Presentation:
Federal Income Taxation
Chapter 13 Business & Investment Expenses
Professors Wells
October 20, 2015
Roadmap for Deductibility Questions
Is an Expenditure for the
Production of Income/
Trade or Business?
Personal
(Hobby)
If deducted, then how
deducted? (above-theline/ itemized
deduction?
Is the business related /
income generating
expenditure currently
deducted or capitalized?
If capitalized,
then how is cost
recovered?
2 “Ordinary & Necessary”
Welch vs. Helvering
p.783
Welch paid debts of the former E.L. Welch Company to improve
his personal relationships with creditors of old co.
Held: Payments by the taxpayer were not ordinary (but were
necessary?) business expenses (§162); but, were these capital
expenditures (extraordinary) for the development of
“goodwill” (and not “personal” expenses).
3 Public Policy Limitations
Commissioner v. Tellier
p.787
FACTS: legal expenses for defense in securities fraud matter
arising from his underwriting business. Court said “there can be no
serious quesiton that the payments deducted by the respondent were
expenses of his securities business.[Really?] IRS conceded these
points and conceded that the expenses met the definition for
deductibility under §162(a) but disallowed these deductions on
public policy grounds?
Tax Court upheld disallowance as a deduction went against public
policy.
Supreme Court says there is no omnibus public policy exception to
deductibility.
4 Public Policy Limitations
Mazzei v. Commissioner
p.790
Facts: Taxpayer claimed $20,000 loss deduction under §165(c) for
theft of money he intended to use in counterfeiting scheme.
Tax Court Majority: disallows loss deduction on public policy grounds
and distinguishes Tellier.
Concurring Opinion (better): says the origin is personal, not business.
Dissent points out two problems. First, legislative public policy
exceptions only deny §162(a) business expense deductions, not loss
deductions claimed under §165. If Congress really intended those rules
to serve as the exclusive grounds for public policy disallowance, then
Tellier standard no longer governs. Second, even if Tellier standard
continues to apply outside of §162, and granting that there is an
important public policy against counterfeiting, still the allowance of a
deduction cannot frustrate that policy where whole scheme was
impossible!
5 Congressional Response:
p.798
Statutory Provisions for Public Policy Issues
Code §162(c) re illegal bribes.
Code §162(f) re fines & penalties (but note mortgage loan settlements &
Origin of the Claim Arguments)
Citibank: $7 billion settlement with DOJ. $4 billion agreed is nondeductible fine.
$2.5 billion to consumer relief. $500 million to state A.G.s.
Chase:
$13 billion settlement. $2 billion agreed is nondeductible fine. $4
billion credited to home owners via loan modifications. $8+ billion to
provide other consumer relief.
BP:
$20.8 billion Gulf Spill Settlement. $5.5 billion non-deductible and
$15.3 billion deductible.
Code §162(g) - 2/3rds of an antitrust treble damage award.
Code §280E – no deduction for activities in illegal drug trafficking.
•  Why enable a deduction for inventory costs (but not other
expenses)?
•  Note that marijuana is legalized in some states, then does this
impact broad non-deductibility rule for illegal drugs?
6 Capital Expenditures
Mt. Morris Drive-In Theater Co
p.799
Issue: Repair (§162) versus improvement (§263) distinction.
Tax Court Majority: Drainage system is a capital expenditure either
because: (1) it was an integral part of the original costs of building the
drive-in; or (2) the drainage system itself was a separate long-lived asset.
Tax Court Dissenters: Ordinary repair currently deductible under
§162(a) because the drainage system did not prolong the useful life of
the drive-in or increase its value or income-producing potential—it’s the
same drive-in with the same seating capacity.
Sixth Circuit Majority: Affirmed capital improvement. Even though the
drainage system did not extend the physical useful life, it did
substantially prolong the economic useful life because absent this
expenditure the neighbors would have shut it down.
7 Cost to Produce Tangible Assets & Inventory
(Supp. pp. 74-75)
Idaho Power Co.
Self-created assets: Automotive equipment was used for the
construction of capital facilities. 10 year depreciation life?
Is construction related depreciation to be included in the tax basis of
the constructed assets? Cf., tax treatment of wage costs.
8 Aircraft Maintenance (Supp. pp. 76-81)
Rev. Rul. 2001-4
Situation 1: Heavy maintenance on airframe. No material upgrade
or addition to its airframe. Holding: deductible.
Situation 2: Heavy maintenance plus replacement of significant
portions of skin panels. Holding: deduction for heavy maintenance
but capitalize skin panels.
Situation 3: Heavy maintenance plus substantial modifications that
increased the plane’s useful life. Holding: Capitalization of all
work.
9 Code §263A
p.811
Capitalization and Inclusion in Inventory Costs and Costs of
other Produced Property
Full inclusion – both direct costs and indirect costs to be included
in tax basis of produced property.
Example: Machinery has $10,000 of depreciation and was used to
create an office building. Labor costs were $100,000 and cost of
materials were $200,000. The basis of the office building is
$310,000 and it gets depreciated over 39 years. If put in service on
January 1, then approximately $7,618 of depreciation in the first
year for all of the costs.
10 Substantial Future Benefits
Indopco case
p.813
Expenses incurred by a target corporation (seller) in a
friendly takeover.
Investment banker charged the seller a valuation opinion fee
of $2.2 million & also attorney’s fees.
The Tax Court and Third Circuit treated these intangible
expenditures as capital.
National Starch (Indopco) paid the fee.
Expenses are to be capitalized, even though no specific asset
was created, since a “future benefit” would be realized.
11 Indopco sequel
Rulings & Regulations
p. 821
Numerous IRS published rulings (p.820-821) distinguishing the
Indopco decision, including with respect to:
1.  Employee training costs,
2.  Employment severance benefits, and
3.  Advertising costs.
Subsequent Regs. § 1.263(a)-4 & 5 providing various exceptions
from strict adherence to the Indopco “future benefits” test for
certain intangibles. IRS authority to issue these rulings &
regulations? Lesson: administrative practicalities.
12 Reasonable Allowance for Salaries
Patton v. Commissioner
p.821
Taxpayer deducted $46,049.41 paid to William Kirk. [$2,400 plus
10% of sales capped at 22.5% of net profits]
IRS said reasonable compensation was $13,000 and disallowed
remainder. Tax Court agrees.
§162(a)(1) provides a deduction for a “reasonable allowance for
salaries. Consider closely held corp. context--- salary as a profits
distribution)?
§162(m) – re no deduction for compensation in excess of $1 million –
unless performance-based. No limit on other than executives (e.g.,
professionals).
§280G and §4999 Golden Parachute Payments
13 Carrying on Trade or Business
Rockefeller v. Commissioner
p.826
Nelson Rockefeller deducted costs associated with confirmation
hearings. IRS disallowed expenses as being incurred before Nelson
Rockefeller was in the trade or business as a public official.
Court agrees that he is not in trade or business yet, so not an expense
related to an existing trade or business.
14