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Internal Revenue Code section 162(a)

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Section 162(a) of the Internal Revenue Code is the deduction provision for business expenses. [1] It is one of the most important provisions in the Internal Revenue Code, because it is the most widely used authority for deductions.[1] Section 162(a) requires six different elements in order to claim a deduction: 1) it must be an ordinary 2) and necessary 3) expense 4) that was paid or incurred during the taxable year 5) in carrying on 6) a trade or business activity.[2]

These elements have been interpreted by the courts and administrative agencies to determine if a certain expense is deductible as a business expense.

Ordinary and Necessary

In general, the expense should be routine and directly related to the business activity. Ordinary does not require be habitual or made often; the court only requires that the expense is one that is ordinary and necessary for that business. [[2]] [3]For example, in Welch v. Helvering[[3]], the United States Supreme Court found that payments must be both ordinary and necessary to be business expenses; it held that although payments made to a creditor by a taxpayer may have been necessary, they were not ordinary because the circumstances under which they were paid were outside the norms of conduct in society. [4]

In Jenkins v. Commissioner[[4]], the Tax Court determined that in order to determine if expenditures are deductible under § 162(a), the Court must first ascertain the motive of the taxpayer in making the expenditures, and then determine if there is a sufficient connection between the expenditures and his/her trade or business. [5] If a taxpayer makes a payment to preserve his/her business reputation, it can be considered an ordinary business expense. [6] However, if the expenses are inherently personal in nature, they are not deductible under section 162(a). [7]. In addition, the amount expended must be considered to be reasonable by the court; therefore, if compensation is deemed unreasonable, it exceeds the amount allowable under section 162(a)(1). [8]

Expenses

Section 162(a) requires that the cost be an expense (a cost paid or incurred to produce a benefit with a useful life of less than one year); capital expenditures (costs paid to produce a benefit with useful lives of greater than one year) are not deductible under 162(a).[[5]] [9]

To be deductible under section 162(a), the expense must be paid or incurred during the taxable year at issue.[10] [[6]]

In Carrying On

The next requirement of section 162(a) is that the taxpayer must be carrying on a trade or business.[11] Start up expenses are not entirely deductible, but must be spread out over 15 years. [12] Because business expenses are fully deductible under section 162, taxpayers try to argue that expenses were not start up expenses. The Second Circuit Court of Appeals found that the Tax Court should look at if employment of the taxpayer is in the same trade or business to determine if it is a start-up expense, or a carrying on expense.[13] If there is a substantial difference between the activities of the occupations of the taxpayer, then they are considered to be separate trades or businesses, and the expenses for the new trade or business activity are not deductible under 162(a).

Trade or Business

Finally, the expense must also be paid or incurred in carrying on the taxpayer’s trade or business.[14] These words are not defined in the Internal Revenue Code. The United States Supreme Court held 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 does not qualify.” [15] In deciding if an activity is a trade or business, the taxpayer should consider if he/she devoted his full-time exertions to that activity on a regular, continuous and substantial basis. [[7]]

More information can be found on how to determine if the taxpayer's expenditures are for carrying on his trade or business by examining Treasury Regulation 1.183-2. [[8]]

References

  1. ^ See Donaldson, Samuel A., Federal Income Taxation of Individuals: Cases, Problems and Materials, 202 (2nd. Ed. 2007).
  2. ^ IRC Section 162(a).
  3. ^ Midland Empire Packing Company v. Commissioner, 14 T.C. 635 (195)
  4. ^ 290 U.S. 111 (1933).
  5. ^ Tax Court Memo 1983-667.
  6. ^ Conti v. Commissioner, 31 T.C.M. 348 (1972).
  7. ^ Trebilcock v. Commissioner, 64 T.C. 852 (1975).
  8. ^ Harolds Club v. Commissioner, 340 F.2d 861 (9th Cir. 1965).
  9. ^ IRC Section 162(a); see also Donaldson, Samuel A., Federal Income Taxation of Individuals: Cases, Problems and Materials, 215 (2nd. Ed. 2007).
  10. ^ Donaldson, Samuel A., Federal Income Taxation of Individuals: Cases, Problems and Materials, 216 (2nd. Ed. 2007).
  11. ^ IRC Section 162(a).
  12. ^ IRC Section 195.
  13. ^ Estate of Rockefeller v. Commissioner,762 F.2d 264 (2nd Cir. 1985).
  14. ^ IRC Section 162(a).
  15. ^ Commissioner v. Groetzinger, 480 U.S. 23 (1987)


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