciation deduction, which is an allowance for the gradual consumption of an asset that the taxpayer uses to produce a product (or to provide a service), the depletion allowance deduction is an allowance for the cost recovery of wasting assets that are the product.140 The depletion allowance is part of the cost of the thing that the taxpayer sells.



Congress enacted the depletion allowance deduction as a means for fossil fuel companies and mine operators to deduct an amount equal to the reduction in value of their mineral reserves as they extracted and sold the mineral. § 611(a). The deduction allows a taxpayer to recover its capital investment so that the investment will not diminish as the minerals are extracted and sold.141 Despite this purpose, there is no requirement that the taxpayer invest any money in the mineral rights,142 and taxpayer does not have to have legal title to take advantage of the deduction.143 First codified in 1913, the depletion allowance deduction was originally limited to mines – and only 5% of the gross value of a mine’s reserves could be deducted in a year.144 Over time, the depletion allowance deduction has expanded to include resources other than mining – such as oil, gas, and timber – and to allow for deductions greater than 5%.



Anyone with an “economic interest” may share145 in the depletion allowance deduction.146 “An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from the extraction of the mineral or severance of the timber, to which he must look for a return of his capital.”147 A broad range of economic interests exists whose owners may claim the depletion allowance deduction.



There are now two ways to calculate a depletion allowance deduction, and taxpayer chooses the one that yields the greater deduction. However, taxpayer may not choose percentage depletion in the case of an interest in timber.148



Cost Depletion: Under cost depletion, taxpayer allocates annually an equal amount of basis149 to each recoverable unit.150 Taxpayer may claim the deduction when it sells the unit151 or cuts the timber.152 Depletion allowance deductions – allowed or allowable – reduce taxpayer’s basis in the property until the basis is $0.153 At that time, taxpayer may shift to percentage depletion, except when taxpayer claims depletion allowance deductions for timber. Recapture of depletion allowance deductions upon sale or exchange of the property is subject to income taxation at ordinary income rates.154



Percentage Depletion: Percentage depletion is a deduction based on a specified percentage of taxpayer’s gross income from the activity155 up to 50% of the taxable income from the activity.156 The limit is 100% of taxable income from oil and gas properties.157 However, Sections 613(d) and 613A disallow any depletion allowance deduction for oil and gas wells, except for some small independent producers and royalty owners of domestic oil and gas.158 Their percentage depletion allowance deduction is 15%159 of gross income, limited to 65% of taxable income.160 A percentage depletion allowance deduction is available even though taxpayer has no basis remaining in the asset.



The percentage depletion method serves to encourage the further development and exploitation of certain natural resources. This is important in a time when we believe that preservation of natural resources should be national policy.161 In recent years, depletion allowance deductions have increased significantly: in 2003, total corporate depletion allowance deductions were nearly $10.2 billion, while in 2009, total corporate depletion allowance deductions rose to more than $21.5 billion.162



III. Depreciation, Amortization, and Cost Recovery



We have encountered at several points the principle that taxpayer’s consumption of only a part of a productive asset in order to generate taxable income entitles taxpayer to a deduction for only that amount of consumption. Such consumption represents a taxpayer’s de-investment in the asset and results in a reduction of basis. We take up here the actual mechanics of some of the Code’s depreciation provisions. The following case provides a good review of depreciation principles and congressional tinkering with them as means of pursuing certain economic policies.


Liddle v. Commissioner, 65 F.3d 329 (3rd Cir. 1995)



McKEE, Circuit Judge:


In this appeal from a decision of the United States Tax Court we are asked to decide if a valuable bass viol can be depreciated under the Accelerated Cost Recovery System when used as a tool of trade by a professional musician even though the instrument actually increased in value while the musician owned it. We determine that, under the facts before us, the taxpayer properly depreciated the instrument and therefore affirm the decision of the Tax Court.




Brian Liddle, the taxpayer here, is a very accomplished professional musician. Since completing his studies in bass viol at the Curtis Institute of Music in 1978, he has performed with various professional music organizations, including the Philadelphia Orchestra, the Baltimore Symphony, the Pennsylvania ProMusica and the Performance Organization.


In 1984, after a season with the Philadelphia Orchestra, he purchased a 17th century bass viol made by Francesco Ruggeri (c. 1620-1695), a luthier who was active in Cremona, Italy. Ruggeri studied stringed instrument construction under Nicolo Amati, who also instructed Antonio Stradivari. Ruggeri’s other contemporaries include the craftsmen Guadanini and Guarneri. These artisans were members of a group of instrument makers known as the Cremonese School.


Liddle paid $28,000 for the Ruggeri bass, almost as much as he earned in 1987 working for the Philadelphia Orchestra. The instrument was then in an excellent state of restoration and had no apparent cracks or other damage. Liddle insured the instrument for its then-appraised value of $38,000. This instrument was his principal instrument and he used it continuously to earn his living, practicing with it at home as much as seven and one-half hours every day, transporting it locally and out of town for rehearsals, performances and auditions. Liddle purchased the bass because he believed it would serve him throughout his professional career – anticipated to be 30 to 40 years.


Despite the anticipated longevity of this instrument, the rigors of Liddle’s profession soon took their toll upon the bass and it began reflecting the normal wear and tear of daily use, including nicks, cracks, and accumulations of resin. At one point, the neck of the instrument began to pull away from the body, cracking the wood such that it could not be played until it was repaired. Liddle had the instrument repaired by renown [sic] artisans. However, the repairs did not restore the instrument’s “voice” to its previous quality. At trial, an expert testified for Liddle that every bass loses mass from use and from oxidation and ultimately loses its tone, and therefore its value as a performance instrument decreases. Moreover, as common sense would suggest, basses are more likely to become damaged when used as performance instruments than when displayed in a museum. Accordingly, professional musicians who use valuable instruments as their performance instruments are exposed to financial risks that do not threaten collectors who regard such instruments as works of art, and treat them accordingly.


There is a flourishing market among nonmusicians for Cremonese School instruments such as Mr. Liddle’s bass. Many collectors seek primarily the “label”, i.e., the maker’s name on the instrument as verified by the certificate of authenticity. As nonplayers, they do not concern themselves with the physical condition of the instrument; they have their eye only on the market value of the instrument as a collectible. As the quantity of these instruments has declined through loss or destruction over the years, the value of the remaining instruments as collectibles has experienced a corresponding increase.


Eventually, Liddle felt the wear and tear had so deteriorated the tonal quality of his Ruggeri bass that he could no longer use it as a performance instrument. Rather than selling it, however, he traded it for a Domenico Busan 18th century bass in May of 1991. The Busan bass was appraised at $65,000 on the date of the exchange, but Liddle acquired it not for its superior value, but because of the greater tonal quality.


Liddle and his wife filed a joint tax return for 1987, and claimed a depreciation deduction of $3,170 for the Ruggeri bass under the Accelerated Cost Recovery System (“ACRS”), § 168. The Commissioner disallowed the deduction asserting that the “Ruggeri bass in fact will appreciate in value and not depreciate.” Accordingly, the Commissioner assessed a deficiency of $602 for the tax year 1987. The Liddles then filed a petition with the Tax Court challenging the Commissioner’s assertion of the deficiency. A closely divided court entered a decision in favor of the Liddles. This appeal followed.




The Commissioner originally argued that the ACRS deduction under § 168 is inappropriate here because the bass actually appreciated in value. However, the Commissioner has apparently abandoned that theory, presumably because an asset can appreciate in market value and still be subject to a depreciation deduction under tax law. Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277 (1966) (“tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation.”); Noyce v. Commissioner, 97 T.C. 670, 1991 WL 263146 (1991) (taxpayer allowed to deduct depreciation under § 168 on an airplane that appreciated in economic value from the date of purchase to the time of trial).


Here, the Commissioner argues that the Liddles can claim the ACRS deduction only if they can establish that the bass has a determinable useful life. Since Mr. Liddle’s bass is already over 300 years old, and still increasing in value, the Commissioner asserts that the Liddles can not establish a determinable useful life and therefore can not take a depreciation deduction. In addition, the Commissioner argues that this instrument is a “work of art” which has an indeterminable useful life and is therefore not depreciable.


… Prior to 1981, § 167 governed the allowance of depreciation deductions with respect to tangible and intangible personality. Section 167 provided, in relevant part, as follows:




(a) General Rule. – There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) –


(1) of property used in the trade or business, or


(2) of property held for the production of income.


26 U.S.C. § 167(a). The regulations promulgated under § 167 provided that in order to qualify for the depreciation deduction, the taxpayer had to establish that the property in question had a determinable useful life. Reg. § 1.167(a)-1(a) and (b). The useful life of an asset was not necessarily the useful life “inherent in the asset but [was] the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business….” Reg. § 1.167(a)-1(b). Nonetheless, under § 167 and its attendant regulations, a determinable useful life was the sine qua non for claiming the deduction. See, Harrah’s Club v. United States, 661 F.2d 203, 207 (1981) (“Under the regulation on depreciation, a useful life capable of being estimated is indispensable for the institution of a system of depreciation.”).


Under § 167, the principal method for determining the useful life of personalty was the Asset Depreciation Range (“ADR”) system. Personalty eligible for the ADR system was grouped into more than 100 classes and a guideline life for each class was determined by the Treasury Department. See Reg. § 1.167(a)-11. A taxpayer could claim a useful life up to 20% longer or shorter than the ADR guideline life. Reg.§ 1.167(a)-11(4)(b). The ADR system was optional with the taxpayer. Reg. § 1.167(a)-11(a). For personalty which was not eligible for ADR, and for taxpayers who did not choose to use ADR, the useful life of an asset was determined according to the unique circumstances of the particular asset or by an agreement between the taxpayer and the Internal Revenue Service. Staff of the Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, 97th Cong. …


In 1981, convinced that tax reductions were needed to ensure the continued economic growth of the country, Congress passed the Economic Recovery Tax Act of 1981, P. L. 97-34 (“ERTA”). Id. It was hoped that the ERTA tax reduction program would “help upgrade the nation’s industrial base, stimulate productivity and innovation throughout the economy, lower personal tax burdens and restrain the growth of the Federal Government.” Id. Congress felt that prior law and rules governing depreciation deductions need to be replaced “because they did not provide the investment stimulus that was felt to be essential for economic expansion.” Id. Further, Congress believed that the true value of the depreciation deduction had declined over the years because of high inflation rates. Id. As a result, Congress believed that a “substantial restructuring” of the depreciation rules would stimulate capital formation, increase productivity and improve the country’s competitiveness in international trade. Id. Congress also felt that the prior rules concerning the determination of a useful life were “too complex”, “inherently uncertain” and engendered “unproductive disagreements between taxpayers and the Internal Revenue Service.” Id. To remedy the situation, Congress decided


that a new capital cost recovery system should be structured which de-emphasizes the concept of useful life, minimizes the number of elections and exceptions and is easier to comply with and to administer.




Accordingly, Congress adopted the Accelerated Cost Recovery System (“ACRS”) in ERTA. The entire cost or other basis of eligible property is recovered under ACRS eliminating the salvage value limitation of prior depreciation law. General Explanation of the Economic Recovery Tax Act of 1981 at 1450. ACRS was codified in I.R.C. § 168, which provided, in relevant part, as follows:


Sec. 168. Accelerated cost recovery system


(a) Allowance of Deduction. – There shall be allowed as a deduction for any taxable year the amount determined under this section with respect to recovery property.


(b) Amount of Deduction.—


(1) In general. – Except as otherwise provided in this section, the amount of the deduction allowable by subsection (a) for any taxable year shall be the aggregate amount determined by applying to the unadjusted basis of recovery property the applicable percentage determined in accordance with the following table:


* * * * * *


(c) Recovery Property. – For purposes of this title –


(1) Recovery Property Defined. – Except as provided in subsection (e), the term “recovery property” means tangible property of a character subject to the allowance for depreciation –


(A) used in a trade or business, or


(B) held for the production of income.


26 U.S.C. § 168. ACRS is mandatory and applied to “recovery property” placed in service after 1980 and before 1987.163



Section 168(c)(2) grouped recovery property into five assigned categories: 3-year property, 5-year property, 10-year property, 15-year real property and 15-year public utility property. Three year property was defined as § 1245 property164 with a class life of 4 years or less. Five year property is all § 1245 property with a class life of more than 4 years. Ten year property is primarily certain public utility property, railroad tank cars, coal-utilization property and certain real property described in I.R.C. § 1250(c). Other long-lived public utility property is in the 15-year class. § 168(a)(2)(A), (B) and (C). Basically, 3-year property includes certain short-lived assets such as automobiles and light-duty trucks, and 5-year property included all other tangible personal property that was not 3-year property. Most eligible personal property was in the 5-year class.



The Commissioner argues that ERTA § 168 did not eliminate the pre-ERTA § 167 requirement that tangible personalty used in a trade or business must also have a determinable useful life in order to qualify for the ACRS deduction. She argues that the phrase “of a character subject to the allowance for depreciation” demonstrates that the pre-ERTA § 167 requirement for a determinable useful life is the threshold criterion for claiming the § 168 ACRS deduction.


Much of the difficulty inherent in this case arises from two related problems. First, Congress left § 167 unmodified when it added § 168; second, § 168 contains no standards for determining when property is “of a character subject to the allowance for depreciation.” In the absence of any express standards, logic and common sense would dictate that the phrase must have a reference point to some other section of the Internal Revenue Code. Section 167(a) would appear to be that section. As stated above, that section provides that “[t]here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear … of property used in a trade or business….” The Commissioner assumes that all of the depreciation regulations promulgated under § 167 must, of necessity, be imported into § 168. That importation would include the necessity that a taxpayer demonstrate that the asset have a demonstrable useful life, and (the argument continues) satisfy the phrase “tangible property of a character subject to the allowance for depreciation” in § 168.


However, we do not believe that Congress intended the wholesale importation of § 167 rules and regulations into § 168. Such an interpretation would negate one of the major reasons for enacting the Accelerated Cost Recovery System. Rather, we believe that the phrase “of a character subject to the allowance for depreciation” refers only to that portion of § 167(a) which allows a depreciation deduction for assets which are subject to exhaustion and wear and tear. Clearly, property that is not subject to such exhaustion does not depreciate. Thus, we hold that “property of a character subject to the allowance for depreciation” refers to property that is subject to exhaustion, wear and tear, and obsolescence. However, it does not follow that Congress intended to make the ACRS deduction subject to the § 167 useful life rules, and thereby breathe continued life into a regulatory scheme that was bewildering, and fraught with problems, and required “substantial restructuring.”


We previously noted that Congress believed that prior depreciation rules and regulations did not provide the investment stimulus necessary for economic expansion. Further, Congress believed that the actual value of the depreciation deduction declined over the years because of inflationary pressures. In addition, Congress felt that prior depreciation rules governing the determination of useful lives were much too complex and caused unproductive disagreements between taxpayers and the Commissioner. Thus, Congress passed a statute which “de-emphasizes the concept of useful life.” General Explanation of the Economic Recovery Tax Act of 1981 at 1449. Accordingly, we decline the Commissioner’s invitation to interpret § 168 in such a manner as to re-emphasize a concept which Congress has sought to “de-emphasize.”


The Commissioner argues that de-emphasis of useful life is not synonymous with abrogation of useful life. As a general statement, that is true. However, the position of the Commissioner, if accepted, would reintroduce unproductive disputes over useful life between taxpayers and the Internal Revenue Service. Indeed, such is the plight of Mr. Liddle.


Congress de-emphasized the § 167 useful life rules by creating four short periods of time over which taxpayers can depreciate tangible personalty used in their trade or business. These statutory “recovery periods … are generally unrelated to, but shorter than, prior law useful lives.” General Explanation of the Economic Recovery Tax Act of 1981 at 1450. The four recovery periods are, in effect, the statutorily mandated useful lives of tangible personalty used in a trade or business.


The recovery periods serve the primary purpose of ERTA. Once a taxpayer has recovered the cost of the tangible personalty used in a trade or business, i.e., once the taxpayer has written off the asset over the short recovery period, his or her basis in that asset will be zero and no further ACRS deduction will be allowed. To avail himself or herself of further ACRS deductions, the taxpayer will have to purchase a new asset. Thus, because the recovery period is generally shorter than the pre-ERTA useful life of the asset, the taxpayer’s purchase of the new asset will increase capital formation and new investment and, as a result, promote the Congressional objective for continued economic expansion.


Thus, in order for the Liddles to claim an ACRS deduction, they must show that the bass is recovery property as defined in § 168(c)(1). It is not disputed that it is tangible personalty which was placed in service after 1980 and that it was used in Brian Liddle’s trade or business. What is disputed is whether the bass is “property of a character subject to the allowance for depreciation.” We hold that that phrase means that the Liddles must only show that the bass was subject to exhaustion and wear and tear. The Tax Court found as a fact that the instrument suffered wear and tear during the year in which the deduction was claimed. That finding was not clearly erroneous. Accordingly, the Liddles are entitled to claim the ACRS deduction for the tax year in question.


Similarly, we are not persuaded by the Commissioner’s “work of art” theory, although there are similarities between Mr. Liddle’s valuable bass, and a work of art. The bass, is highly prized by collectors; and, ironically, it actually increases in value with age much like a rare painting. Cases that addressed the availability for depreciation deductions under § 167 clearly establish that works of art and/or collectibles were not depreciable because they lacked a determinable useful life. See Associated Obstetricians and Gynecologists, P.C. v. Commissioner, 762 F.2d 38 (6th Cir.1985) (works of art displayed on wall in medical office not depreciable); Hawkins v. Commissioner, 713 F.2d 347 (8th Cir.1983) (art displayed in law office not depreciable); Harrah’s Club v. United States, 661 F.2d 203 (1981) (antique automobiles in museum not depreciable). See also, Rev. Rul. 68-232 (“depreciation of works of art generally is not allowable because ‘[a] valuable and treasured art piece does not have a determinable useful life.’“).


… In Brian Liddle’s professional hands, his bass viol was a tool of his trade, not a work of art. It was as valuable as the sound it could produce, and not for its looks. Normal wear and tear from Liddle’s professional demands took a toll upon the instrument’s tonal quality and he, therefore, had every right to avail himself of the depreciation provisions of the Internal Revenue Code as provided by Congress.




Accordingly, for the reasons set forth above, we will affirm the decision of the tax court.


Notes and Questions:


1. Note the court’s account of the evolution of depreciation law. In its first footnote, the court noted that “recovery property” is no longer part of § 168. Section 168 now applies to “any tangible property.”


2. The Second Circuit reached a similar result in Simon v. Commissioner, 68 F.3d 41 (2d Cir. 1995), Nonacq. 1996-29 I.R.B. 4, 1996-2 C.B. 1, 1996 WL 33370246 (cost recovery allowance for a violin bow).


Note: Sections 167 and 168


Section 167 still governs depreciation. It has been supplemented – to the point that it has actually been replaced – by § 168 for tangible property – but not for intangible property. The allowable depreciation deduction of § 167(a) is what is described in § 168 when it is applicable. § 168(a). When § 168 is applicable, its application is mandatory. § 168(a) (“shall be determined”). Application of § 168 is much more mechanical and predictable than application of § 167. The Third Circuit described the mechanics of applying § 167 – and of course, the greater accuracy that § 167 (may have) yielded came at a high administrative cost, both to the taxpayer and to the IRS. The Commissioner’s argument that taxpayer must demonstrate that an asset has a “determinable useful life” in order to claim a deduction for depreciation is an accurate statement of the law of § 167. Applying § 167 required placing an asset in an “Asset Depreciation Range” (ADR), deriving its useful life, determining its future “salvage value,” and then calculating the actual depreciation deduction according to an allowable method. The court in Liddle described this system as “bewildering, and fraught with problems[.]” While ADRs are no longer law, they are still used to determine the “class life” of an asset which in turn determines the type of property that it is – whether 3-year, 5-year, 7-year, 10-year, 15-year, or 20-year property. § 168(e)(1).


The late 1970s and early 1980s was a time of slow economic growth and very high inflation. The court describes the congressional response, i.e., the Economic Recovery Tax Act of 1981 (ERTA). Clearly, Congress – at the urging of President Reagan – was using the tax rules as a device to stimulate the economy. Congress modified the system so that property placed in service in 1986 and after would be subject to the “Modified Accelerated Cost Recovery System” (MACRS). Sufficient time has passed that we do not often have to distinguish between ACRS and MACRS; often we simply refer to the current system as ACRS. Notice that § 168 uses the phrase “accelerated cost recovery system” (ACRS) – implying that we no longer consider this to be depreciation. As we see in the succeeding paragraphs, taxpayers who place property in service to which § 168 applies may “write it off” much faster than they could under the old rules. The Third Circuit in Liddle explained what Congress was trying to accomplish by adopting these rules.


Section 168(e) requires that we identify the “classification of property.” Certain property is classified as 3-year property, 5-year property, 7-year property, 10-year property, 15-year property, and 20-year property. § 168(e)(3). Property not otherwise described is first defined according to the old class life rules, § 168(e)(1), § 168(i)(1), and then placed into one of these classifications. For such properties, the recovery period corresponds to the classification of the property. See § 168(c). In addition, § 168(b)(3) names certain properties whose recovery period is prescribed in § 168(c).


• You should read through these sub-sections – particularly (and in this order) § 168(e)(3), § 168(e)(1), § 168(e)(3), and § 168(c).


• Notice that § 168(e)(3)(C)(v) provides that property without a class life and not otherwise classified is classified as 7-year property. Section 168(e)(3)(C)(v) thus serves as a sort of “default” provision when taxpayers purchase items such as bass viols. At the time the Liddles filed their tax return, the default period was five years.


Section 168(b)(4) treats salvage value as zero. This completely eliminates one point of dispute between taxpayers and the IRS. The basis for depreciation is the adjusted basis provided in § 1011. § 167(c)(1).


Section 168(d) prescribes certain “conventions.” We generally treat all property to which § 168 applies as if it were placed in service or disposed of at the midpoint of the taxpayer’s taxable year. § 168(d)(1 and 4(A) (“half-year convention”)). In the case of real property, we treat it as if it were placed in service or disposed of at the midpoint of the month in which it actually was placed in service or disposed of. § 168(d)(2 and (4)(B) (“mid-month convention”)). A special rule precludes the abuse of these conventions through back-loading. We treat all property to which § 168 applies as if it were placed in service at the midpoint of the quarter in which it was placed in service if more than 40% of the aggregate bases of such property was placed in service during the last quarter of the taxpayer’s tax year. § 168(d)(3)(A). In making this 40% determination, taxpayer does not count nonresidential real property, residential rental property, a railroad grading or tunnel bore, and property placed in service and disposed of during the same taxable year. § 168(d)(3)(B).


Section 168(b) prescribes three cost recovery methods. The straight-line method applies to certain property for which the recovery period is relatively long. § 168(b)(3). This of course means that taxpayer divides the item’s basis by the applicable recovery period. In the first and last year of ownership, taxpayer applies the applicable convention to determine his/her/its “cost recovery” deduction. A faster method of cost recovery applies to property whose classification is 15 or 20 years, i.e., 150% of declining balance. § 168(b)(2)(A). This method also applies to specifically named property. § 168(b)(2)(B and C). A faster method still of cost recovery applies to 3-year, 5-year, 7-year, and 10-year property, i.e., 200% of declining balance. § 168(a).


• A taxpayer may irrevocably elect to apply one of the slower methods of cost recovery to one or more classes of property. § 168(b)(2)(D), § 168(b)(3)(D), § 168(b)(5).


• Rather than work through the 150% and 200% of declining balance methods of cost recovery, we are fortunate that the IRS has promulgated Rev. Proc. 87-57. This revenue procedure has several tables that provide the appropriate multiplier year by year for whatever the recovery period for certain property is. The tables incorporate and apply the depreciation method and the appropriate convention.


• Familiarize yourself with these tables.


Section 168(g)(2) provides an “alternate depreciation system” which provides for straight-line cost recovery over a longer period than the rules of § 168 noted thus far. Taxpayer may irrevocably elect to apply the “alternate depreciation system” to all of the property in a particular class placed in service during the taxable year. § 168(g)(7). Taxpayer may make this election separately with respect to each nonresidential real property or residential rental property. § 168(f)(7).


• A taxpayer might make such an election in order to avoid paying the alternative minimum tax. See § 56(a)(1).


Accelerating cost recovery is one policy tool that Congress has to encourage investment in certain types of property at certain times. See § 168(k).




1. Taxpayer purchased a racehorse on January 2, 2011 for $10,000 and “placed it in service” immediately. Taxpayer purchased no other property subject to ACRS allowances during the year.


• What is Taxpayer’s ACRS allowance for 2011?


Taxpayer sold the horse on December 31, 2013 for $9000.


• What is Taxpayer’s adjusted basis in the racehorse?


• What is Taxpayer’s taxable gain from this sale?


2. Taxpayer purchased a “motorsports entertainment complex” on October 1, 2011 for $10M. See § 168(e)(3)(C)(ii). Assume that there is no backloading problem.


• What is Taxpayer’s ACRS allowance for 2011?


• What is Taxpayer’s ACRS allowance for 2012?


• What is Taxpayer’s ACRS allowance for 2013?


• What is Taxpayer’s ACRS allowance for 2014?


• What is Taxpayer’s ACRS allowance for 2015?


• What is Taxpayer’s ACRS allowance for 2016?


• What is Taxpayer’s ACRS allowance for 2017?


• What is Taxpayer’s ACRS allowance for 2018?


Section 179


Section 179 permits a taxpayer to treat “the cost of any § 179 property as an expense which is not chargeable to capital account.” § 179(a). The limit of this deduction for 2010, 2011, 2012, and 2013 is $500,000, § 179(b)(1)(B). It falls to $25,000 after that, § 179(b)(1)(C). The limit is reduced dollar for dollar by the amount by which the cost of § 179 property that taxpayer places into service exceeds $2,000,000 in 2010, 2011, 2012, and 2013, § 179(b)(2)(B), and the amount by which such cost exceeds $200,000 after that, § 179(b)(2)(C). Moreover, the § 179 deduction is limited to the amount of taxable income that taxpayer derived from the active conduct of a trade or business (computed without regard to any § 179 deduction) during the taxable year. § 179(b)(3)(A). Taxpayers whose § 179 deduction is subject to one of these limitations may carry it forward to succeeding years. § 179(b)(3)(B).


• Thus it seems that Congress intends § 179 to benefit small business taxpayers.


• In an effort to encourage small business investment during the recent recession, Congress dramatically increased the § 179 limit to the figures noted. Hopefully, the recession will have passed by tax year 2014 when the limit falls back to $25,000.


• § 179 property is tangible property to which § 168 applies or § 1245 property purchased “for use in the active conduct of a trade or business.” § 179(d)(1). Prior to 2014, § 179 property also includes computer software. § 179(d)(1)(A)(ii).


• After taking a § 179 deduction, taxpayer may apply the rules of § 168 to his/her/its remaining basis.


Other Code Provisions Providing for Cost Recovery or Amortization


Other provisions of the Code state rules applicable to specific investments – generally with the intent of encouraging them. For example, § 174 permits the expensing of research or experimental expenditures. § 174(a)(1).


Section 197


Section 197 permits the amortization of § 197 intangibles. § 197(a). A § 197 includes such intangibles as goodwill, going concern value, intellectual property, a license or permit granted by a government, etc. § 197(d)(1). Section 197 permits ratable amortization over 15 years of the purchase (as opposed to self-creation) of such intangibles. § 197(a), § 197(c)(2).


• Congress intended that § 197 put an end to expensive contests between the IRS and taxpayers over whether such items could be amortized at all, and if so, the applicable useful life. Now a “one-size-fits-all” approach applies to all such intangibles.


CALI Lesson Logo


Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Basic Depreciation, ACRS, and MACRS Concepts. Do not worry about your answers to questions 10 and 11. It is more important that you know how to compute § 179 limits.


Section 280F: Mixing Business and Pleasure


A taxpayer may make expenditures to purchase items that are helpful in earning income and useful in taxpayer’s personal life as well. An automobile may fit this description. So also may a personal computer. These points may lead some taxpayers to purchase items that they might not otherwise purchase, or to purchase items that are more expensive than they might otherwise purchase. Congress has addressed these points in § 280F. It provides limitations on deductions associated with purchase and use of so-called “listed property.”


Section 280F(d)(4)(A) defines “listed property” to be a passenger automobile, any property used as a means of transportation, any property generally used for entertainment, recreation, or amusement, any computer or peripheral equipment, and any other property that the Secretary specifies.


Section 280F(d)(3)(A) denies “employee” deductions for use of listed property unless “such use is for the convenience of the employer and required as a condition of employment.”


Section 280F provides the following types of limitations on cost recovery and § 179 expensing deductions: an absolute dollar limit on such deductions for listed property, a percentage limitation on such deductions for listed property, and a combination of a percentage limitation on an absolute dollar limit on such deductions.


• Absolute dollar limit on cost recovery and § 179 expensing deductions for listed property: Sections 280F(a)(1)(A and B) place an absolute limit on the amount of depreciation allowable for any passenger automobile. The amounts are indexed for inflation. § 280F(d)(7). Nevertheless, the allowable amounts would place a severe limitation on a taxpayer’s choice of automobile.


• Read §§ 280F(a)(1)(A and B). Consider this to be 1988. Taxpayer was a real estate agent and purchased a Mercedes-Benz for $100,000 in order to squire clients around from property-to-property. An automobile is 5-year property. § 168(e)(3)(B)(i). Assume that taxpayer uses the automobile only for trade or business purposes. Assume also that Taxpayer will not be using any § 179 expensing deduction. What would have been taxpayer’s cost recovery deduction in 1988? – in 1989? – in 1990? When would taxpayer have recovered all of the cost of the automobile?


• Percentage limitation on cost recovery and § 179 expensing deductions for listed property: If a taxpayer uses property partly for business and partly for personal purposes, he/she/it must determine the percentage of total use that is trade or business use. See §§ 280F(d)(6)(A and B). Only the trade or business use portion of the allowable accelerated cost recovery or § 179 expensing amount is deductible if the percentage of total use is more than 50% for trade or business. See § 280F(b)(3). If the percentage of total use is not more than 50% trade or business, then Section 280F(b)(1) provides that the alternative depreciation system of § 168(g) applies. Sections 168(g) of course prescribes less favorable straight-line cost recovery over a longer time period. If taxpayer who has used an item predominantly for trade or business and elected to use an accelerated method of cost recovery subsequently makes a use that is not predominantly for trade or business, then taxpayer must recapture the cost recovery in excess of what would have been allowed under § 168(g). § 280F(b)(2).


• Consider: Taxpayer purchased a Hummer – which is not a passenger automobile. See § 280F(d)(5)(A). However, it is property used for transportation. Assume that a Hummer is 7-year property under § 168(e)(3)(B) with a class life of 10 years. Taxpayer paid $100,000 for the Hummer. Taxpayer used the Hummer 75% for trade or business in both 2011 and 2012. In 2013, Taxpayer used the Hummer 25% for trade or business. In 2014, and all subsequent years, Taxpayer used the Hummer 75% for trade or business. What is Taxpayer’s cost recovery allowance for 2011? – 2012? 2013? 2014? – 2015? – 2016? – 2017? – 2018? – 2019? – 2020? – 2021?


• Perhaps we have discovered another reason to elect cost recovery under the alternative depreciation system of § 168(g).


Computation of cost recovery allowances in any year is based on an assumption that all of a taxpayer’s use of listed property was for trade or business purposes. § 280F(d)(2). Thus, a pro rata reduction of allowable cost recovery for less than predominantly business use does not merely extend the cost recovery period.


• Combination of a percentage limitation on an absolute dollar limit on cost recovery deductions: In the case of passenger automobiles, the absolute dollar limit on cost recovery deductions is applied first. Then subsequent limitations based on less-than-predominantly trade or business use are applied. § 280F(a)(2).


Wrap-Up Questions for Chapter 6



1. What is the relationship between depreciation and basis? Why does the relationship have to be what it is? Feel free to state your answer in Haig-Simons terms.


2. This chapter has offered three different tax treatments of expenses. What are they? What are the rationales for adopting any one of them in a given case?


3. We tax net income? What economic distortions would occur if we taxed gross receipts?


4. What economic distortions occur if we accelerate depreciation allowances? – if we give deductions to certain activities when they are profitable, for example § 199?


5. Do depletion allowances encourage (too much) exploitation of natural resources?


Icon for the Creative Commons Attribution-ShareAlike 4.0 International License

Basic Income Tax by William P. Kratzke is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License, except where otherwise noted.


Leave a Reply

Your email address will not be published. Required fields are marked *