Code Sec. 162: "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 ..."
What's "Ordinary and Necessary"
Leading Case: Welch v. Helvering (Sup. Ct., 1931)
Facts: T was secretary of corp, which went bankrupt. To reestablish his good business relations, T paid company's debts.
Issue: Deductible? Holding: No
Reasoning: It was necessary, meaning "appropriate and helpful". "Ordinary" need not be routine -- can be a typical response to a rare situation. But what Welch did was "extra-ordinary", so no deduction
"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"
? If not an expense, what is it? Credit cash, debit what? Goodwill? Might it be deducted later? What income can it be matched against?
Limit: reasonable allowance for compensation
This is due to concern over related party transactions. Salary as dividend alternative for employee/shareholder, or to shift income to lower bracket family members
"Expenses" or Capitalized Costs ("Assets")?
Matching principle means current use of funds to get future income is not a deduction now, but is shown as an "asset" (deferred cost) and deducted in the year(s) the income is reported
If the benefit lasts as long as the firm exists, there's no deduction while the firm exists. Costs of merger defense xx Indopco, and raising new capital
Repair vs improvement
Question how to distinguish repairs that just maintain equipment from improvements that make it better or prolong the life. Eg. airplane and ship engine overhauls
What if landlord paints an apartment? What if it's part of a major renovation?
"Paid or incurred"
This means "according to Tp's acct'g method". Paid = cash, incurred = accrual
Accrual Tax Accounting
Generally like GAAP, measuring rights and obligations, not cash flows. The "all events" test
Early accruals and economic performance
GAAP has a weakness: matching may not consider time value of $. For income now, accrue an estimateable matched expense that may not require cash outflow for several years, if at all (conservatism). Eg product liability, self-insurance, decommissioning and reclamation costs
Congressional response: Sec. 461(h) "economic performance"
This was overkill, so an 8 1/2 month exception restores GAAP type treatment for "recurring items"
Carrying On
Sec. 195 for business investigation/start-up costs
Expand existing line of business: is "carrying on"
But a new line of business isn't "carried on" yet
Accumulate the start-up costs. If business goes forward, elect to amortize over 60 months. Also applies to cost of organizing Corps and P'ships
Trade or Business
Includes a self-owned proprietorship, as well as the business of being an employee
How busy is "busi-ness"? xx Groetzinger
Illegal business income is taxable
"Pecunia non Olet" -- "Money has no smell."
Limit: payments violating public po
licy. Bribes and fines. Legal expenses in connection with busin
ess xx Tellier Special Rules Limiting Deductions
Political contributions and lobbying. "Politics ain't charity."
Million dollar paycheck deduction limit for executives of public corps. (largely symbolic)
Related party losses and mismatched methods
Definition of related party: family, controlled entities and constructive ownership by attribution
Costs of getting tax-exempt income
Charitable gifts (covered elsewhere)
Research & Experimentation: usually expense, but can elect 60 mo. capitalization
See Week Six outline notes
"Qualifed plans" for retirement, education, etc.
Defined benefit pension plans
Defined contribution plans
- 401(k) and 403(b)
- Individual Retirement Accounts
- Roth-IRA's
- Keoghs
- Simples
Sec. 529 plans for college education & Education IRA's
Deductions, Deferrals and Exemptions
Common features
Money is placed for investment in a qualified "plan" or "account" that is treated as a tax-exempt entity separate from the owner. The result is the deferral of tax on the investment income.
For many retirement plans the amount contributed is also a current deduction/exclusion, and tax is deferred until the time of distribution
For Roth IRA's and the education savings plans the contributions are not deducted, but the distributions are tax free (at least if used for the intended purposes)
The Algebra of Retirement Savings
Deduct Now, Defer, Tax Later
FV = (1-rF)* PV*(1+i)^T => (1-rN)*PV*(1+ i*(1-rF))^T
The real advantage here is the higher rate of compounding -- the government's %% is compounding for the Tp
There may also be a bracket shifting advantage when rF < rP
No deduction, Defer, Tax the growth later
FV = PV*(1-rN)+(1-rF)*{[PV*(1-rN)]*(1+i)^T-PV*(1-rN)}
This is like a deferred annuity or a nondeductible IRA. Q when and whether a 15% bracket Tp should fund an IRA??
No deduction, no tax on later distribution
FV=PV*(1-rN)*(1+i)^T
= (1-rF)*PV*(1+i)^T if rF=rN
Inplies that the combination of deduction and deferral is equivalent to exemption if rates are constant
notes and format (c) 2001-02 Robert H. Daniels