Deductions: Business Expenses

AuthorWilliam Kratzke
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 Code does not provide a definition
of “trade or business.”82 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
This excerpt informs that there is a distinction between a “trade or business” and
82 See generally Paula Wolff, Annot., What constitutes trade or business under Internal Revenue Code
(U.S.C.A. Title 26), 161 A.L.R. FED. 245 (2008).
83 Commissioner v. Groetzinger, 480 U.S. 23, 35 (19 87) (alternative minimum tax; citation omitted).
The Tax Formula:
(gross income)
MINUS deductions named in § 62
EQUALS (adjusted gross income
MINUS (standard deduction or
item ized ded uctions)
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from
tables in § 1 (indexed for inflation)
MINUS (credits against tax)
“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.84
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.”85
Taxpayer may purchase an input that enables him 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 to earn income for
more than the current tax year. For example, taxpayer might purchase a machine
that will enable him to generate income for the next ten years. Taxpayer has made
an “investment” rather than an expenditure on an item that he immediately
84 §§ 183(a) and (b)(2). Furthermore, a taxpay er must attribute to such an activity a share of deductions
allowable without regard to whether an activity is enga ged in for profit, e.g., real estate taxes, to the
activity, § 183(b)(1). This ma y have the effect of reducing by displacement the allowable deduction for
expenses attributable to the hobby or amusement activ ity. Moreover, the deduc tions are “below-the-
line” and subject to the 2% f loor of § 67 for miscellaneous deductions. A presumpti on in favor of the
taxpayer to the effect that the “activity is engaged in for profit” arises if he derives gross income from
the activity greater than deduc tions attributable to it for three of the previous five consecutive tax years.
§ 183(d).
85 Letter Ruling 9331001.
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 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 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 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 defer
recognition derived from inventory by building up deductions through
purchase of inventory in advance of the time he actually makes sales.
Yet another possibility is that taxpayer may purchase an input that enables him 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 “capitali zation.”
(e.g., wages paid) =
(e.g., property,
plant, & equipment) = Cost Recovery
(e.g., land) = Increase
Taxpayer’s Basis

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