Part B. Deductions

• Pages: 123-258
• Author: Marvin A. Chirelstein,Lawrence Zelenak

123

Part B

DEDUCTIONS

Are deductions necessary? Couldn’t we simply have a tax on

gross income and in that way dispense with the bothersome subject

of deductions altogether? The answer, unfortunately (or perhaps

fortunately), is no . Redu cing gro ss income to a net figure by

subtracting the taxpayer’s expenses is an unavoidable step unless

the income tax is to be turned into a kind of sales or excise tax on

transactions by volume. Our income tax system is premised on the

idea that enrichment is the best measure of the taxpayer’s a bility to

bear the costs of government. While gross income may give some

indication of the taxpayer’s income status, it would obviously be

arbitrary and in many instances highly unfair to accept that figure

as fina l. A lawyer who receives $300,000 in fees this year may, or

may not, derive an economic benefit from her professional activi ties;

it all depends on how much she had to spend in the pro cess. Office

rent, library costs, employ ees’ wages, outlays for travel and

entertainment of clients—these and many other expenses will have

been incurre d in generating the fees received. Whether the lawyer

made or lost money, and in either event how much, cannot be known

until her costs are counted and subtracted from her receipts. Without

quibbling about whether Congress could tax the gross figure if it

wished to do so, there can certainly be no doubt that the net figure is

the only suitable measure of the taxpayer’s “income” properly so-

called.

The importance of taxing net, rather than gross, income might

lead one to expect that the de finition of “deductible expense” would

be as broad and sweeping as the definition of includable income. If

§ 61(a) defines gross income to mean “all income,” then perhaps the

corollary should be to define taxable income as gross income less “all

expenses.” Bu t plainly this approach would go too far. The income

tax is aimed at the tax payer’s net accession to wealth, and it is

obvious that unless the latter figure is automatically to be reduced to

zero in every case—that is, re ceipts less all expenditures—a

distinction must be drawn between business outlays, on the one

hand, and expenditures that represent personal consu mption on the

other. Business expenses—the costs incurred by the taxpayer in

earning gross income—are nondiscretionary in the sense that the

income is conditioned on the outlay. Personal expenditures reflect the

disposition which the taxpayer elects to make of the wealth that she

has earned. Business expenses mu st necessarily be deductible if the

124

DEDUCTIONS

PT. B

income tax is to be impo sed on “income”; for the same reason,

personal expenditures should be disallowed.

In contrast to the all-embracin g definition of gross income in

§ 61, there fore, the Code’s definition of deductible expense, though

broad, is limited to those costs which are associated with the

taxpayer’s business or investment activities. Sections 162(a) and 212

allow deduction for all the ordinary expenses incurred in business or

other profit-seeking pursuits, thereby achieving that generality of

application which is required if the inco me tax is to be a tax on net

income. On the other hand, the connection with business or profit-

seeking is equally stressed: nothing is deductible unless it represents

a cost incurred in earning gross income. Section 262 makes the same

point doubly clear by expressly disallowing deductions for all

“personal, living, or family expenses.”

While the line between business and personal expense is of the

essence in all this, the fact is that Congress itself has chosen to cross

that line fairly freely by allowing deductions for a variety of items

which are plainly personal in nature. Doctor’s bills, gifts to charity,

interest on home mortgages, residential prope rty taxes —these and

certain other expenses, concededly personal, are expressly permitted

to be deducted (subject to various limitations) by the taxpayer in

computing her taxable income. Quite obviously, the question rai sed

thereby is why there should be any allowance for personal expense.

What special reasons can be given for excep ting the en umerated

items from the general rule?

The discussion in this Part is divided into two sections. Section

6 takes up business expenses in general, with emphasis on the

limitations which the Code and the courts have imposed on the scope

of § 162(a). Section 7 reviews the personal expense deductions and

their apparent, or at least asserted, justifications.

6. Business Expenses

As indicated above, Code § 162(a) authorizes the deduction of

“all the ordinary and necessary expenses incurred during the taxable

year in carrying on any trade or business.” Together with a few other

provisions of a more specific nature—chiefly, § 163 relating to

interest and §§ 167 and 168 relating to depreciation—the quoted

language constitutes virtually the entire statutory framework for the

deduction of business expenses.

Given the breadth and generality of § 162(a), it is customary to

analyze the provision by reference to its l imitations and boundaries,

by showing what is outside its scope, rather than by attempting to

enumerate all the various expense items that do qualify for

SEC. 6

BUSINESS EXPENSES

125

deduction. Taking this approach, the principal limitations on the

scope of the section are usually said to involve the following issues:

(1) Whether or not the particular expense was “ordinary

and necessary”;

(2) Whether the expenditure was a cu rrent expense or a

capital investment; and

(3) Whether the expense was incurred in business or for

personal reasons.

Apart from certain specific items which entail special criteria,

almost all of the c ases th at students are asked to consider can be

assigned to one or another of these three categories.

Although they emerge from a different perspective, the

questions presented by the deduction cases often have a good deal in

common with the gross income problems that were discussed in Part

A. Exclusions and deductions from gross income would generally be

expected to run together when the same items are inv olved, because

the que stion in either event is essentially as to the composition of

taxable income. While this expectation is sometimes disappointed,

the theoretical issues will at least be similar and familiar. In

addition, the concern about timing which received such emphasis in

Part A i s equally imp ortant in the present context. Quite

frequently—especially wh en the question is one of current expense

versus capital expenditure—the controversy between taxpayer and

Treasury ultimately concerns the acceleration or postponement of

tax payments. Just as the taxpayers in Part A preferred to include

an item in inco me later rather than sooner, so the taxpayers in this

Part prefer the immediate deduction of an expense to the deferral of

that deduction. The reason for this preference has already been

explained; our purpose here is merely to point out that even though

the focus now is on deductions from, rather than inclusions in, gross

income, the stakes are often much the same.

The distinction between personal expenses and business

expenses presents what may be the hardest classification problem in

the entire tax field. One is almost compelled to proceed by rote rather

than by attempting to articulate general principles. The reaso n for

the difficulty, we suppose, is that the notion of a sharp division

between pleasure -seeking and profit-seeking is alien to human

psychology and essentially unrealistic. Everybody combines work

with pleasure to some degree; no one is able to separate and quantify

the two eleme nts at eve ry point, nor even always to state which

objective is predominant. But the tax law cannot embrace this

comfortable commonplace; it must proceed as if individual behavior