Federal Income Taxation Chapter 13 Business & Investment Expenses Professors Wells

Presentation:

October 19, 2016

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Roadmap for Deductibility Questions

Is an Expenditure for the Production of Income/

Trade or Business?

Is the business related / income generating

expenditure currently deducted or capitalized?

Personal (Hobby)

If capitalized, then how is cost recovered?

If deducted, then how deducted? (above-the-

line/ itemized deduction?

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“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).

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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.

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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!

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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?

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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. The drainage system did not extend the physical useful life, but it did substantially prolong the economic useful life because, absent this expenditure, the neighbors would have shut it down.

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Repair and Maintenance Expenses: (Supp. p.82-83) Midland Empire Packing Co. v. Commissioner

Facts: The taxpayer operated a meat packing plant in a building it owned. The building had a basement in which meats were cured and stored. Oil (apparently from a nearby refinery) seeped into the basement and made it unusable. The taxpayer was required to, and did, oil-proof the basement by adding a concrete lining to the walls. It claimed a deduction for the cost, as a repair. The government denied the deduction on the ground that the new lining was a capital expenditure. Held: Deduction allowed. The new concrete lining did not enlarge the basement, make it more desirable (than it was before the seepage), or prolong the life of the building or increase its value (compared with the value before the seepage).

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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.

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Aircraft Maintenance (Supp. pp. 84-88) 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.

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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.

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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.

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Indopco sequel p. 821 Rulings & Regulations

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.

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Reasonable Allowance for Salaries p.821 Patton v. Commissioner

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

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Carrying on Trade or Business p.826 Rockefeller v. Commissioner

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.