Deductions: Business Expenses

• Author: William Kratzke
• Pages: 290-441

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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

qualify.83

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

(AGI))

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)

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“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.

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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) =

“Expensing”

(e.g., property,

plant, & equipment) = Cost Recovery

Deductions

Non-

(e.g., land) = Increase

Taxpayer’s Basis