Deductions: Business Expenses

Our income tax system taxes only “net income.” The Code incorporates principles that prevent taxing as income the expenses of deriving that income. Section 162 provides a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business[.]” Read § 162(a).

Taxpayer may “consume” (i.e., use up) what he buys to produce income in his trade or business at different rates. With regard to such consumption, consider the following possibilities:

• Taxpayer may purchase an input and immediately consume it to make taxable income. Taxpayer purchases a tank of gasoline. We expect that such expenditures would be immediately deductible in full. We sometimes call this treatment “expensing.”

• Alternatively, taxpayer may purchase an input that he will consume more slowly and that will enable him to earn income for more than the current tax year. Nevertheless, the taxpayer will eventually “consume” that input. Taxpayer might purchase a machine that will enable him to generate income for the next ten years. Taxpayer has made an “investment” rather than an expenditure on an item that he immediately consumes. A mere change in the form in which taxpayer holds wealth is not a taxable event. We implement this principle by crediting taxpayer with basis equal to the money removed from his store of property rights to make the investment (i.e., purchase). Taxpayer (might) then consume only a part of the item that he purchased to generate income. What taxpayer consumes is no longer invested, and taxpayer has to that extent “de-invested” the amount consumed. The Code implements in several places a scheme that (theoretically) matches such consumption with the income that the expenditure generates. The Code permits a deduction for such partial consumption under the headings of depreciation, amortization, or more recently, cost recovery. Since such consumption represents a “deinvestment,” taxpayer must adjust his basis in the productive asset downward. We sometimes call this tax treatment of the purchase and use of a productive asset “capitalization.”

• The Code also implements such a matching of income with expenses when taxpayer derives gross income by selling from inventory. The Code has special rules that prohibit taxpayer from deferring recognition of income derived from sales from inventory by building up deductions through purchase of inventory in advance of the time he makes sales.

• Yet another possibility is that taxpayer may purchase an input that enables him to produce income but never in fact consumes that input, e.g., land. There should logically be no deduction – immediately or in the future – for such expenditures. Taxpayer will have a basis in such an asset, but can only recover it for income purposes upon sale of the asset. Some of these assets may not even be capable of sale, e.g., a legal education or other forms of human capital. We also call this tax treatment of the purchase and use of such an asset “capitalization.”

We usually think of disputes between a taxpayer and the Commissioner as binary in nature. The taxpayer argues one thing and the Commissioner argues the (only) opposite. For example, money that the taxpayer finds in a piano is or is not gross income; there are no other possibilities. Disputes concerning trade or business expenditures involve more possibilities. Initially expenditures are “ordinary and necessary” or they are not (binary). Cf. Gilliam, infra. Assuming an expenditure is an “ordinary and necessary” trade or business expense, it may be immediately deductible, it may never be deductible, or it may be deductible over an extended period during which it is consumed. In other words, there are three possibilities.

In the materials ahead, we very roughly consider the placement of expenditures into one group or another – whether expense or capital. Both the Commissioner and taxpayers are aware of the time value of money. Naturally, taxpayer usually wants to classify purchases of inputs that enable him to generate income in a manner that permits the earliest deduction. The Commissioner of course wants the opposite result. Try to determine the controlling principles by which to resolve these issues of classification.

The following cases involve the proper tax treatment of expenditures to purchase income-producing assets – whether immediately deductible, deductible over their useful life, or not deductible.

MR. JUSTICE CARDOZO delivered the opinion of the Court.

The question to be determined is whether payments by a taxpayer, who is in business as a commission agent, are allowable deductions in the computation of his income if made to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit.

In 1922, petitioner was the secretary of the E.L. Welch Company, a Minnesota corporation, engaged in the grain business. The company was adjudged an involuntary bankrupt, and had a discharge from its debts. Thereafter the petitioner made a contract with the Kellogg Company to purchase grain for it on a commission. In order to reestablish his relations with customers whom he had known when acting for the Welch Company and to solidify his credit and standing, he decided to pay the debts of the Welch business so far as he was able. In fulfillment of that resolve, he made payments of substantial amounts during five successive years. … The Commissioner ruled that these payments were not deductible from income as ordinary and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the development of reputation and goodwill. The Board of Tax Appeals sustained the action of the Commissioner and the Court of Appeals for the Eighth Circuit affirmed. The case is here on certiorari. …

We may assume that the payments to creditors of the Welch Company were necessary for the development of the petitioner’s business, at least in the sense that they were appropriate and helpful. [citation omitted]. He certainly thought they were, and we should be slow to override his judgment. But the problem is not solved when the payments are characterized as necessary. Many necessary payments are charges upon capital. There is need to determine whether they are both necessary and ordinary. Now, what is ordinary, though there must always be a strain of constancy within it, is nonetheless a variable affected by time and place and circumstance. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. Cf. Kornhauser v. United States, 276 U.S. 145. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part. At such times, there are norms of conduct that help to stabilize our judgment, and make it certain and objective. The instance is not erratic, but is brought within a known type.

The line of demarcation is now visible between the case that is here and the one supposed for illustration. We try to classify this act as ordinary or the opposite, and the norms of conduct fail us. No longer can we have recourse to any fund of business experience, to any known business practice. Men do at times pay the debts of others without legal obligation or the lighter obligation imposed by the usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity and opulence. Indeed, if language is to be read in its natural and common meaning [citations omitted], we should have to say that payment in such circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in the stimulus evoking it, and none in the response. Here, indeed, as so often in other branches of the law, the decisive distinctions are those of degree, and not of kind. One struggles in vain for any verbal formula that will supply a ready touchstone. 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.

The Commissioner of Internal Revenue resorted to that standard in assessing the petitioner’s income, and found that the payments in controversy came closer to capital outlays than to ordinary and necessary expenses in the operation of a business. His ruling has the support of a presumption of correctness, and the petitioner has the burden of proving it to be wrong. [citations omitted]. Unless we can say from facts within our knowledge that these are ordinary and necessary expenses according to the ways of conduct and the forms of speech prevailing in the business world, the tax must be confirmed. But nothing told us by this record or within the sphere of our judicial notice permits us to give that extension to what is ordinary and necessary. Indeed, to do so would open the door to many bizarre analogies. One man has a family name that is clouded by thefts committed by an ancestor. To add to his own standing he repays the stolen money, wiping off, it may be, his income for the year. The payments figure in his tax return as ordinary expenses. Another man conceives the notion that he will be able to practice his vocation with greater ease and profit if he has an opportunity to enrich his culture. Forthwith the price of his education becomes an expense of the business, reducing the income subject to taxation. There is little difference between these expenses and those in controversy here. Reputation and learning are akin to capital assets, like the goodwill of an old partnership. [citation omitted]. For many, they are the only tools with which to hew a pathway to success. The money spent in acquiring them is well and wisely spent. It is not an ordinary expense of the operation of a business.

The decree should be

Affirmed.

Notes and Questions:

1. The word “ordinary” as used in the phrase “ordinary and necessary” provides a line of demarcation between expenditures currently deductible and those that are either never deductible or deductible only over time, i.e., through depreciation, amortization, or cost recovery allowances.

• Since the expenses in Welch were not “ordinary,” the next question is whether taxpayer could deduct them over time through depreciation or amortization.

• What should be relevant in making this determination?

• Do you think that the expenses in Welch v. Helvering should be recoverable through depreciation or amortization allowances?

• In the second paragraph of the Court’s footnote, the Court cited several cases. Which expenditures should taxpayer be able to deduct over time through depreciation or amortization, and which should taxpayer not be able deduct at all – probably ever?

2. Consider these three rationales of the Court’s opinion: the expenditures were too personal to be deductible, were too bizarre to be ordinary, and were capital so not deductible.

• Personal: Welch felt a moral obligation, as many in Minnesota in such circumstances did at the time, to pay the corporation’s debts. In fact, Welch repaid the debts on the advice of bankers. This would seem to make business the motivation for repaying these debts.

• Bizarre: Others in Minnesota behaved the same way, i.e., repaid the debts of a bankrupt predecessor.

• Capital: The expenditures were no doubt capital in nature. However, they were arguably only an investment designed to generate income for a finite period. As such, the expenditures should be depreciable or amortizable.

• See Joel S. Newman, The Story of Welch: The Use (and Misuse) of the “Ordinary and Necessary” Test for Deducting Business Expenses, in Tax Stories 197-224 (Paul Caron ed., 2d ed. 2009).

3. What should be the tax consequences of making payments to create goodwill? What should be the tax consequences of maintaining or repairing goodwill?

4. By paying the debts of a bankrupt, no-longer-in-existence corporation, was Thomas Welch trying to create goodwill or to maintain or repair it? Whose goodwill?

• Consider: Conway Twitty (actually Harold Jenkins) was a famous country music singer. He formed a chain of fast food restaurants (“Twitty Burger, Inc.”). He persuaded seventy-five friends in the country music business to invest with him. The venture failed. Twitty was concerned about the effect of the adverse publicity on his country music career. He repaid the investors himself.

• If Twitty were trying to protect the reputation of Twitty Burger, the expenditures would surely have been nondeductible. Twitty Burger after all was defunct.

• The court found as a fact that one’s reputation in the country music business is very important.

• Deductible? See Harold L. Jenkins v. Commissioner, T.C. Memo 1983-667, 1983 WL 14653.

5. What should be the tax treatment of expenditures incurred to acquire property that has an indefinite useful life?

MR. JUSTICE MARSHALL delivered the opinion of the Court.

….

Taxpayers owned or controlled a majority of the common stock of the Telegraph-Herald, an Iowa publishing corporation. The Telegraph-Herald was incorporated in 1901, and its charter was extended for 20-year periods in 1921 and 1941. On June 9, 1960, taxpayers voted their controlling share of the stock of the corporation in favor of a perpetual extension of the charter. A minority stockholder voted against the extension. Iowa law requires “those stockholders voting for such renewal . . . [to] purchase at its real value the stock voted against such renewal.” Iowa Code § 491.25 (1966).

Taxpayers attempted to negotiate purchase of the dissenting stockholder’s shares, but no agreement could be reached on the “real value” of those shares. Consequently, in 1962, taxpayers brought an action in state court to appraise the value of the minority stock interest. The trial court fixed a value, which was slightly reduced on appeal by the Iowa Supreme Court, [citations omitted]. In July, 1965, taxpayers purchased the minority stock interest at the price fixed by the court.

During 1963, taxpayers paid attorneys’, accountants’, and appraisers’ fees of over $25,000, for services rendered in connection with the appraisal litigation. On their 1963 federal income tax returns, taxpayers claimed deductions for these expenses, asserting that they were “ordinary and necessary expenses paid … for the management, conservation, or maintenance of property held for the production of income” deductible under § 212 … The Commissioner of Internal Revenue disallowed the deduction “because the fees represent capital expenditures incurred in connection with the acquisition of capital stock of a corporation.” The Tax Court sustained the Commissioner’s determination, with two dissenting opinions, and the Court of Appeals affirmed. We granted certiorari to resolve the conflict over the deductibility of the costs of appraisal proceedings between this decision and the decision of the Court of Appeals for the Seventh Circuit in United States v. Hilton Hotels Corp., [397 U.S. 580 (1970)]. We affirm.

It has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures. The most familiar example of such treatment is the capitalization of brokerage fees for the sale or purchase of securities, as explicitly provided by a longstanding Treasury regulation, Reg. § 1.263(a)-2(e), and as approved by this Court in Helvering v. Winmill, 305 U.S. 79 (1938), and Spreckels v. Commissioner, 315 U.S. 626 (1942). The Court recognized that brokers’ commissions are “part of the acquisition cost of the securities,” Helvering v. Winmill, supra, at 305 U.S. 84, and relied on the Treasury regulation, which had been approved by statutory reenactment, to deny deductions for such commissions even to a taxpayer for whom they were a regular and recurring expense in his business of buying and selling securities.

The regulations do not specify other sorts of acquisition costs, but rather provide generally that “[t]he cost of acquisition … of … property having a useful life substantially beyond the taxable year” is a capital expenditure. Reg. § 1.263(a)-2(a). Under this general provision, the courts have held that legal, brokerage, accounting, and similar costs incurred in the acquisition or disposition of such property are capital expenditures. See, e.g., Spangler v. Commissioner, 323 F.2d 913, 921 (C.A. 9th Cir.1963); United States v. St. Joe Paper Co., 284 F.2d 430, 432 (C.A. 5th Cir.1960). [citation omitted]. The law could hardly be otherwise, for such ancillary expenses incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it.

More difficult questions arise with respect to another class of capital expenditures, those incurred in “defending or perfecting title to property.” Reg. § 1.263(a)-2(c). In one sense, any lawsuit brought against a taxpayer may affect his title to property – money or other assets subject to lien. The courts, not believing that Congress meant all litigation expenses to be capitalized, have created the rule that such expenses are capital in nature only where the taxpayer’s “primary purpose” in incurring them is to defend or perfect title. See, e.g., Rassenfoss v. Commissioner, 158 F.2d 764 (C.A. 7th Cir.1946); Industrial Aggregate Co. v. United States, 284 F.2d 639, 645 (C.A. 8th Cir.1960). This test hardly draws a bright line, and has produced a melange of decisions which, as the Tax Court has noted, “[i]t would be idle to suggest … can be reconciled.” Ruoff v. Commissioner, 30 T.C. 204, 208 (1958).

Taxpayers urge that this “primary purpose” test, developed in the context of cases involving the costs of defending property, should be applied to costs incurred in acquiring or disposing of property as well. And if it is so applied, they argue, the costs here in question were properly deducted, since the legal proceedings in which they were incurred did not directly involve the question of title to the minority stock, which all agreed was to pass to taxpayers, but rather was concerned solely with the value of that stock.

We agree with the Tax Court and the Court of Appeals that the “primary purpose” test has no application here. That uncertain and difficult test may be the best that can be devised to determine the tax treatment of costs incurred in litigation that may affect a taxpayer’s title to property more or less indirectly, and that thus calls for a judgment whether the taxpayer can fairly be said to be “defending or perfecting title.” Such uncertainty is not called for in applying the regulation that makes the “cost of acquisition” of a capital asset a capital expense. In our view, application of the latter regulation to litigation expenses involves the simpler inquiry whether the origin of the claim litigated is in the process of acquisition itself.

A test based upon the taxpayer’s “purpose” in undertaking or defending a particular piece of litigation would encourage resort to formalism and artificial distinctions. For instance, in this case, there can be no doubt that legal, accounting, and appraisal costs incurred by taxpayers in negotiating a purchase of the minority stock would have been capital expenditures. See Atzingen-Whitehouse Dairy Inc. v. Commissioner, 36 T.C. 173 (1961). Under whatever test might be applied, such expenses would have clearly been “part of the acquisition cost” of the stock. Helvering v. Winmill, supra. Yet the appraisal proceeding was no more than the substitute that state law provided for the process of negotiation as a means of fixing the price at which the stock was to be purchased. Allowing deduction of expenses incurred in such a proceeding, merely on the ground that title was not directly put in question in the particular litigation, would be anomalous.

Further, a standard based on the origin of the claim litigated comports with this Court’s recent ruling on the characterization of litigation expenses for tax purposes in United States v. Gilmore, 372 U.S. 39 (1963). This Court there held that the expense of defending a divorce suit was a nondeductible personal expense, even though the outcome of the divorce case would affect the taxpayer’s property holdings, and might affect his business reputation. The Court rejected a test that looked to the consequences of the litigation, and did not even consider the taxpayer’s motives or purposes in undertaking defense of the litigation, but rather examined the origin and character of the claim against the taxpayer, and found that the claim arose out of the personal relationship of marriage.

Affirmed.

Notes and Questions:

1. Will taxpayers be permitted to claim depreciation or amortization deductions for the expenditures in question? Why or why not?

2. This case arose under § 212, not § 162. Section 212 deductions are “miscellaneous deductions” under § 67 and are disallowed until tax year 2026. § 67(g). However, § 162 and § 212 are in pari materia with each other. See the Court’s first footnote.

3. M owned certain real estate in Memphis, Tennessee. In 2018, M entered into contracts to lease the properties for a term of fifty years, and in 2018 paid commissions and fees to a real estate broker and attorney for services in obtaining the contracts.

• For tax purposes, how should M treat the real estate brokerage commissions?

• See Renwick v. United States, 87 F.2d 123, 125 (7^th Cir. 1936); Meyran v. Commissioner, 63 F.2d 986 (3^d Cir. 1933).

4. S owned stock in several different companies. He sold 100 shares of IBM stock for a nice profit and incurred a brokerage commission of $500. For tax purposes, how should S treat the brokerage commissions?

• Does it make any difference whether S treats the brokerage commission as an ordinary and necessary expense of investment activity or as a decrease in his “amount realized?”

• See Spreckels v. Commissioner, 315 U.S. 626 (1942); cf. 67(g).

5. W purchased the IBM stock that S sold, supra. W incurred a brokerage commission of $500. For tax purposes, how should W treat the brokerage commissions?

• Does it make any difference whether W treats the brokerage commission as an ordinary and necessary expense of investment activity or as an increase in his basis?

• See Helvering v. Winmill, 305 U.S. 79 (1938).

A. Expense or Capital: Cost of Constructing a Tangible Capital Asset

What should be the tax treatment of the cost of taxpayer’s self-construction of a productive asset for it to use in its own business? Should there be a parallel between such activity and the tax treatment we accord imputed income?

MR. JUSTICE BLACKMUN delivered the opinion of the Court.

The taxpayer claimed the deduction, but the Commissioner … disallowed it. The Tax Court … upheld the Commissioner’s determination. The United States Court of Appeals for the Ninth Circuit, declining to follow a Court of Claims decision, Southern Natural Gas Co. v. United States, 412 F.2d 1222, 1264-1269 (1969), reversed. We granted certiorari in order to resolve the apparent conflict between the Court of Claims and the Court of Appeals.

I

… The taxpayer-respondent, Idaho Power Company, … is a public utility engaged in the production, transmission, distribution, and sale of electric energy. The taxpayer keeps its books and files its federal income tax returns on the calendar year accrual basis. The tax years at issue are 1962 and 1963.

For many years, the taxpayer has used its own equipment and employees in the construction of improvements and additions to its capital facilities. . The major work has consisted of transmission lines, transmission switching stations, distribution lines, distribution stations, and connecting facilities.

During 1962 and 1963, the tax years in question, taxpayer owned and used in its business a wide variety of automotive transportation equipment, including passenger cars, trucks of all descriptions, power-operated equipment, and trailers. Radio communication devices were affixed to the equipment, and were used in its daily operations. The transportation equipment was used in part for operation and maintenance and in part for the construction of capital facilities having a useful life of more than one year.

….

… [O]n its books, in accordance with Federal Power Commission-Idaho Public Utilities Commission prescribed methods, the taxpayer capitalized the construction-related depreciation, but, for income tax purposes, that depreciation increment was [computed on a composite life of ten years under straight-line and declining balance methods, and] claimed as a deduction under § 167(a).

Upon audit, the Commissioner … disallowed the deduction for the construction-related depreciation. He ruled that that depreciation was a nondeductible capital expenditure to which § 263(a)(1) had application. He added the amount of the depreciation so disallowed to the taxpayer’s adjusted basis in its capital facilities, and then allowed a deduction for an appropriate amount of depreciation on the addition, computed over the useful life (30 years or more) of the property constructed. A deduction for depreciation of the transportation equipment to the extent of its use in day-to-day operation and maintenance was also allowed. The result of these adjustments was the disallowance of depreciation, as claimed by the taxpayer on its returns, in the net amounts of $140,429.75 and $96,811.95 for 1962 and 1963, respectively. This gave rise to asserted deficiencies in taxpayer’s income taxes for those two years of $73,023.47 and $50,342.21.

The Tax Court agreed with the [Commissioner.] …

The Court of Appeals, on the other hand, perceived in the … Code … the presence of a liberal congressional policy toward depreciation, the underlying theory of which is that capital assets used in business should not be exhausted without provision for replacement. The court concluded that a deduction expressly enumerated in the Code, such as that for depreciation, may properly be taken, and that “no exception is made should it relate to a capital item.” Section 263(a)(1) … was found not to be applicable, because depreciation is not an “amount paid out,” as required by that section. …

It is worth noting the various items that are not at issue here. … There is no disagreement as to the allocation of depreciation between construction and maintenance. The issue thus comes down primarily to a question of timing, … that is, whether the construction-related depreciation is to be amortized and deducted over the shorter life of the equipment or, instead, is to be amortized and deducted over the longer life of the capital facilities constructed.

II

The Court of Appeals opined that the purpose of the depreciation allowance under the Code was to provide a means of cost recovery, Knoxville v. Knoxville Water Co., 212 U.S. 1, 13-14 (1909), and that this Court’s decisions, e.g., Detroit Edison Co. v. Commissioner, 319 U.S. 98, 101 (1943), endorse a theory of replacement through “a fund to restore the property.” Although tax-free replacement of a depreciating investment is one purpose of depreciation accounting, it alone does not require the result claimed by the taxpayer here. Only last Term, in United States v. Chicago, B. & Q. R. Co., 412 U.S. 401 (1973), we rejected replacement as the strict and sole purpose of depreciation:

“Whatever may be the desirability of creating a depreciation reserve under these circumstances, as a matter of good business and accounting practice, the answer is … [depreciation] reflects the cost of an existing capital asset, not the cost of a potential replacement.”

Id. at 415.

Even were we to look to replacement, it is the replacement of the constructed facilities, not the equipment used to build them, with which we would be concerned. If the taxpayer now were to decide not to construct any more capital facilities with its own equipment and employees, it, in theory, would have no occasion to replace its equipment to the extent that it was consumed in prior construction.

There can be little question that other construction-related expense items, such as tools, materials, and wages paid construction workers, are to be treated as part of the cost of acquisition of a capital asset. The taxpayer does not dispute this. Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. § 162(a)(1) … But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized, and are then entitled to be amortized over the life of the capital asset so acquired. [citations omitted].

Construction-related depreciation is not unlike expenditures for wages for construction workers. The significant fact is that the exhaustion of construction equipment does not represent the final disposition of the taxpayer’s investment in that equipment; rather, the investment in the equipment is assimilated into the cost of the capital asset constructed. Construction-related depreciation on the equipment is not an expense to the taxpayer of its day-to-day business. It is, however, appropriately recognized as a part of the taxpayer’s cost or investment in the capital asset. … By the same token, this capitalization prevents the distortion of income that would otherwise occur if depreciation properly allocable to asset acquisition were deducted from gross income currently realized. [citations omitted].

An additional pertinent factor is that capitalization of construction-related depreciation by the taxpayer who does its own construction work maintains tax parity with the taxpayer who has its construction work done by an independent contractor. The depreciation on the contractor’s equipment incurred during the performance of the job will be an element of cost charged by the contractor for his construction services, and the entire cost, of course, must be capitalized by the taxpayer having the construction work performed. The Court of Appeals’ holding would lead to disparate treatment among taxpayers, because it would allow the firm with sufficient resources to construct its own facilities and to obtain a current deduction, whereas another firm without such resources would be required to capitalize its entire cost, including depreciation charged to it by the contractor.

….

[Taxpayer argued that the language of § 263(a)(1), which denies a current deduction for “new buildings or for permanent improvements or betterments,” only applies when taxpayer has “paid out” an “amount.” Depreciation, taxpayer argued, represented a decrease in value – not an “amount … paid out.” The Court rejected this limitation on § 263’s applicability. Instead, the Court accepted the IRS’s administrative construction of that phrase to mean “cost incurred.” Construction-related depreciation is such a cost.] In acquiring the transportation equipment, taxpayer “paid out” the equipment’s purchase price; depreciation is simply the means of allocating the payment over the various accounting periods affected. As the Tax Court stated in Brooks v. Commissioner, 50 T.C. at 935, “depreciation – inasmuch as it represents a using up of capital – is as much an expenditure’ as the using up of labor or other items of direct cost.”

The Court of Appeals concluded, without reference to § 161, that § 263 did not apply to a deduction, such as that for depreciation of property used in a trade or business, allowed by the Code even though incurred in the construction of capital assets. We think that the court erred in espousing so absolute a rule, and it obviously overlooked the contrary direction of § 161. To the extent that reliance was placed on the congressional intent, in the evolvement of the 1954 Code, to provide for “liberalization of depreciation,” H.R. Rep. No. 1337, 83d Cong., 2d Sess., 22 (1954), that reliance is misplaced. The House Report also states that the depreciation provisions would “give the economy added stimulus and resilience without departing from realistic standards of depreciation accounting.” Id. at 24. To be sure, the 1954 Code provided for new and accelerated methods for depreciation, resulting in the greater depreciation deductions currently available. These changes, however, relate primarily to computation of depreciation. Congress certainly did not intend that provisions for accelerated depreciation should be construed as enlarging the class of depreciable assets to which § 167(a) has application or as lessening the reach of § 263(a). [citation omitted].

We hold that the equipment depreciation allocable to taxpayer’s construction of capital facilities is to be capitalized.

The judgment of the Court of Appeals is reversed.

It is so ordered.

MR. JUSTICE DOUGLAS, dissenting. [omitted].

Notes and Questions:

1. The Court noted that the net of taxpayer’s disallowed depreciation deductions was $140,429.75 and $96,811.95 for 1962 and 1963 respectively. The useful life of the items that taxpayer was constructing was three or more times as long as the useful life of the equipment it used to construct those items. This case is about the fraction of the figures noted here that taxpayer may deduct – after the item is placed in service.

• Assuming straight-line depreciation of the equipment, the difference in the parties’ treatment of a depreciation deduction was the difference between 1/10 and 1/30 of 1/10 of the cost of equipment.

2. Why do we allow deductions for depreciation? Is it that –

• “capital assets used in business should not be exhausted without provision for replacement”?

• physical consumption of a capital asset reduces its value and utility, and a depreciation deduction implicitly recognizes this.

• obsolescence may reduce the value and utility of an asset, even if the asset is not exhausted and could still function, e.g., a twenty-year old personal computer? See the Court’s fifth footnote.

• a depreciation deduction in effect allocates the expense of using an asset to the various periods which are benefitted by that asset?

How do these rationales apply to a case where taxpayer consumes depreciable assets in the construction of income-producing capital assets?

3. Aside from the Code’s mandate in § 1016(a)(2), why must a taxpayer reduce its adjusted basis in an asset subject to depreciation?

4. How did the Court’s treatment of depreciation in this case prevent the distortion of income?

5. Why might Congress want to mismatch the timing of income and expenses and thereby distort income?

6. The case demonstrates again how important the time value of money is.

B. Expense or Capital: Cost of “Constructing” an Intangible Capital Asset

What should be the rule when taxpayer self-creates an intangible asset that it can use to generate taxable income? Are there any (obvious) difficulties to applying the rule of Idaho Power to such a situation? Identify what taxpayer in INDOPCO argued was the rule of Lincoln Savings? Would taxpayer’s statement of that rule solve those difficulties?

JUSTICE BLACKMUN delivered the opinion of the Court.

In this case we must decide whether certain professional expenses incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as “ordinary and necessary” business expenses under § 162(a) of the Internal Revenue Code.

I

… Petitioner INDOPCO, Inc., formerly named National Starch and Chemical Corporation and hereinafter referred to as National Starch, … manufactures and sells adhesives, starches, and specialty chemical products. In October 1977, representatives of Unilever United States, Inc., … (Unilever), expressed interest in acquiring National Starch, which was one of its suppliers, through a friendly transaction. National Starch at the time had outstanding over 6,563,000 common shares held by approximately 3,700 shareholders. The stock was listed on the New York Stock Exchange. Frank and Anna Greenwall were the corporation’s largest shareholders and owned approximately 14.5% of the common. The Greenwalls, getting along in years and concerned about their estate plans, indicated that they would transfer their shares to Unilever only if a transaction tax free for them could be arranged.

Lawyers representing both sides devised a “reverse subsidiary cash merger” that they felt would satisfy the Greenwalls’ concerns. Two new entities would be created – National Starch and Chemical Holding Corp. (Holding), a subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Holding that would have only a transitory existence. …

In November 1977, National Starch’s directors were formally advised of Unilever’s interest and the proposed transaction. At that time, Debevoise, Plimpton, Lyons & Gates, National Starch’s counsel, told the directors that under Delaware law they had a fiduciary duty to ensure that the proposed transaction would be fair to the shareholders. National Starch thereupon engaged the investment banking firm of Morgan Stanley & Co., Inc., to evaluate its shares, to render a fairness opinion, and generally to assist in the event of the emergence of a hostile tender offer.

Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket expenses and $18,000 for legal fees. The Debevoise firm charged National Starch $490,000, along with $15,069 for out-of-pocket expenses. National Starch also incurred expenses aggregating $150,962 for miscellaneous items – such as accounting, printing, proxy solicitation, and Securities and Exchange Commission fees – in connection with the transaction. No issue is raised as to the propriety or reasonableness of these charges.

On its federal income tax return … National Starch claimed a deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to Debevoise or the other expenses. Upon audit, the Commissioner of Internal Revenue disallowed the claimed deduction and issued a notice of deficiency. Petitioner sought redetermination in the United States Tax Court, asserting, however, not only the right to deduct the investment banking fees and expenses but, as well, the legal and miscellaneous expenses incurred.

II

Section 162(a) … allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” In contrast, § 263 … allows no deduction for a capital expenditure – an “amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.” § 263(a)(1). The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer’s cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See 26 U.S.C. §§ 167(a) and 336(a); Reg. § 1.167(a) (1991). Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. See, e. g., Commissioner v. Idaho Power Co., 418 U.S. 1, 16 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 (CA ll 1982), cert. denied, 463 U.S. 1207 (1983).

In exploring the relationship between deductions and capital expenditures, this Court has noted the “familiar rule” that “an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer.” Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The notion that deductions are exceptions to the norm of capitalization finds support in various aspects of the Code. Deductions are specifically enumerated and thus are subject to disallowance in favor of capitalization. See §§ 161 and 261. Nondeductible capital expenditures, by contrast, are not exhaustively enumerated in the Code; rather than providing a “complete list of nondeductible expenditures,” Lincoln Savings, 403 U.S. at 358, § 263 serves as a general means of distinguishing capital expenditures from current expenses. See Commissioner v. Idaho Power Co., 418 U.S. at 16. For these reasons, deductions are strictly construed and allowed only “as there is a clear provision therefor.” New Colonial Ice Co. v. Helvering, 292 U.S., at 440; Deputy v. Du Pont, 308 U.S., at 493.

The Court also has examined the interrelationship between the Code’s business expense and capital expenditure provisions. In so doing, it has had occasion to parse § 162(a) and explore certain of its requirements. For example, in Lincoln Savings, we determined that, to qualify for deduction under § 162(a), “an item must (1) be ‘paid or incurred during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’ expense, and (5) be an ‘ordinary’ expense.” 403 U.S. at 352. See also Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (the term “necessary” imposes “only the minimal requirement that the expense be ‘appropriate and helpful’ for ‘the development of the [taxpayer’s] business,’” quoting Welch v. Helvering, 290 U.S. 111, 113 (1933)); Deputy v. Du Pont, 308 U.S. at 495 (to qualify as “ordinary,” the expense must relate to a transaction “of common or frequent occurrence in the type of business involved”). The Court has recognized, however, that the “decisive distinctions” between current expenses and capital expenditures “are those of degree and not of kind,” Welch v. Helvering, 290 U.S. at 114, and that because each case “turns on its special facts,” Deputy v. Du Pont, 308 U.S. at 496, the cases sometimes appear difficult to harmonize. See Welch v. Helvering, 290 U.S. at 116.

National Starch contends that the decision in Lincoln Savings changed these familiar backdrops and announced an exclusive test for identifying capital expenditures, a test in which “creation or enhancement of an asset” is a prerequisite to capitalization, and deductibility under § 162(a) is the rule rather than the exception. We do not agree, for we conclude that National Starch has overread Lincoln Savings.

In Lincoln Savings, we were asked to decide whether certain premiums, required by federal statute to be paid by a savings and loan association to the Federal Savings and Loan Insurance Corporation (FSLIC), were ordinary and necessary expenses under § 162(a), as Lincoln Savings argued and the Court of Appeals had held, or capital expenditures under § 263, as the Commissioner contended. We found that the “additional” premiums, the purpose of which was to provide FSLIC with a secondary reserve fund in which each insured institution retained a pro rata interest recoverable in certain situations, “serv[e] to create or enhance for Lincoln what is essentially a separate and distinct additional asset.” 403 U.S. at 354. “[A]s an inevitable consequence,” we concluded, “the payment is capital in nature and not an expense, let alone an ordinary expense, deductible under § 162(a).” Ibid.

Lincoln Savings stands for the simple proposition that a taxpayer’s expenditure that “serves to create or enhance … a separate and distinct” asset should be capitalized under § 263. It by no means follows, however, that only expenditures that create or enhance separate and distinct assets are to be capitalized under § 263. We had no occasion in Lincoln Savings to consider the tax treatment of expenditures that, unlike the additional premiums at issue there, did not create or enhance a specific asset, and thus the case cannot be read to preclude capitalization in other circumstances. In short, Lincoln Savings holds that the creation of a separate and distinct asset well may be a sufficient, but not a necessary, condition to classification as a capital expenditure. See General Bancshares Corp. v. Commissioner, 326 F.2d 712, 716 (CA8) (although expenditures may not “resul[t] in the acquisition or increase of a corporate asset, … these expenditures are not, because of that fact, deductible as ordinary and necessary business expenses”), cert. denied, 379 U.S. 832 (1964).

III

In applying the foregoing principles to the specific expenditures at issue in this case, we conclude that National Starch has not demonstrated that the investment banking, legal, and other costs it incurred in connection with Unilever’s acquisition of its shares are deductible as ordinary and necessary business expenses under § 162(a).

Although petitioner attempts to dismiss the benefits that accrued to National Starch from the Unilever acquisition as “entirely speculative” or “merely incidental,” the Tax Court’s and the Court of Appeals’ findings that the transaction produced significant benefits to National Starch that extended beyond the tax year in question are amply supported by the record. For example, in commenting on the merger with Unilever, National Starch’s 1978 “Progress Report” observed that the company would “benefit greatly from the availability of Unilever’s enormous resources, especially in the area of basic technology.” (Unilever “provides new opportunities and resources”). Morgan Stanley’s report to the National Starch board concerning the fairness to shareholders of a possible business combination with Unilever noted that National Starch management “feels that some synergy may exist with the Unilever organization given a) the nature of the Unilever chemical, paper, plastics and packaging operations … and b) the strong consumer products orientation of Unilever United States, Inc.”

In addition to these anticipated resource-related benefits, National Starch obtained benefits through its transformation from a publicly held, freestanding corporation into a wholly owned subsidiary of Unilever. The Court of Appeals noted that National Starch management viewed the transaction as “‘swapping approximately 3500 shareholders for one.’” Following Unilever’s acquisition of National Starch’s outstanding shares, National Starch was no longer subject to what even it terms the “substantial” shareholder-relations expenses a publicly traded corporation incurs, including reporting and disclosure obligations, proxy battles, and derivative suits. The acquisition also allowed National Starch, in the interests of administrative convenience and simplicity, to eliminate previously authorized but unissued shares of preferred and to reduce the total number of authorized shares of common from 8,000,000 to 1,000.

IV

The expenses that National Starch incurred in Unilever’s friendly takeover do not qualify for deduction as “ordinary and necessary” business expenses under § 162(a). The fact that the expenditures do not create or enhance a separate and distinct additional asset is not controlling; the acquisition-related expenses bear the indicia of capital expenditures and are to be treated as such.

The judgment of the Court of Appeals is affirmed.

It is so ordered.

Notes and Questions:

1. The INDOPCO decision was not well received in the business community. Why not?

• Should taxpayer in INDOPCO amortize the intangible that it purchased? – over what period?

2. Capitalization of expenditures to construct a tangible asset followed by depreciation, amortization, or cost recovery works more predictably than when expenditures are directed towards the “construction” of an intangible asset. Why do you think that this is so?

• Perhaps because a tangible asset physically deteriorates over time and so its useful life is more easily determinable.

3. Advertising and marketing campaigns: A marketing campaign requires current and future expenditures, but the “asset” it creates (consumer loyalty? brand recognition?) should endure past the end of the campaign. It is not even possible to know when this asset no longer generates income – as would be the case with an asset as tangible as, say, a building. A rational approach to depreciation, amortization, or cost recovery requires that we not only be able to recognize when an expenditure no longer generates income, but also be able to predict how long that would be.

• Consider expenditures for advertising. Not only do these problems emerge, but answers would be different from one taxpayer to the next.

4. The compliance costs of a rule that requires taxpayer to capitalize expenditures that generate income into the future can be enormous. At least one case was litigated all the way to the Supreme Court. Cf. Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993) (at-will subscription list is not goodwill and purchaser of newspaper permitted to depreciate it upon proof of value and useful life).

5. Perhaps there is something to be said for National Starch’s contention that capitalization required the “creation or enhancement of a separate and distinct asset.” Moreover, its statement in the third footnote (“absent a separate-and-distinct-asset requirement for capitalization, a taxpayer will have no ‘principled basis’ upon which to differentiate business expenses from capital expenditures”) just might be accurate. The Court dismissed this argument in the next sentence of the footnote by observing that the Court’s position essentially is no worse than taxpayer’s.

6. “Deduction rather than capitalization becomes more likely as the link between the outlay and a readily identifiable asset decreases, and as the asset to which the outlay is linked becomes less and less tangible.” Joseph Bankman, The Story of INDOPCO: What Went Wrong in the Capitalization v. Deduction Debate, in Tax Stories 228 (Paul Caron ed., 2d ed. 2009).

• “Deduction also becomes more likely for expenses that are recurring, or fit within a commonsense definition of ordinary and necessary.” Id.

7. Lower courts gradually began to read Lincoln Savings as requiring the creation or enhancement of a separate and distinct asset. Id. at 233.

• Nevertheless, the Supreme Court was correct in its reading of Lincoln Savings to the effect “that the creation of a separate and distinct asset well may be a sufficient, but not a necessary, condition to classification as a capital expenditure.”

8. On the other hand, does the Court announce that the presence of “some future benefit” is a sufficient condition to classification as a capital expenditure?

9. The INDOPCO holding called into question many long-standing positions that taxpayers had felt comfortable in taking. The cost of complete and literal compliance with every ramification of the holding would have been enormous. The IRS produced some (favorable to the taxpayer) clarifications in revenue rulings concerning the deductibility of certain expenditures. See Joseph Bankman, The Story of INDOPCO: What Went Wrong in the Capitalization v. Deduction Debate, in Tax Stories 244-45 (Paul Caron ed., 2d ed. 2009). In 2004, the IRS published final regulations. Guidance Regarding Deduction and Capitalization of Expenditures, 69 Fed. Reg. 436 (Jan. 5, 2004). The regulations represented an IRS effort to allay fears and/or provide predictability to the application of capitalization rules. In its “Explanation and Summary of Comments Concerning § 1.263(a)-4,” the IRS wrote:

The final regulations identify categories of intangibles for which capitalization is required. … [T]he final regulations provide that an amount paid to acquire or create an intangible not otherwise required to be capitalized by the regulations is not required to be capitalized on the ground that it produces significant future benefits for the taxpayer, unless the IRS publishes guidance requiring capitalization of the expenditure. If the IRS publishes guidance requiring capitalization of an expenditure that produces future benefits for the taxpayer, such guidance will apply prospectively. …

Id. at 436.

This positivist approach severely limits application of the “significant future benefits” theory to require capitalization of untold numbers of expenditures.

10. The “capitalization list” appears in Regs. §§ 1.263(a)-4(b)(1) and 1.263(a)-5(a).

• an amount paid to another party to acquire an intangible;

• an amount paid to create an intangible specifically named in Reg. § 1.263(a)-4(d);

• an amount paid to create or enhance a separate and distinct intangible asset;

• an amount paid to create or enhance a future benefit that the IRS has specifically identified in published guidance;

• an amount paid to “facilitate” (as that term is specifically defined) an acquisition or creation of any of the above-named intangibles; and

• amounts paid or incurred to facilitate acquisition of a trade or business, a change in the capital structure of a business entity, and various other transactions.

11. Moreover, Reg. § 1.263(a)-4(f)(1) states a 12-month rule, i.e., that

a taxpayer is not required to capitalize … any right or benefit for the taxpayer that does not extend beyond the earlier of –

(i) 12 months after the first date on which the taxpayer realizes the right or benefit; or

(ii) The end of the taxable year following the taxable year in which the payment is made.

12. When taxpayers incur recurring expenses intended to provide future benefits – notably advertising – what is gained by strict adherence to capitalization principles?

• In Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7^th Cir. 1982), Judge Posner wrote:

If one really takes seriously the concept of a capital expenditure as anything that yields income, actual or imputed, beyond the period (conventionally one year, [citation omitted]) in which the expenditure is made, the result will be to force the capitalization of virtually every business expense. It is a result courts naturally shy away from. [citation omitted]. It would require capitalizing every salesman’s salary, since his selling activities create goodwill for the company and goodwill is an asset yielding income beyond the year in which the salary expense is incurred. The administrative costs of conceptual rigor are too great. The distinction between recurring and nonrecurring business expenses provides a very crude but perhaps serviceable demarcation between those capital expenditures that can feasibly be capitalized and those that cannot be.

13. (Note 12, continued): Imagine: An author spends $5 every year for pen and paper with which to write books. Each book will generate income for the author for 5 years. Let’s assume that “the rules” permit such a taxpayer to deduct $1 of that $5 expenditure in each of the succeeding five years. This tax treatment matches the author’s expenses with his income. The following table demonstrates that this taxpayer will (eventually) be deducting $5 every year.

Beginning in year 5, how much does the year by year total change? Does this table suggest that there is an easier way to handle recurring capital expenditures than to require taxpayer to capitalize and depreciate every such expenditure?

14. You are expected to recognize a capitalization of intangibles issue – but the details of the regulations are left to a more advanced tax course.

C. Expense or Capital: Protecting Stock Investment or Protecting Employment

MR. JUSTICE BLACKMUN delivered the opinion of the Court.

The issue’s resolution is important for the taxpayer. If the obligation was a business debt, he may use it to offset ordinary income and for carryback purposes under § 172 of the Code … On the other hand, if the obligation is a nonbusiness debt, it is to be treated as a short-term capital loss subject to the restrictions imposed on such losses by § 166(d)(1)(B) and §§ 1211 and 1212, and its use for carryback purposes is restricted by § 172(d)(4). The debt is one or the other in its entirety, for the Code does not provide for its allocation in part to business and in part to nonbusiness.

In determining whether a bad debt is a business or a nonbusiness obligation, the Regulations focus on the relation the loss bears to the taxpayer’s business. If, at the time of worthlessness, that relation is a “proximate” one, the debt qualifies as a business bad debt and the aforementioned desirable tax consequences then ensue.

The present case turns on the proper measure of the required proximate relation. Does this necessitate a “dominant” business motivation on the part of the taxpayer, or is a “significant” motivation sufficient?

Tax in an amount somewhat in excess of $40,000 is involved. The taxpayer, Allen H. Generes, prevailed in a jury trial in the District Court. On the Government’s appeal, the Fifth Circuit affirmed by a divided vote. Certiorari was granted to resolve a conflict among the circuits.

I

The taxpayer, as a young man in 1909, began work in the construction business. His son-in law, William F. Kelly, later engaged independently in similar work. During World War II, the two men formed a partnership in which their participation was equal. The enterprise proved successful. In 1954, Kelly Generes Construction Co., Inc., was organized as the corporate successor to the partnership. It engaged in the heavy-construction business, primarily on public works projects.

The taxpayer and Kelly each owned 44% of the corporation’s outstanding capital stock. The taxpayer’s original investment in his shares was $38,900. The remaining 12% of the stock was owned by a son of the taxpayer and by another son-in law. Mr. Generes was president of the corporation, and received from it an annual salary of $12,000. Mr. Kelly was executive vice-president, and received an annual salary of $15,000.

The taxpayer and Mr. Kelly performed different services for the corporation. Kelly worked full time in the field, and was in charge of the day-to-day construction operations. Generes, on the other hand, devoted no more than six to eight hours a week to the enterprise. He reviewed bids and jobs, made cost estimates, sought and obtained bank financing, and assisted in securing the bid and performance bonds that are an essential part of the public project construction business. Mr. Generes, in addition to being president of the corporation, held a full-time position as president of a savings and loan association he had founded in 1937. He received from the association an annual salary of $19,000. The taxpayer also had other sources of income. His gross income averaged about $40,000 a year during 1959-1962.

Taxpayer Generes from time to time advanced personal funds to the corporation to enable it to complete construction jobs. He also guaranteed loans made to the corporation by banks for the purchase of construction machinery and other equipment. In addition, his presence with respect to the bid and performance bonds is of particular significance. Most of these were obtained from Maryland Casualty Co. That underwriter required the taxpayer and Kelly to sign an indemnity agreement for each bond it issued for the corporation. In 1958, however, in order to eliminate the need for individual indemnity contracts, taxpayer and Kelly signed a blanket agreement with Maryland whereby they agreed to indemnify it, up to a designated amount, for any loss it suffered as surety for the corporation. Maryland then increased its line of surety credit to $2,000,000. The corporation had over $14,000,000 gross business for the period 1954 through 1962.

In 1962, the corporation seriously underbid two projects and defaulted in its performance of the project contracts. It proved necessary for Maryland to complete the work. Maryland then sought indemnity from Generes and Kelly. The taxpayer indemnified Maryland to the extent of $162,104.57. In the same year, he also loaned $158,814.49 to the corporation to assist it in its financial difficulties. The corporation subsequently went into receivership and the taxpayer was unable to obtain reimbursement from it.

… [T]he jury found that the taxpayer’s signing of the indemnity agreement was proximately related to his trade or business of being an employee of the corporation. Judgment on this verdict was then entered for the taxpayer.

The Fifth Circuit majority approved the significant motivation standard so specified and agreed with a Second Circuit majority in Weddle v. Commissioner, 325 F.2d 849, 851 (1963), in finding comfort for so doing in the tort law’s concept of proximate cause. Judge Simpson dissented. 427 F.2d at 284. He agreed with the holding of the Seventh Circuit in Niblock v. Commissioner, 417 F.2d 1185 (1969), and with Chief Judge Lumbard, separately concurring in Weddle, 325 F.2d at 852, that dominant and primary motivation is the standard to be applied.

II

A. The fact responsible for the litigation is the taxpayer’s dual status relative to the corporation. Generes was both a shareholder and an employee. These interests are not the same, and their differences occasion different tax consequences. In tax jargon, Generes’ status as a shareholder was a nonbusiness interest. It was capital in nature, and it was composed initially of tax-paid dollars. Its rewards were expectative, and would flow not from personal effort, but from investment earnings and appreciation. On the other hand, Generes’ status as an employee was a business interest. Its nature centered in personal effort and labor, and salary for that endeavor would be received. The salary would consist of pre-tax dollars.

Thus, for tax purposes, it becomes important and, indeed, necessary to determine the character of the debt that went bad and became uncollectible. Did the debt center on the taxpayer’s business interest in the corporation or on his nonbusiness interest? If it was the former, the taxpayer deserves to prevail here. [citations omitted.]

B. Although arising in somewhat different contexts, two tax cases decided by the Court in recent years merit initial mention. In each of these cases, a major shareholder paid out money to or on behalf of his corporation and then was unable to obtain reimbursement from it. In each, he claimed a deduction assertable against ordinary income. In each, he was unsuccessful in this quest:

1. In Putnam v. Commissioner, 352 U. S. 82 (1956), the taxpayer was a practicing lawyer who had guaranteed obligations of a labor newspaper corporation in which he owned stock. He claimed his loss as fully deductible … The Court … held that the loss was a nonbusiness bad debt subject to short-term capital loss treatment …

The loss was deductible as a bad debt or not at all. See Rev. Rul. 60-48, 1961 Cum. Bull. 112.

2. In Whipple v. Commissioner, 373 U. S. 193 (1963), the taxpayer had provided organizational, promotional, and managerial services to a corporation in which he owned approximately an 80% stock interest. He claimed that this constituted a trade or business, and, hence, that debts owing him by the corporation were business bad debts when they became worthless in 1953. The Court also rejected that contention, and held that Whipple’s investing was not a trade or business, that is, that “[d]evoting one’s time and energies to the affairs of a corporation is not, of itself, and without more, a trade or business of the person so engaged.” 373 U.S. at 202. The rationale was that a contrary conclusion would be inconsistent with the principle that a corporation has a personality separate from its shareholders, and that its business is not necessarily their business. The Court indicated its approval of the Regulations’ proximate relation test:

Moreover, there is no proof (which might be difficult to furnish where the taxpayer is the sole or dominant stockholder) that the loan was necessary to keep his job or was otherwise proximately related to maintaining his trade or business as an employee.

Compare Trent v. Commissioner, [291 F.2d 669 (CA2 1961)]. 373 U.S. at 204.

These two cases approach, but do not govern, the present one. They indicate, however, a cautious, and not a free-wheeling, approach to the business bad debt. Obviously, taxpayer Generes endeavored to frame his case to bring it within the area indicated in the above quotation from Whipple v. Commissioner.

III

We conclude that, in determining whether a bad debt has a “proximate” relation to the taxpayer’s trade or business, as the Regulations specify, and thus qualifies as a business bad debt, the proper measure is that of dominant motivation, and that only significant motivation is not sufficient. We reach this conclusion for a number of reasons:

A. The Code itself carefully distinguishes between business and nonbusiness items. It does so, for example, in § 165 with respect to losses, in § 166 with respect to bad debts, and in § 162 with respect to expenses. It gives particular tax benefits to business losses, business bad debts, and business expenses, and gives lesser benefits, or none at all, to nonbusiness losses, nonbusiness bad debts, and nonbusiness expenses. It does this despite the fact that the latter are just as adverse in financial consequence to the taxpayer as are the former. But this distinction has been a policy of the income tax structure ever since the Revenue Act of 1916 …

The point, however, is that the tax statutes have made the distinction, that the Congress therefore intended it to be a meaningful one, and that the distinction is not to be obliterated or blunted by an interpretation that tends to equate the business bad debt with the nonbusiness bad debt. We think that emphasis upon the significant rather, than upon the dominant, would have a tendency to do just that.

B. Application of the significant motivation standard would also tend to undermine and circumscribe the Court’s holding in Whipple, and the emphasis there that a shareholder’s mere activity in a corporation’s affairs is not a trade or business. As Chief Judge Lumbard pointed out in his separate and disagreeing concurrence in Weddle, supra, 325 F.2d at 852-853, both motives – that of protecting the investment and that of protecting the salary – are inevitably involved, and an inquiry whether employee status provides a significant motivation will always produce an affirmative answer and result in a judgment for the taxpayer.

C. The dominant motivation standard has the attribute of workability. It provides a guideline of certainty for the trier of fact. The trier then may compare the risk against the potential reward and give proper emphasis to the objective, rather than to the subjective. As has just been noted, an employee-shareholder, in making or guaranteeing a loan to his corporation, usually acts with two motivations, the one to protect his investment and the other to protect his employment. By making the dominant motivation the measure, the logical tax consequence ensues and prevents the mere presence of a business motive, however small and however insignificant, from controlling the tax result at the taxpayer’s convenience. This is of particular importance in a tax system that is so largely dependent on voluntary compliance.

D. The dominant motivation test strengthens, and is consistent with, the mandate of § 262 of the Code, … that “no deduction shall be allowed for personal, living, or family expenses” except as otherwise provided. It prevents personal considerations from circumventing this provision.

E. The dominant motivation approach to § 166(d) is consistent with that given the loss provisions in § 165(c)(1), see, for example, Imbesi v. Commissioner, 361 F.2d 640, 644 (CA3 1966), and in § 165(c)(2), see Austin v. Commissioner, 298 F.2d 583, 584 (CA2 1962). In these related areas, consistency is desirable. See also Commissioner v. Duberstein, 363 U. S. 278, 286 (1960).

F. …

G. The Regulations’ use of the word “proximate” perhaps is not the most fortunate, for it naturally tempts one to think in tort terms. The temptation, however, is best rejected, and we reject it here. In tort law, factors of duty, of foreseeability, of secondary cause, and of plural liability are under consideration, and the concept of proximate cause has been developed as an appropriate application and measure of these factors. It has little place in tax law, where plural aspects are not usual, where an item either is or is not a deduction, or either is or is not a business bad debt, and where certainty is desirable.

IV

The conclusion we have reached means that the District Court’s instructions, based on a standard of significant, rather than dominant, motivation are erroneous, and that, at least, a new trial is required. We have examined the record, however, and find nothing that would support a jury verdict in this taxpayer’s favor had the dominant motivation standard been embodied in the instructions. Judgment n.o.v. for the United States, therefore, must be ordered. See Neely v. Eby Construction Co., 386 U. S. 317 (1967).

As Judge Simpson pointed out in his dissent, 427 F.2d at 284-285, the only real evidence offered by the taxpayer bearing upon motivation was his own testimony that he signed the indemnity agreement “to protect my job,” that “I figured, in three years’ time, I would get my money out,” and that “I never once gave it [his investment in the corporation] a thought.”

The statements obviously are self-serving. In addition, standing alone, they do not bear the light of analysis. What the taxpayer was purporting to say was that his $12,000 annual salary was his sole motivation, and that his $38,900 original investment, the actual value of which, prior to the misfortunes of 1962, we do not know, plus his loans to the corporation, plus his personal interest in the integrity of the corporation as a source of living for his son-in law and as an investment for his son and his other son-in law, were of no consequence whatever in his thinking. The comparison is strained all the more by the fact that the salary is pre-tax and the investment is tax-paid. With his total annual income about $40,000, Mr. Generes may well have reached a federal income tax bracket of 40% or more for a joint return in 1958-1962. §§ 1 and 2 of the 1954 Code … The $12,000 salary thus would produce for him only about $7,000 net after federal tax and before any state income tax. This is the figure, and not $12,000, that has any possible significance for motivation purposes, and it is less than 1/5 of the original stock investment.

We conclude on these facts that the taxpayer’s explanation falls of its own weight, and that reasonable minds could not ascribe, on this record, a dominant motivation directed to the preservation of the taxpayer’s salary as president of Kelly Generes Construction Co., Inc.

The judgment is reversed, and the case is remanded with direction that judgment be entered for the United States.

It is so ordered.

MR. JUSTICE POWELL and MR. JUSTICE REHNQUIST took no part in the consideration or decision of this case.

MR. JUSTICE MARSHALL, concurring (omitted).

MR. JUSTICE WHITE, with whom MR. JUSTICE BRENNAN joins.

While I join Parts I, II, and III of the Court’s opinion and its judgment of reversal, I would remand the case to the District Court with directions to hold a hearing on the issue of whether a jury question still exists as to whether taxpayer’s motivation was “dominantly” a business one in the relevant transactions …

MR. JUSTICE DOUGLAS, dissenting. [omitted.]

Notes and Questions:

1. What were the stakes in the outcome of the case? See §§ 1211(b) ($1000 limit at the time the Court decided Generes), 1212(b).

2. Investing is not a trade or business. Rather it is comprised of transactions entered for profit, but not connected with a trade or business. Section 212 defines the “below-the-line” deductions available to a taxpayer who incurs expenses in pursuit of profit outside of a trade or business

• An employee is engaged in the trade or business of being an employee.

• Section 67(g) suspends until 2026 “miscellaneous deductions” – which include investment expenses and the trade or business expenses of an employee.

3. What information should be critical to the valuation of taxpayer’s stock? In a closely-held corporation in which shareholders, officers, employees, and creditors are usually the same people who wear different hats on different occasions – is it ever realistic to say that a bad debt is “one or the other in its entirety?”

D. Expense or Capital: Repair vs. Improvement

A recurring question that arises is whether an expenditure is for a deductible repair or for an improvement that must be capitalized. When reading the following materials do not forget some basic points. Section 263(a) denies a deduction for “[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property” and for “[a]ny amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.” The expenditures that are the subject of this section could be ordinary and necessary trade or business expenditures and so deductible under § 162, but §§ 161 and 261 make § 162 subject to and subordinate to § 263. Reg. § 1.162-4(a) restates this prioritization; it provides in part that “[a] taxpayer may deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized.” The scope of what is affirmatively covered by § 263 preempts what § 162 might allow as an immediate deduction.

The line between deductibility and capitalization has often been the subject of dispute between taxpayers and the government in the context of a taxpayer’s trade or business. We look at two old cases and note what were important factors in deciding that an expenditure was for a deductible repair or for a capital improvement. More recently, the IRS and Treasury have undertaken through regulations to articulate workable standards and procedures to assure more taxpayers predictable treatment. We will explore the high points of the portions of these regulations most relevant to this topic.

….

ARUNDELL, Judge:

The issue in this case is whether an expenditure for a concrete lining in petitioner’s basement to oilproof it against an oil nuisance created by a neighboring refinery is deductible as an ordinary and necessary expense under § [162(a)] … on the theory it was an expenditure for a repair …

The respondent [Commissioner] has contended, in part, that the expenditure is for a capital improvement and should be recovered through depreciation charges and is, therefore, not deductible as an ordinary and necessary business expense or as a loss.

It will be noted that the first sentence of the [regulation] … relates to repairs, while the second sentence deals in effect with replacements. In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied against current earnings.

… [F]or some 25 years prior to the taxable year [(1943)] petitioner [Midland Empire] had used the basement rooms of its plant [situated in Billings near the Yellowstone River] as a place for the curing of hams and bacon and for the storage of meat and hides. The basement had been entirely satisfactory for this purpose over the entire period in spite of the fact that there was some seepage of water into the rooms from time to time. In the taxable year it was found that not only water, but oil, was seeping through the concrete walls of the basement of the packing plant and, while the water would soon drain out, the oil would not, and there was left on the basement floor a thick scum of oil which gave off a strong odor that permeated the air of the entire plant, and the fumes from the oil created a fire hazard. It appears that the oil which came from a nearby refinery [of the Yale Oil Corporation] had also gotten into the water wells which served to furnish water for petitioner’s plant, and as a result of this whole condition the Federal meat inspectors advised petitioner that it must discontinue the use of the water from the wells and oilproof the basement, or else shut down its plant.

To meet this situation, petitioner during the taxable year undertook steps to oilproof the basement by adding a concrete lining to the walls from the floor to a height of about four feet and also added concrete to the floor of the basement. It is the cost of this work, [$4,868.81,] which it seeks to deduct as a repair. The basement was not enlarged by this work [and in fact petitioner’s operating space contracted], nor did the oilproofing serve to make it more desirable for the purpose for which it had been used through the years prior to the time that the oil nuisance had occurred. The evidence is that the expenditure did not add to the value or prolong the expected life of the property over what they were before the event occurred which made the repairs necessary. It is true that after the work was done the seepage of water, as well as oil, was stopped, but, as already stated, the presence of the water had never been found objectionable. The repairs merely served to keep the property in an operating condition over its probable useful life for the purpose for which it was used.

[Midland charged the $4,868.81 to repair expense on its regular books and deducted that amount on its tax returns as an ordinary and necessary business expense for the fiscal year 1943. The Commissioner, in his notice of deficiency, determined that the cost of oilproofing was not deductible … as an ordinary and necessary expense … in 1943.]

While it is conceded on brief that the expenditure was ‘necessary,’ respondent contends that the encroachment of the oil nuisance on petitioner’s property was not an ‘ordinary’ expense in petitioner’s particular business. But the fact that petitioner had not theretofore been called upon to make a similar expenditure to prevent damage and disaster to its property does not remove that expense from the classification of ‘ordinary’ … Steps to protect a business building from the seepage of oil from a nearby refinery, which had been erected long subsequent to the time petitioner started to operate its plant, would seem to us to be a normal thing to do, and in certain sections of the country it must be a common experience to protect one’s property from the seepage of oil. Expenditures to accomplish this result are likewise normal.

….

[The petitioner thereafter filed suit against Yale, on April 22, 1944, in a cause of action sounding in tort … This action was to recover damages for the nuisance created by the oil seepage. … Petitioner subsequently settled its cause of action against Yale for $11,659.49 and gave Yale a complete release of all liability. This release was dated October 23, 1946.]

In our opinion, the expenditure of $4,868.81 for lining the basement walls and floor was essentially a repair and, as such, it is deductible as an ordinary and necessary business expense. …

Notes and Questions:

1. The court said: “It is none too easy to determine on which side of the line certain expenditures fall so that they may be accorded their proper treatment for tax purposes.”

• What facts convinced the court to place the expenditure on the “repair” side of the line?

2. In the fifth-to-last paragraph of the case, the court stated conclusions taken almost verbatim from the regulation. Does this give you any idea of the type of evidence that taxpayer must have presented?

3. The Yale Oil Corporation owned a nearby oil-refining plant and storage area and its discharges caused the problems that Midland Empire had to address. Yale Oil made a payment to Midland Empire to settle the nuisance suit brought against it. May Yale Oil deduct the amount it paid to settle the case, or should it capitalize that amount? Cf. Mt. Morris Drive-In, infra?

• What tax treatment should Midland accord the $11,659.49 payment it received from Yale?

….

FINDINGS OF FACT.

….

In 1947 petitioner purchased 13 acres of farm land located on the outskirts of Flint, Michigan, upon which it proceeded to construct a drive-in or outdoor theatre. Prior to its purchase by the petitioner the land on which the theatre was built was farm land and contained vegetation. The slope of the land was such that the natural drainage of water was from the southerly line to the northerly boundary of the property and thence onto the adjacent land, owned by David and Mary D. Nickola, which was used both for farming and as a trailer park. The petitioner’s land sloped sharply from south to north and also sloped from the east downward towards the west so that most of the drainage from the petitioner’s property was onto the southwest corner of the Nickolas’ land. The topography of the land purchased by petitioner was well known to petitioner at the time it was purchased and developed. The petitioner did not change the general slope of its land in constructing the drive-in theatre, but it removed the covering vegetation from the land, slightly increased the grade, and built aisles or ramps which were covered with gravel and were somewhat raised so that the passengers in the automobiles would be able to view the picture on the large outdoor screen.

As a result of petitioner’s construction on and use of this land rain water falling upon it drained with an increased flow into and upon the adjacent property of the Nickolas. This result should reasonably have been anticipated by petitioner at the time when the construction work was done.

The Nickolas complained to the petitioner at various times after petitioner began the construction of the theatre that the work resulted in an acceleration and concentration of the flow of water which drained from the petitioner’s property onto the Nickolas’ land causing damage to their crops and roadways. On or about October 11, 1948, the Nickolas filed a suit against the petitioner … asking for an award for damages done to their property by the accelerated and concentrated drainage of the water and for a permanent injunction restraining the defendant from permitting such drainage to continue. … [T]he suit was settled by an agreement dated June 27, 1950. This agreement provided for the construction by the petitioner of a drainage system to carry water from its northern boundary across the Nickolas’ property and thence to a public drain. The cost of maintaining the system was to be shared by the petitioner and the Nickolas, and the latter granted the petitioner and its successors an easement across their land for the purpose of constructing and maintaining the drainage system. The construction of the drain was completed in October 1950 under the supervision of engineers employed by the petitioner and the Nickolas at a cost to the petitioner of $8,224, which amount was paid by it in November 1950. The performance by the petitioner on its part of the agreement to construct the drainage system and to maintain the portion for which it was responsible constituted a full release of the Nickolas’ claims against it. The petitioner chose to settle the dispute by constructing the drainage system because it did not wish to risk the possibility that continued litigation might result in a permanent injunction against its use of the drive-in theatre and because it wished to eliminate the cause of the friction between it and the adjacent landowners, who were in a position to seriously interfere with the petitioner’s use of its property for outdoor theatre purposes. A settlement based on a monetary payment for past damages, the petitioner believed, would not remove the threat of claims for future damages.

… In its petition the petitioner asserted that the entire amount spent to construct the drainage system was fully deductible in 1950 as an ordinary and necessary business expense incurred in the settlement of a lawsuit, or, in the alternative, as a loss, and claimed a refund of part of the $10,591.56 of income and excess profits tax paid by it for that year.

The drainage system was a permanent improvement to the petitioner’s property, and the cost thereof constituted a capital expenditure.

….

KERN, Judge:

When petitioner purchased, in 1947, the land which it intended to use for a drive-in theatre, its president was thoroughly familiar with the topography of this land which was such that when the covering vegetation was removed and graveled ramps were constructed and used by its patrons, the flow of natural precipitation on the lands of abutting property owners would be materially accelerated. Some provision should have been made to solve this drainage problem in order to avoid annoyance and harassment to its neighbors. If petitioner had included in its original construction plans an expenditure for a proper drainage system no one could doubt that such an expenditure would have been capital in nature.

Within a year after petitioner had finished its inadequate construction of the drive-in theatre, the need of a proper drainage system was forcibly called to its attention by one of the neighboring property owners, and under the threat of a lawsuit filed approximately a year after the theatre was constructed, the drainage system was built by petitioner who now seeks to deduct its cost as an ordinary and necessary business expenses, or as a loss.

We agree with respondent that the cost to petitioner of acquiring and constructing a drainage system in connection with its drive-in theatre was a capital expenditure.

Here was no sudden catastrophic loss caused by a ‘physical fault’ undetected by the taxpayer in spite of due precautions taken by it at the time of its original construction work as in American Bemberg Corporation, 10 T.C. 361; no unforeseeable external factor as in Midland Empire Packing Co., 14 T.C. 635; and no change in the cultivation of farm property caused by improvements in technique and made many years after the property in question was put to productive use as in J. H. Collingwood, 20 T.C. 937. In the instant case it was obvious at the time when the drive-in theatre was constructed, that a drainage system would be required to properly dispose of the natural precipitation normally to be expected, and that until this was accomplished, petitioner’s capital investment was incomplete. In addition, it should be emphasized that here there was no mere restoration or rearrangement of the original capital asset, but there was the acquisition and construction of a capital asset which petitioner had not previously had, namely, a new drainage system.

That this drainage system was acquired and constructed and that payments therefor were made in compromise of a lawsuit is not determinative of whether such payments were ordinary and necessary business expenses or capital expenditures. ‘The decisive test is still the character of the transaction which gives rise to the payment.’ Hales-Mullaly v. Commissioner, 131 F.2d 509, 511, 512.

In our opinion the character of the transaction in the instant case indicates that the transaction was a capital expenditure.

Reviewed by the Court.

Decision will be entered for the respondent.

RAUM, J., with whom FISHER, J., agrees, concurring: [omitted]

RICE, J. dissenting:

… [T]he expenditure which petitioner made was an ordinary and necessary business expense, which did not improve, better, extend, increase, or prolong the useful life of its property. The expenditure did not cure the original geological defect of the natural drainage onto the Nickolas’ land, but only dealt with the intermediate consequence thereof. … I cannot agree with the majority that the expenditure here was capital in nature.

OPPER, JOHNSON, BRUCE, and MULRONEY, JJ., agree with this dissent.

Notes and Questions:

1. Upon reading Midland Empire and Mt. Morris Drive-In, do you get the feeling that repair vs. improvement – at least in close cases – comes down to who can argue facts that fit within certain considerations better? Notice and consider:

• The magnitude of what was done to the properties in the two cases was probably comparable.

• Neither taxpayer could continue in business without making the expenditure.

• Both taxpayers had operational businesses before making the necessary expenditures.

• Is “foreseeability” really the distinction between these two cases? “Foreseeability” of course is a very malleable term.

2. Does “quantitative” eventually becomes “qualitative?” Suppose taxpayer makes many discrete repairs; can they together add up to a renovation? Consider this excerpt from United States v. Wehrli, 400 F.2d 686 (10^th Cir. 1968):

In the continuing quest for formularization, the courts have superimposed upon the criteria in the repair regulation an overriding precept that an expenditure made for an item which is part of a “general plan” of rehabilitation, modernization, and improvement of the property, must be capitalized, even though, standing along, the item may appropriately be classified as one of repair. … Whether the plan exists, and whether a particular item is part of it, are usually questions of fact to be determined by the fact finder based upon a realistic appraisal of all the surrounding facts and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done, e.g., whether the work was done to suit the needs of an incoming tenant, or to adapt the property to a different use, or, in any event, whether what was done resulted in an appreciable enhancement of the property’s value.

Id. at 689 (citations and footnotes omitted).

Quantity does eventually become quality. Application of the standard of Wehrli will certainly lead to disputes between taxpayers and the IRS. Generalized standards can inherently be unpredictable in application. The IRS and Treasury have worked to provide more predictability in this area through a revenue ruling and most recently rulemaking. As often happens, the difficulty that the IRS and Treasury faced in drafting regulations was to make them general enough to be applicable to a broad range of situations and a great number of taxpayers, yet specific enough to provide meaningful guidance.

3. The excerpt from Illinois Merchants Trust Co. that the court in Midland Empire quoted referenced “replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use.” On the other hand, “[a] repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition.” Id. Consider some routine (?) maintenance procedures for an automobile. If the taxpayer uses the automobile in a trade or business, should taxpayer treat them as repairs or as expenditures to be capitalized?

• changing the oil every 6000 miles; this will certainly prolong the life of the automobile, for failure to do so will destroy the engine;

• replacing tires warranted for 20,000 miles with tires warranted for 60,000 miles;

• equipping the automobile with a trailer hitch so that taxpayer can attach a flatbed trailer and transport large items;

• flushing the radiator and filling it with antifreeze every fall;

• replacing an engine block that cracked on a cold winter night because taxpayer had not flushed the radiator and filled it with antifreeze.

4. In Rev. Rul. 2001-4, the IRS reviewed the statements of several courts. The following is an excerpt:

Any properly performed repair, no matter how routine, could be considered to prolong the useful life and increase the value of the property if it is compared with the situation existing immediately prior to the repair. Consequently, courts have articulated a number of ways to distinguish between deductible repairs and non-deductible capital improvements. For example, in Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103, 106 (1926), acq., V-2 C.B. 2, the court explained that repair and maintenance expenses are incurred for the purpose of keeping the property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. Capital expenditures, in contrast, are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use. In Estate of Walling v. Commissioner, 373 F.2d 192-93 (3^rd Cir. 1966), the court explained that the relevant distinction between capital improvements and repairs is whether the expenditures were made to “put” or “keep” property in ordinary efficient operating conditi. In Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8, the court stated that if the expenditure merely restores the property to the state it was in before the situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer-lived, then such an expenditure is usually considered a deductible repair. In contrast, a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property. …

Even if the expenditures include the replacement of numerous parts of an asset, if the replacements are a relatively minor portion of the physical structure of the asset, or of any of its major parts, such that the asset as [sic] whole has not gained materially in value or useful life, then the costs incurred may be deducted as incidental repairs or maintenance expenses. [citations omitted]. The same conclusion is true even if such minor portion of the asset is replaced with new and improved materials. [citation omitted].

If, however, a major component or a substantial structural part of the asset is replaced and, as a result, the asset as a whole has increased in value, life expectancy, or use then the costs of the replacement must be capitalized. [citations omitted].

In addition, although the high cost of work performed may be considered in determining whether an expenditure is capital in nature, cost alone is not dispositive. [citations omitted].

Similarly, the fact that a taxpayer is required by a regulatory authority to make certain repairs or to perform certain maintenance on an asset in order to continue operating the asset in its business does not mean that the work performed materially increases the value of such asset, substantially prolongs its useful life, or adapts it to a new use. [citations omitted].

The characterization of any cost as a deductible repair or capital improve-ment depends on the context in which the cost is incurred. Specifically, where an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expenditure must be capitalized, even though, standing alone, the item may be classified as one of repair or maintenance. United States v. Wehrli, 400 F.2d 686, 689 (10^th Cir. 1968). Whether a general plan of rehabilitation exists, and whether a particular repair or maintenance item is part of it, are questions of fact to be determined based upon all the surrounding facts and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done. Id. at 690. The existence of a written plan, by itself, is not sufficient to trigger the plan of rehabilitation doctrine. [citations omitted].

In general, the courts have applied the plan of rehabilitation doctrine to require a taxpayer to capitalize otherwise deductible repair and maintenance costs where the taxpayer has a plan to make substantial capital improvements to property and the repairs are incidental to that plan. [citations omitted].

On the other hand, the courts and the Service have not applied the plan of rehabilitation doctrine to situations where the plan did not include substantial capital improvements and repairs to the same asset, the plan primarily involved repair and maintenance items, or the work was performed merely to keep the property in an ordinarily efficient operating condition. [citations omitted].

5. Consider again our servicing of an automobile.

• changing the oil “keeps” the automobile in operating condition – it does not “put” the automobile in an ordinarily efficient operating condition over its probable useful life for the uses for which it was acquired. It does not prolong the life of the automobile, materially increase its value, or make it adaptable to a different use. Deduct as repair.

• replacing worn out tires with better tires has not appreciably prolonged the life of the automobile or made it more useful. However, it may have increased the value of the automobile to more than it was, even when the 20,000 tires were new. Capitalize.

• equipping the automobile with a trailer hitch may have adapted the automobile to a different use than transporting passengers and made the automobile more useful. Capitalize.

• flushing the radiator and filling it with antifreeze should probably be treated in the same manner as changing the oil. Deduct as repair.

• replacing the engine block is the replacement of a major component or a substantial structural part of the automobile that results in increasing the value, life expectancy, or use of an otherwise permanently and completely inoperable automobile. Capitalize.

These answers are obvious, right?

6. This revenue ruling did not put an end to disputes between the government and taxpayers. See Fedex Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6^th Cir. 2005). In Fedex, the court determined that an entire aircraft rather than one of its engines on which work was performed was the appropriate “unit of property” to distinguish between a repair and an improvement. Id. at 712. The court considered four factors in making this determination:

First, … whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. Second, … whether the economic useful life of the component part is coextensive with the economic useful life of the larger unit of property. Third, … whether the larger unit of property and smaller unit of property can function without each other. Finally, … whether the component part can be and is maintained while affixed to the larger unit of property.

Id. at 710.

8. New buildings or permanent improvements or betterments to increase value: Reg. § 1.263(a)-1(a) denies deductions for amounts paid for new buildings or for permanent improvements or betterments to increase the value of any property or estate. It also denies deductions for amounts paid to restore property or to make good the exhaustion of property for which an allowance has been made.

9. Reg. § 1.263(a)-1(f)(1)(i) now provides an elective de minimis safe harbor under which taxpayers with “applicable financial statements” may deduct expenditures of up to $5000 per invoice that it treats as an expense on its “applicable financial statement” and in accord with its written accounting procedures. There is no limit to the number of times taxpayer may rely on this safe harbor during a tax year.

• An “applicable financial statement” is – in order of preference – (1) a financial statement that taxpayer must file with the SEC, (2) a certified audited financial statement that taxpayer uses for credit purposes, reports to shareholders or the like, or for any other substantial non-tax purpose, and (3) a financial statement that taxpayer must provide to a federal or state government agency other than the SEC or the IRS. Reg. § 1.263-1(f)(4).

• Taxpayers without an applicable financial statement, but who maintain throughout the year accounting procedures that treat an item as an expense for non-tax purposes, may expense up to $500 per invoice. Reg. § 1.263(a)-1(f)(1)(ii).

The importance of this safe harbor is that it eases the accounting burdens of taxpayers – both by not requiring capitalization of de minimis amounts and by allowing taxpayer to use the same accounting information that it uses for certain parties other than the IRS.

10. Unit of property: The new regulations provide a definition of a “unit of property,” i.e., “all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.” Reg. 1.263-3(e)(3)(i). There are some exceptions.

• Focus on a “unit of property” often goes far to resolve questions of deductible repair versus capitalized improvement. The larger the “unit of property,” the more substantial may be the components on which work is merely a “repair.” See e.g., Fedex Corp. v. United States, 291 F. Supp. 2d 699, 712 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6^th Cir. 2005) (entire aircraft rather than engine was unit of property; cost of servicing engine deductible).

10a. Buildings as units of property: The regulations provide that each building and each structural component are separate single units of property. Reg. § 1.263(a)-3(e)(2)(i). The structural components of a building include HVAC systems, plumbing systems, electrical systems, all escalators, all elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other components identified in published guidance in the Federal Register or the Internal Revenue Bulletin. Reg. § 1.263(a)-3(e)(2)(B).

11. Acquired or produced tangible property: Reg. § 1.263(a)-2(d)(1) provides in part: “Acquired or produced tangible property – (1) Requirement to capitalize. Except [for maintenance and supplies and for the de minimis safe harbor,] a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property … including leasehold improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. …

12. Improvements. Reg. § 1.263(a)-3(d) provides in part: “Requirement to capitalize amounts paid for improvements. Except [for “small taxpayers,” reliance on taxpayer’s own accounting treatment of expenditures, and de minimis expenditures,] … a taxpayer generally must capitalize the related amounts … paid to improve a unit of property owned by the taxpayer. … For purposes of this section, a unit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer –

(1) Are for a betterment to the unit of property …;

(2) Restore the unit of property …; or

(3) Adapt the unit of property to a new or different use …”

12a. Betterments: Taxpayer must capitalize a “betterment to a unit of property.” Reg. § 1.263(a)-3(j)(1). A “betterment” –

“(i) Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;

(ii) Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component … to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or

(iii) Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.”

Reg. § 1.263(a)-3(j)(1).

• Would the improvement in Mr. Morris Drive-In be a betterment?

12b. Restoration: Taxpayer must capitalize amounts paid to restore property. Reg. § 1.263(a)-3(k)(1). A “restoration” –

“(i) Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss …;

(ii) Is for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;

(iii) Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss … or relating to a casualty event …;

(iv) Returns the unit to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;

(v) Results in the rebuilding of the unit of property to a like-new condition after the end of its class life …; or

(vi) Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property …”

Reg. § 1.263(a)-3(k)(1).

Whether “a part or a combination of parts … comprise a major component or a substantial structural part of a unit of property” depends on all of the facts and circumstances, including “the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.” Reg. § 1.263(a)-3(k)(6)(i). Application of this regulation will require distinguishing between parts that are “a major component or a substantial structural part of a unit of property” and those that are not.

12c. Adaptation: Taxpayer must capitalize amounts paid to adapt a unit of property to a new use. Reg. § 1.263(a)-3(l)(1). An “adaptation” adapts “a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in service by the taxpayer.” Reg. § 1.263(a)-3(l)(1). In the case of a building, the adaptation adapts the building to a “new or different use.” Reg. § 1.263(a)-3(l)(2).

13. The regulations provide some safe harbors to the regulation governing improvements.

• A “small taxpayer” – one whose average gross receipts for the three preceding taxable years does not exceed $10M – may elect not to apply the improvements provision to building property “if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the … building property does not exceed the lesser of” 2% of the unadjusted basis [of $1M or less] of the building property or $10,000. Reg. § 1.263(a)-3(h)(1, 3, and 4).

• “Routine maintenance” does not improve property. Reg. § 1.263(a)-3(i)(1). “Routine maintenance” is recurring activities that a taxpayer expects to perform in order to keep the building or each building system in “ordinarily efficient operating condition.” In order to be “routine” in the case of a building, taxpayer must expect to perform the activities more than once during the 10-year period following placement in service. In order to be “routine” in the case of other property, taxpayer must expect at the time of placement into service to perform the activities more than once during the class life of the property. Reg. § 1.263(a)-3(i)(i, ii).

• A taxpayer may elect to capitalize all repair and maintenance costs as improvements consistent with the manner in which it keeps its own books and records. § 1.263(a)-3(n)(1). This permits taxpayers who conservatively capitalized all repair and maintenance costs to elect not to undertake the burden of changing their practices.

14. Reg. § 1.162-4(a) permits expensing of residual amounts as “repairs and maintenance.” Additionally, Reg. § 1.162-3 establishes rules for the timing and deductibility of incidental and non-incidental “materials and supplies.” “Materials and supplies” are tangible property that taxpayer uses or consumes in its operations that is not inventory that

• is a component that taxpayer acquires to maintain, repair, or improve a unit of tangible property and that is not acquired as a part of any single unit of tangible property,

• is fuel, lubricants, water, and the like – that taxpayer reasonably expects to consume in 12 months or less, beginning when taxpayer uses the items in its operations,

• is a unit of property with an “economic useful life” (i.e., the period over which taxpayer may reasonably expect the property to be useful and relying on taxpayer’s assessment in its “applicable financial statement” if it has one, Reg. § 1.162-3(c)(4)), of 12 months or less, beginning when the taxpayer uses or consumes the item in its operations,

• is a unit of property whose acquisition cost or production cost is $200 or less, or

• is identified in the Federal Register or the Internal Revenue Bulletin as “materials and supplies.”

Reg. § 1.162-3(c)(1).

“Incidental materials and supplies” are those that taxpayer keeps on hand and of which taxpayer keeps no record of consumption or takes no physical inventory at the beginning and end of the taxable year. Taxpayer may deduct the costs of “incidental materials and supplies” in the year in which it pays for them, provided that its income is clearly reflected. Reg. § 1.162-3(a)(2). “Non-incidental materials and supplies” are, presumably, all other materials and supplies. Taxpayer may deduct their costs when it first uses or consumes them in its operations. Reg. § 1.162-3(a)(1).

“Materials and supplies” are neither a capital asset under § 1221 nor “property used in the trade or business” under § 1231. Reg. § 1.162-3(g). There is no provision to capitalize “materials and supplies” except for rotable spare parts, temporary spare parts, and standby emergency spare parts. Taxpayer must deduct expenditures for other “materials and supplies” at the appropriate time.

15. Examples and hypotheticals:

15a. In Year 1, A purchases 10 printers at $250 each for a total cost of $2500 as indicated by the invoice. Assume that each printer is a unit of property. A does not have an AFS. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property that costs less than $500, and A treats the amounts paid for the printers as an expense on its books and records. May A deduct the cost of the printers? See Reg. § 1.263(a)-1(f)(7), Example 1.

• Same facts, except that the printers cost $600 each. A has accounting procedures in place at the beginning of Year 1 to expense amounts paid for property costing less than $1000, and A treats the amounts paid for the printers as an expense on its books and records. May A deduct the cost of the printers? See Reg. § 1.263(a)-1(f)(7), Example 2.

15b. A purchases new cash registers for use in its retail store located in leased space in a shopping mall that cost $6000 each. Assume each cash register is a unit of property and is not a material or supply. May A deduct the cost of the cash registers? See Reg. § 1.263(a)-2(d)(2), Example 1.

15c. H owns locomotives that it uses in its railroad business. Each locomotive consists of various components, such as an engine, generators, batteries, and trucks. H acquired a locomotive with all its components. Is the locomotive a single unit of property? See Reg. § 1.263(a)-3(e)(6), Example 8.

15d. J provides legal services to its clients. J purchases a laptop computer and a printer for its employees to use in providing legal services. Are the computer and printer a single unit of property or separate units of property? See Reg. § 1.263(a)-3(e)(6), Example 9.

15e. E is a towboat operator that owns and leases a fleet of towboats. Each towboat is equipped with two diesel-powered engines. Assume that each towboat, including its engines, is the unit of property and that a towboat has a class life of 18 years. At the time that E places its towboats into service, E is aware that approximately every three to four years E will need to perform scheduled maintenance on the two towboat engines to keep the engines in their ordinarily efficient operating condition. This maintenance is completed while the engines are attached to the towboat and involves the cleaning and inspecting of the engines to determine which parts are within acceptable operating tolerances and can continue to be used, which parts must be reconditioned to be brought back to acceptable tolerances, and which parts must be replaced. Engine parts replaced during these procedures are replaced with comparable and commercially available replacement parts. Assume the towboat engines are not rotable spare parts. In Year 1, E acquired a new towboat, including its two engines, and placed the towboat into service. In Year 5, E pays amounts to perform scheduled maintenance on both engines in the towboat. Should E be permitted to deduct these expenses as routine maintenance? See Reg. § 1.263(a)-3(i)(6), Example 9.

15f. Consider the following: In Year 1, X purchased a store located on a parcel of land that contained underground gasoline storage tanks left by prior occupants. Assume that the parcel of land is the unit of property. The tanks had leaked, causing soil contamination. X was not aware of the contamination at the time of purchase. In Year 2, X discovered the contamination and incurred costs to remediate the soil. May X deduct the expenses of soil remediation, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 1.

15g. X owns an office building that was constructed with insulation that contained asbestos. The health dangers of asbestos were not widely known when the building was constructed. Several years after X places the building into service, B determines that certain areas of asbestos-containing insulation had begun to deteriorate and could eventually pose a health risk to employees. Therefore, X decided to remove the asbestos-containing insulation from the building and replace it with new insulation that was safer to employees, but no more efficient or effective than the asbestos insulation. May X deduct the expenses of removal of the asbestos and replacement with safer insulation, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 2.

15h. X acquires a building for use in its business of providing assisted living services. Before and after the purchase, the building functioned as an assisted living facility. However, at the time of the purchase, X was aware that the building was in a condition below the standards that it requires for facilities used in its business. Immediately after the acquisition and during the following two years, while X continued to use the building as an assisted living facility, X incurred costs for extensive repairs and maintenance, and the acquisition of new property to bring the facility into the high-quality condition for which X’s facilities are known. The work included repairing damaged drywall; repainting and re-wallpapering; replacing flooring materials, windows, and tiling and fixtures in bathrooms; replacing window treatments, furniture, and cabinets; and repairing or replacing roofing materials, heating and cooling systems. May X deduct the expenses of bringing the facility into high-quality condition, or must X capitalize the expenditure? See Reg. 1.263(a)-3(j)(3), Example 5 (i and ii).

15i. G is a common carrier that owns a fleet of petroleum hauling trucks. G pays amounts to replace the existing engine, cab, and petroleum tank with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a single unit of property and that the trailer (which contains the petroleum tank) is a separate unit of property. May G deduct the expenses of replacing the existing engine, cab, and petroleum tank with a new engine, cab, and tank? See § 1.263(a)-3(k)(7), Example 10.

15j. D owns a parcel of land on which it previously operated a manufacturing facility. Assume that the land is the unit of property. During the course of D’s operation of the manufacturing facility, the land became contaminated with wastes from its manufacturing processes. D discontinues manufacturing operations at the site and decides to develop the property for residential housing. In anticipation of building residential property, D pays an amount to remediate the contamination caused by D’s manufacturing process. In addition, D pays an amount to regrade the land so that it can be used for residential purposes. May D deduct the amounts it paid to clean up the waste? What about the amounts it paid to regrade the land? See Reg. § 1.263(a)-3(l)(3), Example 4.

After determining that an expense is not a capital expenditure, § 162 (and § 212), coupled with § 274 define and delimit the precise scope of expenses of generating income that taxpayer may deduct. Read § 162(a). How many specific types of trade or business expenses does it name? We consider several § 162 issues.

• Read § 262. What are the consequences of a court concluding that an expenditure is for a personal expense?

A. Travel Expenses

Read § 162(a)(2).

MR. JUSTICE MURPHY delivered the opinion of the Court.

This case presents a problem as to the meaning and application of the provision of § [162(a)(2)] of the Internal Revenue Code, allowing a deduction for income tax purposes of “traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business.”

The taxpayer, a lawyer, has resided with his family in Jackson, Mississippi, since 1903. There, he has paid taxes, voted, schooled his children, and established social and religious connections. He built a house in Jackson nearly thirty years ago, and at all times has maintained it for himself and his family. He has been connected with several law firms in Jackson, one of which he formed and which has borne his name since 1922.

In 1906, the taxpayer began to represent the predecessor of the Gulf, Mobile & Ohio Railroad, his present employer. He acted as trial counsel for the railroad throughout Mississippi. From 1918 until 1927, he acted as special counsel for the railroad in Mississippi. He was elected general solicitor in 1927, and continued to be elected to that position each year until 1930, when he was elected general counsel. Thereafter, he was annually elected general counsel until September, 1940, when the properties of the predecessor company and another railroad were merged and he was elected vice-president and general counsel of the newly formed Gulf, Mobile & Ohio Railroad.

The main office of the Gulf, Mobile & Ohio Railroad is in Mobile, Alabama, as was also the main office of its predecessor. When offered the position of general solicitor in 1927, the taxpayer was unwilling to accept it if it required him to move from Jackson to Mobile. He had established himself in Jackson both professionally and personally, and was not desirous of moving away. As a result, an arrangement was made between him and the railroad whereby he could accept the position and continue to reside in Jackson on condition that he pay his traveling expenses between Mobile and Jackson and pay his living expenses in both places. This arrangement permitted the taxpayer to determine for himself the amount of time he would spend in each of the two cities, and was in effect during 1939 and 1940, the taxable years in question.

The railroad company provided an office for the taxpayer in Mobile, but not in Jackson. When he worked in Jackson, his law firm provided him with office space, although he no longer participated in the firm’s business or shared in its profits. He used his own office furniture and fixtures at this office. The railroad, however, furnished telephone service and a typewriter and desk for his secretary. It also paid the secretary’s expenses while in Jackson. Most of the legal business of the railroad was centered in or conducted from Jackson, but this business was handled by local counsel for the railroad. The taxpayer’s participation was advisory only, and was no different from his participation in the railroad’s legal business in other areas.

The taxpayer’s principal post of business was at the main office in Mobile. However, during the taxable years of 1939 and 1940, he devoted nearly all of his time to matters relating to the merger of the railroads. Since it was left to him where he would do his work, he spent most of his time in Jackson during this period. In connection with the merger, one of the companies was involved in certain litigation in the federal court in Jackson, and the taxpayer participated in that litigation.

During 1939, he spent 203 days in Jackson and 66 in Mobile, making 33 trips between the two cities. During 1940, he spent 168 days in Jackson and 102 in Mobile, making 40 trips between the two cities. The railroad paid all of his traveling expenses when he went on business trips to points other than Jackson or Mobile. But it paid none of his expenses in traveling between these two points or while he was at either of them.

The portion of § [162(a)(2)] authorizing the deduction of “traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business” is one of the specific examples given by Congress in that section of “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” It is to be contrasted with the provision of § [262(a)] of the Internal Revenue Code, disallowing any deductions for “personal, living, or family expenses.” … In pertinent part, [the applicable regulation] states that “Traveling expenses, as ordinarily understood, include railroad fares and meals and lodging. If the trip is undertaken for other than business purposes, the railroad fares are personal expenses, and the meals and lodging are living expenses. If the trip is solely on business, the reasonable and necessary traveling expenses, including railroad fares, meals, and lodging, are business expenses. … Only such expenses as are reasonable and necessary in the conduct of the business and directly attributable to it may be deducted. … Commuters’ fares are not considered as business expenses, and are not deductible.”

Three conditions must thus be satisfied before a traveling expense deduction may be made under § [162(a)(2)]:

(1) The expense must be a reasonable and necessary traveling expense, as that term is generally understood. This includes such items as transportation fares and food and lodging expenses incurred while traveling.

(2) The expense must be incurred “while away from home.”

(3) The expense must be incurred in pursuit of business. This means that there must be a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer. Moreover, such an expenditure must be necessary or appropriate to the development and pursuit of the business or trade.

Whether particular expenditures fulfill these three conditions so as to entitle a taxpayer to a deduction is purely a question of fact in most instances. See Commissioner v. Heininger, 320 U. S. 467, 475. And the Tax Court’s inferences and conclusions on such a factual matter, under established principles, should not be disturbed by an appellate court. Commissioner v. Scottish American Co., 323 U. S. 119; Dobson v. Commissioner, 320 U. S. 489.

In this instance, the Tax Court, without detailed elaboration, concluded that “The situation presented in this proceeding is, in principle, no different from that in which a taxpayer’s place of employment is in one city and, for reasons satisfactory to himself, he resides in another.” It accordingly disallowed the deductions on the ground that they represent living and personal expenses, rather than traveling expenses incurred while away from home in the pursuit of business. The court below accepted the Tax Court’s findings of fact, but reversed its judgment on the basis that it had improperly construed the word “home” as used in the second condition precedent to a traveling expense deduction under § [162(a)(2)] The Tax Court, it was said, erroneously construed the word to mean the post, station, or place of business where the taxpayer was employed – in this instance, Mobile – and thus erred in concluding that the expenditures in issue were not incurred “while away from home.” The Court below felt that the word was to be given no such “unusual” or “extraordinary” meaning in this statute, that it simply meant “that place where one in fact resides” or “the principal place of abode of one who has the intention to live there permanently.” Since the taxpayer here admittedly had his home, as thus defined, in Jackson, and since the expenses were incurred while he was away from Jackson, the deduction was permissible.

We deem it unnecessary here to enter into or to decide this conflict. The Tax Court’s opinion, as we read it, was grounded neither solely nor primarily upon that agency’s conception of the word “home.” Its discussion was directed mainly toward the relation of the expenditures to the railroad’s business, a relationship required by the third condition of the deduction. Thus, even if the Tax Court’s definition of the word “home” was implicit in its decision, and even if that definition was erroneous, its judgment must be sustained here if it properly concluded that the necessary relationship between the expenditures and the railroad’s business was lacking. Failure to satisfy any one of the three conditions destroys the traveling expense deduction.

Turning our attention to the third condition, this case is disposed of quickly. …

The facts demonstrate clearly that the expenses were not incurred in the pursuit of the business of the taxpayer’s employer, the railroad. Jackson was his regular home. Had his post of duty been in that city, the cost of maintaining his home there and of commuting or driving to work concededly would be nondeductible living and personal expenses lacking the necessary direct relation to the prosecution of the business. The character of such expenses is unaltered by the circumstance that the taxpayer’s post of duty was in Mobile, thereby increasing the costs of transportation, food, and lodging. Whether he maintained one abode or two, whether he traveled three blocks or three hundred miles to work, the nature of these expenditures remained the same.

The added costs in issue, moreover, were as unnecessary and inappropriate to the development of the railroad’s business as were his personal and living costs in Jackson. They were incurred solely as the result of the taxpayer’s desire to maintain a home in Jackson while working in Mobile, a factor irrelevant to the maintenance and prosecution of the railroad’s legal business. The railroad did not require him to travel on business from Jackson to Mobile, or to maintain living quarters in both cities. Nor did it compel him, save in one instance, to perform tasks for it in Jackson. It simply asked him to be at his principal post in Mobile as business demanded and as his personal convenience was served, allowing him to divide his business time between Mobile and Jackson as he saw fit. Except for the federal court litigation, all of the taxpayer’s work in Jackson would normally have been performed in the headquarters at Mobile. The fact that he traveled frequently between the two cities and incurred extra living expenses in Mobile, while doing much of his work in Jackson, was occasioned solely by his personal propensities. The railroad gained nothing from this arrangement except the personal satisfaction of the taxpayer.

Travel expenses in pursuit of business within the meaning of § [162(a)(2)] could arise only when the railroad’s business forced the taxpayer to travel and to live temporarily at some place other than Mobile, thereby advancing the interests of the railroad. Business trips are to be identified in relation to business demands and the traveler’s business headquarters. The exigencies of business, rather than the personal conveniences and necessities of the traveler, must be the motivating factors. Such was not the case here.

It follows that the court below erred in reversing the judgment of the Tax Court.

Reversed.

MR. JUSTICE JACKSON took no part in the consideration or decision of this case.

MR. JUSTICE RUTLEDGE, dissenting.

I think the judgment of the Court of Appeals should be affirmed. When Congress used the word “home” in § [162] of the Code, I do not believe it meant “business headquarters.” And, in my opinion, this case presents no other question.

….

Administrative construction should have some bounds. It exceeds what are legitimate when it reconstructs the statute to nullify or contradict the plain meaning of nontechnical terms not artfully employed. …

Notes and Questions:

1. Reg. § 1.162-2 is now the regulation covering “traveling expenses.” Its provisions have not materially changed from those that the Court quoted in Flowers.

2. Can commuting expenses ever meet the third requirement of deductibility, i.e., “a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer?”

3. Does Justice Rutledge have a point? After all, the Court later construed the word “gift” in its ordinary sense in Duberstein.

4. Upon application of the Court’s standards, why will taxpayer’s home usually be the “post, station, or place of business where the taxpayer [is] employed?”

5. Robert Rosenspan was a jewelry salesman who worked on a commission basis and paid his own traveling expenses without reimbursement. In 1964 he was the employee of two New York City jewelry manufacturers. For 300 days during the year he traveled by automobile through an extensive sales territory in the Middle West. He stayed at hotels and motels and ate at restaurants. Five times during the year he returned to New York and spent several days at his employers’ offices. There he performed a variety of services essential to his work, i.e., cleaned up his sample case, checked orders, discussed customers’ credit problems, recommended changes in stock, attended annual staff meetings, and the like. He used his brother’s Brooklyn home as a personal residential address. He kept some clothing and other belongings there. He voted, and filed his income tax returns from that address. On his trips to New York City, “out of a desire not to abuse his welcome at his brother’s home, he stayed more often” at an inn near the John F. Kennedy Airport.

• What tax issue(s) do these facts raise? How should they be resolved?

• See Rosenspan v. United States, 438 F.2d 905 (2d Cir.), cert. denied, 404 U.S. 864 (1971).

5a. Folkman, an airline pilot, was stationed in San Francisco International Airport as an employee of Pan American World Airways. He flew infrequently as a pilot with Pan American because of his low seniority. His principal work was that of navigator. This work gave him little opportunity to keep up basic flying skills. To maintain his proficiency as a jet pilot, and to earn extra income, Folkman enlisted in a military reserve program. The closest Air National Guard unit that had openings for pilots of jet aircraft was in Reno, Nevada, about 250 miles from San Francisco. As a condition of membership, the Nevada Air National Guard required all pilots to reside in the Reno area. Folkman and his family moved from their home near the San Francisco airport, to Reno. Folkman divided his time between flying with Pan American from his San Francisco base and flying for the Nevada Air National Guard. During an average month Folkman spent 10 to 13 days performing services for Pan American and four to seven days fulfilling his military reserve flying obligations. Whether he was scheduled to fly for the National Guard on a given day, Folkman routinely returned to Reno immediately after his Pan American flights. Folkman spent more time in Reno than in San Francisco, but derived approximately 85% of his earnings from his Pan American employment.

• What tax issue(s) do these facts raise? How do you think they should be resolved and why?

• See Folkman v. United States, 615 F.2d 493 (9^th Cir. 1980).

5b. Taxpayer Brandl was employed by Strong Electric Co. as a traveling technical representative of the marketing department. His duties consisted of visiting, assisting and selling to Strong dealers throughout the United States. Taxpayer did a great deal of traveling. Strong’s headquarters are in Toledo, Ohio. Taxpayer neither owned nor rented an apartment or house in Toledo. When Taxpayer was in Toledo he either stayed at a motel or with his brother and sister-in-law. When Taxpayer stayed with his brother he paid no rent but did help pay for groceries and household items, and worked around the house doing maintenance and remodeling. He usually was away from Toledo visiting customers from four to six weeks at a time, but on occasion he was away for up to three months. When Taxpayer traveled he stayed in hotels. When Taxpayer was at Strong headquarters in Toledo he took care of paper work, wrote letters to customers he had visited, and helped with general office work of the marketing department. During the tax year, Taxpayer spent a total of three months in Toledo. Taxpayer received personal mail at his brother’s home in Toledo, and he had an Ohio driver’s license. For the tax year in question, Strong paid Taxpayer $8,288.68 for his travel expenses. Taxpayer did not include that amount in income. Taxpayer did not claim a deduction for traveling expenses while away from home.

• Must Taxpayer Brandl include the $8288.68 in his taxable income?

• If so, may he deduct that amount as a “travel expense” under § 162(a)(2)?

• See Brandl v. Commissioner, T.C. Memo 1974-160 (1974).