MR. JUSTICE STEWART delivered the opinion of the Court.

The Commissioner of Internal Revenue has long maintained that a taxpayer traveling on business may deduct the cost of his meals only if his trip requires him to stop for sleep or rest. The question presented here is the validity of that rule.

Any rule in this area must make some rather arbitrary distinctions , but at least the sleep or rest rule avoids the obvious inequity of permitting the New Yorker who makes a quick trip to Washington and back, missing neither his breakfast nor his dinner at home, to deduct the cost of his lunch merely because he covers more miles than the salesman who travels locally and must finance all his meals without the help of the Federal Treasury. And the Commissioner’s rule surely makes more sense than one which would allow the respondent in this case to deduct the cost of his breakfast and lunch simply because he spends a greater percentage of his time at the wheel than the commuter who eats breakfast on his way to work and lunch a block from his office.

Alternatives to the Commissioner’s sleep or rest rule are, of course, available. Improvements might be imagined. But we do not sit as a committee of revision to perfect the administration of the tax laws. Congress has delegated to the Commissioner, not to the courts, the task of prescribing “all needful rules and regulations for the enforcement” of the Internal Revenue Code. 26 U.S.C. § 7805(a). In this area of limitless factual variations, “it is the province of Congress and the Commissioner, not the courts, to make the appropriate adjustments.” Commissioner v. Stidger, 386 U.S. 287, 296. The role of the judiciary in cases of this sort begins and ends with assuring that the Commissioner’s regulations fall within his authority to implement the congressional mandate in some reasonable manner. Because the rule challenged here has not been shown deficient on that score, the Court of Appeals should have sustained its validity. The judgment is therefore

Reversed.

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

MR. JUSTICE DOUGLAS, with whom MR. JUSTICE BLACK and MR. JUSTICE FORTAS concur, dissenting.

The statutory words “while away from home,” § 162(a)(2), may not, in my view, be shrunken to “overnight” by administrative construction or regulations. “Overnight” injects a time element in testing deductibility, while the statute speaks only in terms of geography. As stated by the Court of Appeals:

“In an era of supersonic travel, the time factor is hardly relevant to the question of whether or not travel and meal expenses are related to the taxpayer’s business, and cannot be the basis of a valid regulation under the present statute.”

Correll v. United States, 369 F.2d 87, 89-90.

I would affirm the judgment below.

Notes and Questions:

1. Is this an appropriate area for a bright line rule that may unfairly “catch” some taxpayers?

2. Read the instruction that the federal district court gave to the jury (in a footnote). Does it seem that the standard resembles the standard that the Court later adopted for § 119?

3. Under § 162(a)(2), how strong must the nexus be between the actual meals and a business purpose? See the Court’s last footnote. Does your answer make the approach of the commissioner seem more reasonable?

4. Did the majority’s statement of the Commissioner’s rule require an “overnight” stay – as Justice Douglas claimed in his dissent?

• The rule was originally an “overnight” rule. I.T. 3395, 1940-2 C.B. 64. The IRS endorsed the “sleep or rest” rule in Rev. Rul. 61-221, 1961-2 C.B. 34 for purposes of deducting the expense of sleeping.

5. F.M. Williams was a railroad conductor with more than forty years of service with the Atlanta and West Point Railroad and the Western Railway of Alabama. Every other day Williams got up shortly after five in the morning, left his house in Montgomery, Alabama, in time to arrive at the railroad station about 6:45 a.m., attended to duties at the station, left Montgomery on the Crescent at 7:40 a.m., arrived in Atlanta, Georgia, at 12:15 p.m., took six hours off, returned to duty in time to leave Atlanta at 6:15 p.m. on the Piedmont, pulled in to Montgomery at 10:15 p.m., left the Piedmont, and reached home about midnight. It is a long, hard day. The railroad never ordered Williams to rent a room in Atlanta, nor required him to sleep during the layover period. For years, however, because he felt he needed sleep and rest in Atlanta before his return run, Williams rented a reasonably priced room in the Gordon Hotel, a small hotel near the railroad station. At the hotel he had lunch and dinner, rested and slept, bathed and freshened up before boarding the Piedmont. He had the same room for eight years. His superiors knew that he could always be reached in Atlanta at the Gordon Hotel; taxpayer was subject to call at all times. In 1955 Captain Williams incurred expenses of $796 for meals, lodging, and tips at the Gordon Hotel during his layover in Atlanta.

• Should Williams be permitted to deduct the expenses that he incurred at the Gordon Hotel?

• What issues (sub-issues) do these facts raise?

• See Williams v. Patterson, 286 F.2d 333 (5^th Cir. 1961).

5a. Taxpayer B was a ferryboat captain. He worked in the Puget Sound area of Washington State. During the summer months, he typically worked 18-hour days for seven consecutive days. Then he would have seven consecutive days off. His schedule was the same in the winter, except that he would typically captain a ship from Seattle to Victoria. The return voyage would be six hours later. During the six-hour layover, he would take a nap on a cot provided by his employer. He would also purchase one or two meals.

• Should taxpayer B be permitted to deduct the cost of his meals?

• See Bissonnette v. Commissioner, 127 T.C. 124 (2006).

5b. Taxpayers were employees at the Nevada Test Site, a nuclear testing facility. Las Vegas, Nevada, the closest habitable community to the Test Site, is 65 miles south of the Camp Mercury control point, located at the southernmost boundary of the Test Site, and 130 miles from the northernmost boundary of the Test Site. Because of the potential dangers arising out of the activities conducted at the Test Site, the government chose this location precisely because of its remoteness from populated areas. All the taxpayers assigned to the Test Site received, in addition to their regular wages, a per diem allowance for each day they reported for work at the Test Site. The amount of the allowance varied. Employees reporting to Camp Mercury received $5 per day; those reporting to any forward area received $7.50 per day. Employees received these allowances without regard to the actual costs incurred by them for transportation, meals, or lodging. A private contractor maintained meal and lodging facilities onsite. Employees were responsible for procuring transportation, meals, and occasionally overnight lodging when they had to work overtime.

• Should Taxpayers be permitted to exclude their per diem allowances? See Commissioner v. Kowalski, 434 U.S. 77 (1977), supra.

• Disregarding the fact that for employees, meal and lodging expenses would be “miscellaneous deductions” and so suspended until tax year 2026, § 67(g) –

• Should Taxpayers be permitted to deduct the cost of their travel?

• Should Taxpayers be permitted to deduct the cost of their meals?

• Should Taxpayers be permitted to deduct the cost of their lodging?

• See Coombs v. Commissioner, 608 F.2d 1269 (9^th Cir. 1979).

LEVIN H. CAMPBELL, Circuit Judge.

The Commissioner of Internal Revenue (Commissioner) appeals a decision of the United States Tax Court that allowed a deduction under § 162(a)(2) (1976) for expenses incurred by a law student in the course of her summer employment. …

In the fall of 1973 Catharine Hantzis (taxpayer), formerly a candidate for an advanced degree in philosophy at the University of California at Berkeley, entered Harvard Law School in Cambridge, Massachusetts, as a full-time student. During her second year of law school she sought unsuccessfully to obtain employment for the summer of 1975 with a Boston law firm. She did, however, find a job as a legal assistant with a law firm in New York City, where she worked for ten weeks beginning in June 1975. Her husband, then a member of the faculty of Northeastern University with a teaching schedule for that summer, remained in Boston and lived at the couple’s home there. At the time of the Tax Court’s decision in this case, Mr. and Mrs. Hantzis still resided in Boston.

On their joint income tax return for 1975, Mr. and Mrs. Hantzis reported the earnings from taxpayer’s summer employment ($3,750) and deducted the cost of transportation between Boston and New York, the cost of a small apartment rented by Mrs. Hantzis in New York and the cost of her meals in New York ($3,204). The deductions were taken under § 162(a)(2), which provides:

“§ 162. Trade or business expenses

(a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including

(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business ….”

The Commissioner disallowed the deduction on the ground that taxpayer’s home for purposes of § 162(a)(2) was her place of employment and the cost of traveling to and living in New York was therefore not “incurred … while away from home.” The Commissioner also argued that the expenses were not incurred “in the pursuit of a trade or business.” Both positions were rejected by the Tax Court, which found that Boston was Mrs. Hantzis’ home because her employment in New York was only temporary and that her expenses in New York were “necessitated” by her employment there. The court thus held the expenses to be deductible under § 162(a)(2).

In asking this court to reverse the Tax Court’s allowance of the deduction, the Commissioner has contended that the expenses were not incurred “in the pursuit of a trade or business.” We do not accept this argument; nonetheless, we sustain the Commissioner and deny the deduction, on the basis that the expenses were not incurred “while away from home.”

I.

Section 262 of the Code, declares that “except as otherwise provided in this chapter, no deductions shall be allowed for personal, living, or family expenses.” Section 162 provides less of an exception to this rule than it creates a separate category of deductible business expenses. This category manifests a fundamental principle of taxation: that a person’s taxable income should not include the cost of producing that income. [citation omitted]; Commissioner v. Flowers, 326 U.S. 465, 469 (1946); [citation omitted].

With these fundamentals in mind, we proceed to ask whether the cost of taxpayer’s transportation to and from New York, and of her meals and lodging while in New York, was incurred “while away from home in the pursuit of a trade or business.”

II.

The Commissioner has directed his argument at the meaning of “in pursuit of a trade or business.” He interprets this phrase as requiring that a deductible traveling expense be incurred under the demands of a trade or business which predates the expense, i.e., an “already existing” trade or business. [The court rejected the commissioner’s contention.]

….

III.

As already noted, Flowers construed § 162(a)(2) to mean that a traveling expense is deductible only if it is (1) reasonable and necessary, (2) incurred while away from home, and (3) necessitated by the exigencies of business. Because the Commissioner does not suggest that Mrs. Hantzis’ expenses were unreasonable or unnecessary, we may pass directly to the remaining requirements. Of these, we find dispositive the requirement that an expense be incurred while away from home. As we think Mrs. Hantzis’ expenses were not so incurred, we hold the deduction to be improper.

We begin by recognizing that the location of a person’s home for purposes of § 162(a)(2) becomes problematic only when the person lives one place and works another. Where a taxpayer resides and works at a single location, he is always home, however defined; and where a taxpayer is constantly on the move due to his work, he is never “away” from home. (In the latter situation, it may be said either that he has no residence to be away from, or else that his residence is always at his place of employment. See Rev. Rul. 60-16.) However, in the present case, the need to determine “home” is plainly before us, since the taxpayer resided in Boston and worked, albeit briefly, in New York.

We think the critical step in defining “home” in these situations is to recognize that the “while away from home” requirement has to be construed in light of the further requirement that the expense be the result of business exigencies. The traveling expense deduction obviously is not intended to exclude from taxation every expense incurred by a taxpayer who, in the course of business, maintains two homes. Section 162(a)(2) seeks rather “to mitigate the burden of the taxpayer who, because of the exigencies of his trade or business, must maintain two places of abode and thereby incur additional and duplicate living expenses.” [citations omitted]. Consciously or unconsciously, courts have effectuated this policy in part through their interpretation of the term “home” in § 162(a)(2). Whether it is held in a particular decision that a taxpayer’s home is his residence or his principal place of business, the ultimate allowance or disallowance of a deduction is a function of the court’s assessment of the reason for a taxpayer’s maintenance of two homes. If the reason is perceived to be personal, the taxpayer’s home will generally be held to be his place of employment rather than his residence and the deduction will be denied. [citations omitted]. If the reason is felt to be business exigencies, the person’s home will usually be held to be his residence and the deduction will be allowed. See, e.g., Frederick v. United States, 603 F.2d 1292 (8th Cir. 1979); [citations omitted]. We understand the concern of the concurrence that such an operational interpretation of the term “home” is somewhat technical and perhaps untidy, in that it will not always afford bright line answers, but we doubt the ability of either the Commissioner or the courts to invent an unyielding formula that will make sense in all cases. The line between personal and business expenses winds through infinite factual permutations; effectuation of the travel expense provision requires that any principle of decision be flexible and sensitive to statutory policy.

“Where a taxpayer reasonably expects to be employed in a location for a substantial or indefinite period of time, the reasonable inference is that his choice of a residence is a personal decision, unrelated to any business necessity. Thus, it is irrelevant how far he travels to work. The normal expectation, however, is that the taxpayer will choose to live near his place of employment. Consequently, when a taxpayer reasonable [sic] expects to be employed in a location for only a short or temporary period of time and travels a considerable distance to the location from his residence, it is unreasonable to assume that his choice of a residence is dictated by personal convenience. The reasonable inference is that he is temporarily making these travels because of a business necessity.”

Frederick, supra, 603 F.2d at 1294-95 (citations omitted).

The temporary employment doctrine does not, however, purport to eliminate any requirement that continued maintenance of a first home have a business justification. We think the rule has no application where the taxpayer has no business connection with his usual place of residence. If no business exigency dictates the location of the taxpayer’s usual residence, then the mere fact of his taking temporary employment elsewhere cannot supply a compelling business reason for continuing to maintain that residence. Only a taxpayer who lives one place, works another and has business ties to both is in the ambiguous situation that the temporary employment doctrine is designed to resolve. In such circumstances, unless his employment away from his usual home is temporary, a court can reasonably assume that the taxpayer has abandoned his business ties to that location and is left with only personal reasons for maintaining a residence there. Where only personal needs require that a travel expense be incurred, however, a taxpayer’s home is defined so as to leave the expense subject to taxation. See supra. Thus, a taxpayer who pursues temporary employment away from the location of his usual residence, but has no business connection with that location, is not “away from home” for purposes of § 162(a)(2). [citations omitted].

On this reasoning, the temporary nature of Mrs. Hantzis’ employment in New York does not affect the outcome of her case. She had no business ties to Boston that would bring her within the temporary employment doctrine. By this holding, we do not adopt a rule that “home” in § 162(a)(2) is the equivalent of a taxpayer’s place of business. Nor do we mean to imply that a taxpayer has a “home” for tax purposes only if he is already engaged in a trade or business at a particular location. Though both rules are alluringly determinate, we have already discussed why they offer inadequate expressions of the purposes behind the travel expense deduction. We hold merely that for a taxpayer in Mrs. Hantzis’ circumstances to be “away from home in the pursuit of a trade or business,” she must establish the existence of some sort of business relation both to the location she claims as “home” and to the location of her temporary employment sufficient to support a finding that her duplicative expenses are necessitated by business exigencies. This, we believe, is the meaning of the statement in Flowers that “[b]usiness trips are to be identified in relation to business demands and the traveler’s business headquarters.” 326 U.S. at 474 254 (emphasis added). On the uncontested facts before us, Mrs. Hantzis had no business relation to Boston; we therefore leave to cases in which the issue is squarely presented the task of elaborating what relation to a place is required under § 162(a)(2) for duplicative living expenses to be deductible.

Reversed.

KEETON, District Judge, concurring in the result.

….

… I read the [majority] opinion as indicating that in a dual residence case, the Commissioner must determine whether the exigencies of the taxpayer’s trade or business require her to maintain both residences. If so, the Commissioner must decide that the taxpayer’s principal residence is her “home” and must conclude that expenses associated with the secondary residence were incurred “while away from home,” and are deductible. If not, as in the instant case, the Commissioner must find that the taxpayer’s principal place of business is her “home” and must conclude that the expenses in question were not incurred “while away from home.” The conclusory nature of these determinations as to which residence is her “home” reveals the potentially confusing effect of adopting an extraordinary definition of “home.”

A word used in a statute can mean, among the cognoscenti, whatever authoritative sources define it to mean. Nevertheless, it is a distinct disadvantage of a body of law that it can be understood only by those who are expert in its terminology. Moreover, needless risks of misunderstanding and confusion arise, not only among members of the public but also among professionals who must interpret and apply a statute in their day-to-day work, when a word is given an extraordinary meaning that is contrary to its everyday usage.

The result reached by the court can easily be expressed while also giving “home” its ordinary meaning, and neither Congress nor the Supreme Court has directed that “home” be given an extraordinary meaning in the present context. See Flowers, supra, Stidger, supra, and Peurifoy, supra. In Rosenspan v. United States, supra, Judge Friendly, writing for the court, rejected the Commissioner’s proposed definition of home as the taxpayer’s business headquarters, concluding that in § 162(a)(2) “‘home’ means ‘home.’” Id. at 912.

When Congress uses a non-technical word in a tax statute, presumably it wants administrators and courts to read it in the way that ordinary people would understand, and not “to draw on some unexpressed spirit outside the bounds of the normal meaning of words.” Addison v. Holly Hill Fruit Prods., Inc., 322 U.S. 607, 617 (1944).

Id. at 911. [citation omitted].

In analyzing dual residence cases, the court’s opinion advances compelling reasons that the first step must be to determine whether the taxpayer has business as opposed to purely personal reasons for maintaining both residences. This must be done in order to determine whether the expenses of maintaining a second residence were, “necessitated by business, as opposed to personal, demands,” and were in this sense incurred by the taxpayer “while away from home in pursuit of trade or business.” Necessarily implicit in this proposition is a more limited corollary that is sufficient to decide the present case: When the taxpayer has a business relationship to only one location, no traveling expenses the taxpayer incurs are “necessitated by business, as opposed to personal demands,” regardless of how many residences the taxpayer has, where they are located, or which one is “home.”

In the contrasting case in which a taxpayer has established that both residences were maintained for business reasons, § 162(a)(2) allows the deduction of expenses associated with travel to, and maintenance of, one of the residences if they are incurred for business reasons and that abode is not the taxpayer’s home. A common sense meaning of “home” works well to achieve the purpose of this provision.

In summary, the court announces a sound principle that, in dual residence cases, deductibility of traveling expenses depends upon a showing that both residences were maintained for business reasons. If that principle is understood to be derived from the language of § 162(a)(2) taken as a whole, “home” retains operative significance for determining which of the business-related residences is the one the expense of which can be treated as deductible. In this context, “home” should be given its ordinary meaning to allow a deduction only for expenses relating to an abode that is not the taxpayer’s principal place of residence. On the undisputed facts in this case, the Tax Court found that Boston was the taxpayer’s “home” in the everyday sense, i.e., her principal place of residence. Were the issue relevant to disposition of the case, I would uphold the Tax Court’s quite reasonable determination on the evidence before it. However, because the taxpayer had no business reason for maintaining both residences, her deduction for expenses associated with maintaining a second residence closer than her principal residence to her place of employment must be disallowed without regard to which of her two residences was her “home” under § 162(a)(2).

Notes and Questions:

1. Obviously, the meaning of “home” is not to be determined by the ordinary use of the term. Right?

2. Does the court’s opinion conflate the second and third requirements of Flowers?

3. On which of the Flowers requirements does Judge Keeton rely to deny taxpayers a deduction?

4. Taxpayer owned and operated a very successful swimming pool construction business in Lynnfield, Massachusetts. He also owned and operated a very successful horse breeding and racing business in Lighthouse Point, Florida. From November through April, he resided in Florida. From May through October, he resided in Massachusetts. Taxpayer owned a home in both Florida and Massachusetts and traveled between them to tend to his businesses.

• Does Taxpayer have two tax homes so that he may deduct the travel expenses associated with neither of them?

• What guidance do the opinions in Hantzis offer in answering this question?

• See Andrews v. Commissioner, 931 F.2d 132 (1^st Cir. 1991) (“major” post of duty; “minor” post of duty).

4a. For the past five years, Taxpayers (Mr. and Mrs. Chwalow) have maintained a residence in Bala Cynwyd, Pennsylvania. Mrs. Chwalow is a teacher in the Philadelphia public school system and specializes in working with deaf children. Dr. Chwalow is a physicist whose specialty is military optics and electrooptics encompassing areas such as night vision, laser range finding, missile guidance, aerial reconnaissance, etc. Dr. Chwalow works for IBM in Washington, D.C., where he rents an apartment. He uses public transportation to get to his job. Mrs. Chwalow continues to live in Bala Cynwyd, Pennsylvania.

• May either Mr. or Mrs. Chwalow deduct meal and lodging expenses as “travel expenses” under § 162(a)(2)?

• See Chwalow v. Commissioner, 470 F.2d 475 (3^rd Cir. 1972).

4b. Taxpayer Dews was a coach on the staff of the Atlanta Braves baseball team. He and his wife lived in Albany, Georgia. In the course of over 20 years in professional baseball, Dews had 37 different assignments, including as a manager of farm teams in the Atlanta organization. During one 4-year period, he was a coach for the Atlanta team. He maintained an apartment in Atlanta.

• May Dews deduct the expenses of traveling between Albany and Atlanta? May he deduct the expenses of living in Atlanta?

• See Dews v. Commissioner, T.C. Memo. 1987-353, available at 1987 WL 40405.

Read the second sentence of the carryout paragraph that ends § 162(a). It refers to § 162(a)(2). Also read § 274(m)(3). Then do the CALI Lesson: Basic Federal Income Taxation: Deductions: Traveling Expenses.

B. Reasonable Salaries

Read § 162(a)(1). How would you determine the reasonableness of salaries? What constraints exist outside of the Code that prevent payment of excessive salaries or other compensation? What conditions make it more (or less) likely that a taxpayer is paying a greater-than-reasonable salary?

• Notice that the approach of the Code is to deny a deduction to the one who pays an excessive salary. Hence, both the recipient of the salary and the employer would pay tax on the amount paid in salary that the employer may not deduct.

POSNER, Chief Judge.

This appeal from a judgment by the Tax Court, requires us to interpret and apply § 162(a)(1), which allows a business to deduct from its income its “ordinary and necessary” business expenses, including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” In 1993 and 1994, Exacto Spring Corporation, a closely held corporation engaged in the manufacture of precision springs, paid its cofounder, chief executive, and principal owner, William Heitz, $1.3 and $1.0 million, respectively, in salary. The Internal Revenue Service thought this amount excessive, that Heitz should not have been paid more than $381,000 in 1993 or $400,000 in 1994, with the difference added to the corporation’s income, and it assessed a deficiency accordingly, which Exacto challenged in the Tax Court. That court found that the maximum reasonable compensation for Heitz would have been $900,000 in the earlier year and $700,000 in the later one – figures roughly midway between his actual compensation and the IRS’s determination – and Exacto has appealed.

In reaching its conclusion, the Tax Court applied a test that requires the consideration of seven factors, none entitled to any specified weight relative to another. The factors are, in the court’s words, “(1) the type and extent of the services rendered; (2) the scarcity of qualified employees; (3) the qualifications and prior earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer’s business.” It is apparent that this test, though it or variants of it (one of which has the astonishing total of 21 factors, Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-79 (1981)), are encountered in many cases, see, e.g. Edwin’s Inc. v. United States, 501 F.2d 675, 677 (7th Cir.1974); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323 (5th Cir.1987); Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.1949); 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts ¶ 22.2.2, p. 22-21 (3d ed.1999), leaves much to be desired – being, like many other multi-factor tests, “redundant, incomplete, and unclear.” Palmer v. City of Chicago, 806 F.2d 1316, 1318 (7th Cir.1986).

To begin with, it is nondirective. No indication is given of how the factors are to be weighed in the event they don’t all line up on one side. And many of the factors, such as the type and extent of services rendered, the scarcity of qualified employees, and the peculiar characteristics of the employer’s business, are vague.

Second, the factors do not bear a clear relation either to each other or to the primary purpose of § 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. E.g., Rapco, Inc. v. Commissioner, 85 F.3d 950, 954 n. 2 (2d Cir.1996). Suppose that an employee who let us say was, like Heitz, a founder and the chief executive officer and principal owner of the taxpayer rendered no services at all but received a huge salary. It would be absurd to allow the whole or for that matter any part of his salary to be deducted as an ordinary and necessary business expense even if he were well qualified to be CEO of the company, the company had substantial net earnings, CEOs of similar companies were paid a lot, and it was a business in which high salaries are common. The multi-factor test would not prevent the Tax Court from allowing a deduction in such a case even though the corporation obviously was seeking to reduce its taxable income by disguising earnings as salary. The court would not allow the deduction, but not because of anything in the multi-factor test; rather because it would be apparent that the payment to the employee was not in fact for his services to the company. Reg. § 1.162-7(a); 1 Bittker & Lokken, supra, ¶ 22.2.1, p. 22-19.

Third, the seven-factor test invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts, as we have repeatedly noted in the Title VII context, e.g., Jackson v. E.J. Brach Corp., 176 F.3d 971, 984 (7th Cir. 1999), and as the Delaware Chancery Court has noted in the more germane context of derivative suits alleging excessive compensation of corporate employees. Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 (Del. Ch. 1996). The test – the irruption of “comparable worth” thinking (see, e.g., American Nurses’ Ass’n v. Illinois, 783 F.2d 716 (7th Cir. 1986)) in a new context – invites the court to decide what the taxpayer’s employees should be paid on the basis of the judges’ own ideas of what jobs are comparable, what relation an employee’s salary should bear to the corporation’s net earnings, what types of business should pay abnormally high (or low) salaries, and so forth. The judges of the Tax Court are not equipped by training or experience to determine the salaries of corporate officers; no judges are.

Fourth, since the test cannot itself determine the outcome of a dispute because of its nondirective character, it invites the making of arbitrary decisions based on uncanalized discretion or unprincipled rules of thumb. The Tax Court in this case essentially added the IRS’s determination of the maximum that Mr. Heitz should have been paid in 1993 and 1994 to what he was in fact paid, and divided the sum by two. It cut the baby in half. One would have to be awfully naive to believe that the seven-factor test generated this pleasing symmetry.

Fifth, because the reaction of the Tax Court to a challenge to the deduction of executive compensation is unpredictable, corporations run unavoidable legal risks in determining a level of compensation that may be indispensable to the success of their business.

The drawbacks of the multi-factor test are well illustrated by its purported application by the Tax Court in this case. With regard to factor (1), the court found that Heitz was “indispensable to Exacto’s business” and “essential to Exacto’s success.” Heitz is not only Exacto’s CEO; he is also the company’s chief salesman and marketing man plus the head of its research and development efforts and its principal inventor. The company’s entire success appears to be due on the one hand to the research and development conducted by him and on the other hand to his marketing of these innovations (though he receives some additional compensation for his marketing efforts from a subsidiary of Exacto). The court decided that factor (1) favored Exacto.

Likewise factor (2), for, as the court pointed out, the design of precision springs, which is Heitz’s specialty, is “an extremely specialized branch of mechanical engineering, and there are very few engineers who have made careers specializing in this area,” let alone engineers like Heitz who have “the ability to identify and attract clients and to develop springs to perform a specific function for that client…. It would have been very difficult to replace Mr. Heitz.” Notice how factors (1) and (2) turn out to be nearly identical.

Factors (3) and (4) also supported Exacto, the court found. “Mr Heitz is highly qualified to run Exacto as a result of his education, training, experience, and motivation. Mr. Heitz has over 40 years of highly successful experience in the field of spring design.” And his “efforts were of great value to the corporation.” So factor (4) duplicated (2), and so the first four factors turn out to be really only two.

With regard to the fifth factor – the employer’s (Exacto’s) net earnings – the Tax Court was noncommittal. Exacto had reported a loss in 1993 and very little taxable income in 1994. But it conceded having taken some improper deductions in those years unrelated to Heitz’s salary. After adjusting Exacto’s income to remove these deductions, the court found that Exacto had earned more than $1 million in each of the years at issue net of Heitz’s supposedly inflated salary.

The court was noncommital with regard to the sixth factor – earnings of comparable employees – as well. The evidence bearing on this factor had been presented by expert witnesses, one on each side, and the court was critical of both. The taxpayer’s witness had arrived at his estimate of Heitz’s maximum reasonable compensation in part by aggregating the salaries that Exacto would have had to pay to hire four people each to wear one of Heitz’s “hats,” as chief executive officer, chief manufacturing executive, chief research and development officer, and chief sales and marketing executive. Although the more roles or functions an employee performs the more valuable his services are likely to be, Dexsil Corp. v. Commissioner, 147 F.3d 96, 102-03 (2d Cir.1998); Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-46 (9th Cir.1983), an employee who performs four jobs, each on a part-time basis, is not necessarily worth as much to a company as four employees each working full time at one of those jobs. It is therefore arbitrary to multiply the normal full-time salary for one of the jobs by four to compute the reasonable compensation of the employee who fills all four of them. Anyway salaries are determined not by the method of comparable worth but, like other prices, by the market, which is to say by conditions of demand and supply. Especially in the short run, salaries may vary by more than any difference in the “objective” characteristics of jobs. An individual who has valuable skills that are in particularly short supply at the moment may command a higher salary than a more versatile, better-trained, and more loyal employee whose skills are, however, less scarce.

The Internal Revenue Service’s expert witness sensibly considered whether Heitz’s compensation was consistent with Exacto’s investors’ earning a reasonable return (adjusted for the risk of Exacto’s business), which he calculated to be 13%. But in concluding that Heitz’s compensation had pushed the return below that level, he neglected to consider the concessions of improper deductions, which led to adjustments to Exacto’s taxable income. The Tax Court determined that with those adjustments the investors’ annual return was more than 20% despite Heitz’s large salary. The government argues that the court should not have calculated the investors’ return on the basis of the concessions of improper deductions, because when Heitz’s compensation was determined the corporation was unaware that the deductions would be disallowed. In other words, the corporation thought that its after-tax income was larger than it turned out to be. But if the ex ante perspective is the proper one, as the government contends, it favors the corporation if when it fixed Heitz’s salary it thought there was more money in the till for the investors than has turned out to be the case.

What is puzzling is how disallowing deductions and thus increasing the taxpayer’s tax bill could increase the investors’ return. What investors care about is the corporate income available to pay dividends or be reinvested; obviously money paid in taxes to the Internal Revenue Service is not available for either purpose. The reasonableness of Heitz’s compensation thus depends not on Exacto’s taxable income but on the corporation’s profitability to the investors, which is reduced by the disallowance of deductions – if a corporation succeeds in taking phantom deductions, shareholders are better off because the corporation’s tax bill is lower. But the government makes nothing of this. Its only objection is to the Tax Court’s having taken account of adjustments made after Heitz’s salary was fixed. Both parties, plus the Tax Court, based their estimates of investors’ returns on the after-tax income shown on Exacto’s tax returns, which jumped after the deductions were disallowed, rather than on Exacto’s real profits, which declined. The approach is inconsistent with a realistic assessment of the investors’ rate of return, but as no one in the case questions it we shall not make an issue of it.

Finally, under factor (7) (“peculiar characteristics”), the court first and rightly brushed aside the IRS’s argument that the low level of dividends paid by Exacto (zero in the two years at issue, but never very high) was evidence that the corporation was paying Heitz dividends in the form of salary. The court pointed out that shareholders may not want dividends. They may prefer the corporation to retain its earnings, causing the value of the corporation to rise and thus enabling the shareholders to obtain corporate earnings in the form of capital gains taxed at a lower rate than ordinary income. The court also noted that while Heitz, as the owner of 55% of Exacto’s common stock, obviously was in a position to influence his salary, the corporation’s two other major shareholders, each with 20% of the stock, had approved it. They had not themselves been paid a salary or other compensation, and are not relatives of Heitz; they had no financial or other incentive to allow Heitz to siphon off dividends in the form of salary.

Having run through the seven factors, all of which either favored the taxpayer or were neutral, the court reached a stunning conclusion: “We have considered the factors relevant in deciding reasonable compensation for Mr. Heitz. On the basis of all the evidence, we hold that reasonable compensation for Mr. Heitz” was much less than Exacto paid him. The court’s only effort at explaining this result when Exacto had passed the seven-factor test with flying colors was that “we have balanced Mr. Heitz’ unique selling and technical ability, his years of experience, and the difficulty of replacing Mr. Heitz with the fact that the corporate entity would have shown a reasonable return for the equity holders, after considering petitioners’ concessions.” Id. But “the fact that the corporate entity would have shown a reasonable return for the equity holders” after the concessions is on the same side of the balance as the other factors; it does not favor the Internal Revenue Service’s position. The government’s lawyer was forced to concede at the argument of the appeal that she could not deny the possibility that the Tax Court had pulled its figures for Heitz’s allowable compensation out of a hat.

The failure of the Tax Court’s reasoning to support its result would alone require a remand. But the problem with the court’s opinion goes deeper. The test it applied does not provide adequate guidance to a rational decision. We owe no deference to the Tax Court’s statutory interpretations, its relation to us being that of a district court to a court of appeals, not that of an administrative agency to a court of appeals. 26 U.S.C. § 7482(a)(1); [citations omitted]. The federal courts of appeals, whose decisions do of course have weight as authority with us even when they are not our own decisions, have been moving toward a much simpler and more purposive test, the “independent investor” test. Dexsil Corp. v. Commissioner, supra; Elliotts, Inc. v. Commissioner, supra, 716 F.2d at 1245-48; Rapco, Inc. v. Commissioner, supra, 85 F.3d at 954-55. We applaud the trend and join it.

Because judges tend to downplay the element of judicial creativity in adapting law to fresh insights and changed circumstances, the cases we have just cited prefer to say (as in Dexsil and Rapco) that the “independent investor” test is the “lens” through which they view the seven (or however many) factors of the orthodox test. But that is a formality. The new test dissolves the old and returns the inquiry to basics. The Internal Revenue Code limits the amount of salary that a corporation can deduct from its income primarily in order to prevent the corporation from eluding the corporate income tax by paying dividends but calling them salary because salary is deductible and dividends are not. (Perhaps they should be, to avoid double taxation of corporate earnings, but that is not the law.) In the case of a publicly held company, where the salaries of the highest executives are fixed by a board of directors that those executives do not control, the danger of siphoning corporate earnings to executives in the form of salary is not acute. The danger is much greater in the case of a closely held corporation, in which ownership and management tend to coincide; unfortunately, as the opinion of the Tax Court in this case illustrates, judges are not competent to decide what business executives are worth.

There is, fortunately, an indirect market test, as recognized by the Internal Revenue Service’s expert witness. A corporation can be conceptualized as a contract in which the owner of assets hires a person to manage them. The owner pays the manager a salary and in exchange the manager works to increase the value of the assets that have been entrusted to his management; that increase can be expressed as a rate of return to the owner’s investment. The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid, for it will be implausible that if he quit if his salary was cut, and he was replaced by a lower-paid manager, the owner would be better off; it would be killing the goose that lays the golden egg. The Service’s expert believed that investors in a firm like Exacto would expect a 13% return on their investment. Presumably they would be delighted with more. They would be overjoyed to receive a return more than 50% greater than they expected – and 20%, the return that the Tax Court found that investors in Exacto had obtained, is more than 50% greater than the benchmark return of 13%.

When, notwithstanding the CEO’s “exorbitant” salary (as it might appear to a judge or other modestly paid official), the investors in his company are obtaining a far higher return than they had any reason to expect, his salary is presumptively reasonable. We say “presumptively” because we can imagine cases in which the return, though very high, is not due to the CEO’s exertions. Suppose Exacto had been an unprofitable company that suddenly learned that its factory was sitting on an oil field, and when oil revenues started to pour in its owner raised his salary from $50,000 a year to $1.3 million. The presumption of reasonableness would be rebutted. There is no suggestion of anything of that sort here and likewise no suggestion that Mr. Heitz was merely the titular chief executive and the company was actually run by someone else, which would be another basis for rebuttal.

The government could still have prevailed by showing that while Heitz’s salary may have been no greater than would be reasonable in the circumstances, the company did not in fact intend to pay him that amount as salary, that his salary really did include a concealed dividend though it need not have. This is material (and the “independent investor” test, like the multi-factor test that it replaces, thus incomplete, though invaluable) because any business expense to be deductible must be, as we noted earlier, a bona fide expense as well as reasonable in amount. The fact that Heitz’s salary was approved by the other owners of the corporation, who had no incentive to disguise a dividend as salary, goes far to rebut any inference of bad faith here, which in any event the Tax Court did not draw and the government does not ask us to draw.

The judgment is reversed with directions to enter judgment for the taxpayer. Reversed.

Notes and Questions:

1. Judge Posner is right in describing what is probably still the prevailing standard as a multi-factor test – with all the problems that go with it. See E.L. Kellett, Annot., Reasonableness of Compensation Paid to Officers or Employees, so as to Warrant Deduction Thereof in Computing Employer’s Income Tax, 10 A.L.R. Fed.3d 125.

2. For what reasons would a taxpayer “pay,” i.e., compensate, an employee more than a reasonable amount of salary?

• The court observed that a shareholder derivative suit is a “more germane context” in which to evaluate excessive compensation? Why would this be true?

3. Read § 162(m). Notice that it only applies to publicly held corporations. How effective do you think § 162(m) is at curtailing excessive compensation? Keep in mind that the Tax Cuts and Jobs Act reduced the maximum corporate tax rate from 35% to 21%. See David I. Walker, Expanding and Effectively Repealing the Executive Pay Deductibility Limitations, Tax Notes 1819 (Sept. 24, 2018).

C. Ordinary and Necessary Expenses

Section 162(a) allows taxpayer to deduct all ordinary and necessary expenses paid or incurred in carrying on any trade or business, but §§ 162 and 274 limit trade or business deductions incurred for certain purposes.

Section 212 allows a similar deduction for the ordinary and necessary expenses that taxpayer pays or incurs –

• for the production or collection of income,

• for the management, conservation, or maintenance of property held for the production of income, or

• in connection with the determination, collection, or refund of any tax.

Section 67(g) suspends “miscellaneous deductions” until 2026. Section 212 deductions are included in “miscellaneous deductions.”

• This will encourage taxpayers to characterize their activities as a trade or business.

We consider here a few recurring issues.

1. Personal vs. Trade or Business

We have already seen that § 162(a)(2) implicitly treats taxpayer’s choice of where to live as a personal one (Flowers). So is the choice to be married (Hantzis). Hence, taxpayer may not deduct expenditures associated with these choices. § 262(a). The Code also implicitly treats certain other choices as “personal.”

….

OPINION – OPPER

Respondent determined a deficiency of $23.62 in petitioner’s 1937 income tax. This was due to the disallowance of a deduction claimed by petitioners, who are husband and wife, for sums spent by the wife in employing nursemaids to care for petitioners’ young child, the wife, as well as the husband, being employed. …

Petitioners would have us apply the ‘but for’ test. They propose that but for the nurses the wife could not leave her child; but for the freedom so secured she could not pursue her gainful labors; and but for them there would be no income and no tax. This thought evokes an array of interesting possibilities. The fee to the doctor, but for whose healing service the earner of the family income could not leave his sickbed; the cost of the laborer’s raiment, for how can the world proceed about its business unclothed; the very home which gives us shelter and rest and the food which provides energy, might all by an extension of the same proposition be construed as necessary to the operation of business and to the creation of income. Yet these are the very essence of those ‘personal’ expenses the deductibility of which is expressly denied. [citation omitted]

We are told that the working wife is a new phenomenon. This is relied on to account for the apparent inconsistency that the expenses in issue are now a commonplace, yet have not been the subject of legislation, ruling, or adjudicated controversy. But if that is true it becomes all the more necessary to apply accepted principles to the novel facts. We are not prepared to say that the care of children, like similar aspects of family and household life, is other than a personal concern. The wife’s services as custodian of the home and protector of its children are ordinarily rendered without monetary compensation. There results no taxable income from the performance of this service and the correlative expenditure is personal and not susceptible of deduction. [citation omitted] Here the wife has chosen to employ others to discharge her domestic function and the services she performs are rendered outside the home. They are a source of actual income and taxable as such. But that does not deprive the same work performed by others of its personal character nor furnish a reason why its cost should be treated as an offset in the guise of a deductible item.

We are not unmindful that, as petitioners suggest, certain disbursements normally personal may become deductible by reason of their intimate connection with an occupation carried on for profit. In this category fall entertainment [citation omitted], and traveling expenses [citation omitted], and the cost of an actor’s wardrobe [citation omitted]. The line is not always an easy one to draw nor the test simple to apply. But we think its principle is clear. It may for practical purposes be said to constitute a distinction between those activities which, as a matter of common acceptance and universal experience, are ‘ordinary’ or usual as the direct accompaniment of business pursuits, on the one hand; and those which, though they may in some indirect and tenuous degree relate to the circumstances of a profitable occupation, are nevertheless personal in their nature, of a character applicable to human beings generally, and which exist on that plane regardless of the occupation, though not necessarily of the station in life, of the individuals concerned. See Welch v. Helvering, 290 U.S. 111.

In the latter category, we think, fall payments made to servants or others occupied in looking to the personal wants of their employers. [citation omitted]. And we include in this group nursemaids retained to care for infant children.

Decision will be entered for the respondent.

Notes and Questions:

1. The B.T.A. says that the expenses of a nursemaid “are the very essence of those ‘personal expenses the deductibility of which is expressly denied.’”

• What was the personal choice that taxpayer made in this case that made these expenses non-deductible?

2. We have already noted §§ 21 and 129. These provisions reverse the result of Smith, but not its construction of § 162.

• What do these provisions say about the underlying rationale of Smith, particularly the role of the wife and mother?

Do the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax Computation: Dependent Care Credit.

2. Limitations on Deductibility of Ordinary and Necessary Trade or Business Expenses

Consider the sources of limitation on the deductibility of expenses that taxpayer incurs to generate income that the following cases consider:

MR. JUSTICE STEWART delivered the opinion of the Court.

The question presented in this case is whether expenses incurred by a taxpayer in the unsuccessful defense of a criminal prosecution may qualify for deduction from taxable income under § 162(a), which allows a deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. …” The respondent Walter F. Tellier was engaged in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers. In 1956, he was brought to trial upon a 36-count indictment that charged him with violating the fraud section of the Securities Act of 1933 and the mail fraud statute, and with conspiring to violate those statutes. He was found guilty on all counts, and was sentenced to pay an $18,000 fine and to serve four and a half years in prison. The judgment of conviction was affirmed on appeal. In his unsuccessful defense of this criminal prosecution, the respondent incurred and paid $22,964.20 in legal expenses in 1956. He claimed a deduction for that amount on his federal income tax return for that year. The Commissioner disallowed the deduction, and was sustained by the Tax Court. The Court of Appeals for the Second Circuit reversed in a unanimous en banc decision, and we granted certiorari. We affirm the judgment of the Court of Appeals.

There can be no serious question that the payments deducted by the respondent were expenses of his securities business under the decisions of this Court, and the Commissioner does not contend otherwise. In United States v. Gilmore, 372 U.S. 39, we held that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal’” within the meaning of § 162(a). Cf. Kornhauser v. United States, 276 U.S. 145; Deputy v. du Pont, 308 U.S. 488. The criminal charges against the respondent found their source in his business activities as a securities dealer. The respondent’s legal fees, paid in defense against those charges, therefore clearly qualify under Gilmore as “expenses paid or incurred … in carrying on any trade or business” within the meaning of § 162(a).

The Commissioner also concedes that the respondent’s legal expenses were “ordinary” and “necessary” expenses within the meaning of § 162(a). Our decisions have consistently construed the term “necessary” as imposing only the minimal requirement that the expense be “appropriate and helpful” for “the development of the [taxpayer’s] business.” Welch v. Helvering, 290 U.S. 111; cf. Kornhauser v. United States, supra, at 276 U.S. 152; Lilly v. Commissioner, 343 U.S. 90, 93-94; Commissioner v. Heininger, 320 U.S. 467, 320 U.S. 471; McCulloch v. Maryland, 4 Wheat. 316, 17 U.S. 413-415. The principal function of the term “ordinary” in § 162(a) is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset. Welch v. Helvering, supra, at 290 U.S. 113-116. The legal expenses deducted by the respondent were not capital expenditures. They were incurred in his defense against charges of past criminal conduct, not in the acquisition of a capital asset. Our decisions establish that counsel fees comparable to those here involved are ordinary business expenses, even though a “lawsuit affecting the safety of a business may happen once a lifetime.” Welch v. Helvering, supra, at 290 U.S. 114. Kornhauser v. United States, supra, at 276 U.S. 152-153; cf. Trust of Bingham v. Commissioner, 325 U.S. 365, 376.

We start with the proposition that the federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources. “[T]he fact that a business is unlawful [does not] exempt it from paying the taxes that if lawful it would have to pay.” United States v. Sullivan, 274 U.S. 259. See James v. United States, 366 U.S. 213.

With respect to deductions, the basic rule, with only a few limited and well defined exceptions, is the same. During the Senate debate in 1913 on the bill that became the first modern income tax law, amendments were rejected that would have limited deductions for losses to those incurred in a “legitimate” or “lawful” trade or business. Senator Williams, who was in charge of the bill, stated on the floor of the Senate that

“[T]he object of this bill is to tax a man’s net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men’s moral characters; that is not the object of the bill at all. The tax is not levied for the purpose of restraining people from betting on horse races or upon ‘futures,’ but the tax is framed for the purpose of making a man pay upon his net income, his actual profit during the year. The law does not care where he got it from, so far as the tax is concerned, although the law may very properly care in another way.”

The application of this principle is reflected in several decisions of this Court. As recently as Commissioner v. Sullivan, 356 U.S. 27, we sustained the allowance of a deduction for rent and wages paid by the operators of a gambling enterprise, even though both the business itself and the specific rent and wage payments there in question were illegal under state law. In rejecting the Commissioner’s contention that the illegality of the enterprise required disallowance of the deduction, we held that, were we to “enforce as federal policy the rule espoused by the Commissioner in this case, we would come close to making this type of business taxable on the basis of its gross receipts, while all other business would be taxable on the basis of net income. If that choice is to be made, Congress should do it.” Id. at 356 U.S. 29. In Lilly v. Commissioner, 343 U.S. 90, the Court upheld deductions claimed by opticians for amounts paid to doctors who prescribed the eyeglasses that the opticians sold, although the Court was careful to disavow “approval of the business ethics or public policy involved in the payments. …” 343 U.S. at 97. And in Commissioner v. Heininger, 320 U.S. 467, a case akin to the one before us, the Court upheld deductions claimed by a dentist for lawyer’s fees and other expenses incurred in unsuccessfully defending against an administrative fraud order issued by the Postmaster General.

The present case falls far outside that sharply limited and carefully defined category. No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense. That is not “proscribed conduct.” It is his constitutional right. Chandler v. Fretag, 348 U.S. 3. See Gideon v. Wainwright, 372 U.S. 335. In an adversary system of criminal justice, it is a basic of our public policy that a defendant in a criminal case have counsel to represent him.

The judgment is

Affirmed.

Notes and Questions:

1. Why should the standard of “necessary” under § 162 be a minimal one, i.e., appropriate and helpful? Are there forces other than the rules of § 162 that will provide controls on the amounts that a taxpayer spends to further his/her/its business?

• Recall the statement in Welch v. Helvering: Taxpayer “certainly thought [payments to creditors of a bankrupt corporation were necessary], and we should be slow to override his judgment.”

2. The income tax is a tax only on net income. One significant exception to this – explicitly stated in the Code – is § 280E. The expenses of carrying on the trade or business of trafficking in controlled substances are not deductible.

• See, e.g., Beck v. Commissioner, T.C. Memo. 2015-149 (no deduction for expenses of marijuana business, no loss deduction under § 165 for inventory lost to DEA seizure).

3. What norms does a refusal to incorporate public policy into the Code further?

• A refusal to incorporate public policy into the Code hardly means that there is no public policy limitation on deductibility under § 162. Rather, those limitations must be explicitly stated in the statute itself.

• See Court’s discussion of the point and its third footnote.

• Note the topics covered in §§ 162(b, c, e, f, g, k, l, and m).

4. The term “ordinary” has a relatively special meaning as used in § 162. What is it?

5. In Tellier, taxpayer was a criminal. He nevertheless could deduct the “ordinary and necessary” trade or business expenses arising from this character flaw.

• Should taxpayer be permitted to deduct the ordinary and necessary expenses associated with mental “flaws?” Is Gilliam distinguishable from Tellier?

MEMORANDUM FINDINGS OF FACT AND OPINION

CHABOT, JUDGE:

FINDINGS OF FACT

….

[Taxpayer] Gilliam is, and was at all material periods, a noted artist. His works have been exhibited in numerous art galleries throughout the United States and Europe … In addition, Gilliam is, and was at all material periods, a teacher of art. On occasion, Gilliam lectured and taught art at various institutions.

Gilliam accepted an invitation to lecture and teach for a week at the Memphis Academy of Arts in Memphis, Tennessee. On Sunday, February 23, 1975, he flew to Memphis to fulfill this business obligation.

Gilliam had a history of hospitalizations for mental and emotional disturbances and continued to be under psychiatric care until the time of his trip to Memphis. In December 1963, Gilliam was hospitalized in Louisville; Gilliam had anxieties about his work as an artist. For periods of time in both 1965 and 1966, Gilliam suffered from depression and was unable to work. In 1970, Gilliam was again hospitalized. In 1973, while Gilliam was a visiting artist at a number of university campuses in California, he found it necessary to consult an airport physician; however, when he returned to Washington, D.C., Gilliam did not require hospitalization.

Before his Memphis trip, Gilliam created a 225-foot painting for the Thirty-fourth Biennial Exhibition of American Painting at the Corcoran Gallery of Art (hereinafter sometimes referred to as ‘the Exhibition’). The Exhibition opened on Friday evening, February 21, 1975. In addition, Gilliam was in the process of preparing a giant mural for an outside wall of the Philadelphia Museum of Art for the 1975 Spring Festival in Philadelphia. The budget plans for this mural were due on Monday, February 24, 1975.

On the night before his Memphis trip, Gilliam felt anxious and unable to rest. On Sunday morning, Gilliam contacted Ranville Clark (hereinafter sometimes referred to as ‘Clark’), a doctor Gilliam had been consulting intermittently over the years, and asked Clark to prescribe some medication to relieve his anxiety. Clark arranged for Gilliam to pick up a prescription of the drug Dalmane on the way to the airport. Gilliam had taken medication frequently during the preceding 10 years. Clark had never before prescribed Dalmane for Gilliam.

On Sunday, February 23, 1975, Gilliam got the prescription and at about 3:25 p.m., he boarded American Airlines flight 395 at Washington National Airport, Washington, D.C., bound for Memphis. Gilliam occupied a window seat. He took the Dalmane for the first time shortly after boarding the airplane.

About one and one-half hours after the airplane departed Washington National Airport, Gilliam began to act in an irrational manner. He talked of bizarre events and had difficulty in speaking. According to some witnesses, he appeared to be airsick and held his head. Gilliam began to feel trapped, anxious, disoriented, and very agitated. Gilliam said that the plane was going to crash and that he wanted a life raft. Gilliam entered the aisle and, while going from one end of the airplane to the other, he tried to exit from three different doors. Then Gilliam struck Seiji Nakamura (hereinafter sometimes referred to as ‘Nakamura’), another passenger, several times with a telephone receiver. Nakamura was seated toward the rear of the airplane, near one of the exits. Gilliam also threatened the navigator and a stewardess, called for help, and cried. As a result of the attack, Nakamura sustained a one-inch laceration above his left eyebrow which required four sutures. Nakamura also suffered ecchymosis of the left arm and pains in his left wrist. Nakamura was treated for these injuries at Methodist Hospital in Memphis.

On arriving in Memphis, Gilliam was arrested by Federal officials. On March 10, 1975, Gilliam was indicted. He was brought to trial in the United States District Court for the Western District of Tennessee, Western Division, on one count of violation of 49 U.S.C. § 1472(k) (relating to certain crimes aboard an aircraft in flight) and two counts of violation 49 U.S.C. § 1472(j) (relating to interference with flight crew members or flight attendants). Gilliam entered a plea of not guilty to the criminal charges. … After Gilliam presented all of his evidence, the district court granted Gilliam’s motion for a judgment of acquittal by reason of temporary insanity.

Petitioners paid $8250 and $8600 for legal fees in 1975 and 1976, respectively, in connection with both the criminal trial and Nakamura’s civil claim. In 1975, petitioners also paid $3800 to Nakamura in settlement of the civil claim.

Petitioners claimed deductions for the amounts paid in 1975 and 1976 on the appropriate individual income tax returns. Respondent disallowed the amounts claimed in both years attributable to the incident on the airplane. .

* * *

Gilliam’s trip to Memphis was a trip in furtherance of his trades or businesses.

….

OPINION

Petitioners contend that they are entitled to deduct the amounts paid in defense of the criminal prosecution and in settlement of the related civil claim under § 162. . Petitioners maintain that the instant case is directly controlled by our decision in Dancer v. Commissioner, 73 T.C. 1103 (1980). According to petitioners, ‘[t]he clear holding of Dancer is *** that expenses for litigation arising out of an accident which occurs during a business trip are deductible as ordinary and necessary business expenses.’ Petitioners also contend that Clark v. Commissioner, 30 T.C. 1330 (1958), is to the same effect as Dancer.

Respondent maintains that Dancer and Clark are distinguishable. Respondent contends that the legal fees paid are not deductible under either § 162 or § 212 because the criminal charges against Gilliam were neither directly connected with nor proximately resulted from his trade or business and the legal fees were not paid for the production of income. Respondent maintains that ‘the criminal charges which arose as a result of *** (the incident on the airplane), could hardly be deemed ‘ordinary,’ given the nature of (Gilliam’s) profession.’ Respondent contends ‘that the provisions of § 262 control this situation.’ As to the settlement of the related civil claim, respondent asserts that since Gilliam committed an intentional tort, the settlement of the civil claim constitutes a nondeductible personal expense.

We agree with respondent that the expenses are not ordinary expenses of Gilliam’s trade or business.

Section 162(a) allows a deduction for all the ordinary and necessary expenses of carrying on a trade or business. In order for the expense to be deductible by a taxpayer, it must be an ordinary expense, it must be a necessary expense, and it must be an expense of carrying on the taxpayer’s trade or business. If any one of these requirements is not met, the expense is not deductible under § 162(a). Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933); Kornhauser v. United States, 276 U.S. 145 (1928). In Deputy v. du Pont, the Supreme Court set forth a guide for application of the statutory requirement that the expense be ‘ordinary’, as follows (308 U.S. at 494-497):

[…] Ordinary has the connotation of normal, usual, or customary. To be sure, an expense may be ordinary though it happens but once in the taxpayer’s lifetime. Cf. Kornhauser v. United States, supra. Yet the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved. Welch v. Helvering, supra, 114. Hence, the fact that a particular expense would be an ordinary or common one in the course of one business and so deductible under [§ 162(a)] does not necessarily make it such in connection with another business. *** As stated in Welch v. Helvering, supra, pp. 113-114: ‘… What is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance.’

22 F. Supp. 589, 597.

One of the extremely relevant circumstances is the nature and scope of the particular business out of which the expense in question accrued. The fact that an obligation to pay has arisen is not sufficient. It is the kind of transaction out of which the obligation arose and its normalcy in the particular business which are crucial and controlling.

Review of the many decided cases is of little aid since each turns on its special facts. But the principle is clear. […] [T]he fact that the payments might have been necessary … is of no aid. For Congress has not decreed that all necessary expenses may be deducted. Though plainly necessary they cannot be allowed unless they are also ordinary.

Welch v. Helvering, supra.

… It undoubtedly is ordinary for people in Gilliam’s trades or businesses to travel (and to travel by air) in the course of such trades or businesses; however, we do not believe it is ordinary for people in such trades or businesses to be involved in altercations of the sort here involved in the course of any such travel. The travel was not itself the conduct of Gilliam’s trades or businesses. Also, the expenses here involved are not strictly a cost of Gilliam’s transportation. Finally, it is obvious that neither the altercation nor the expenses were undertaken to further Gilliam’s trades or businesses.

We conclude that Gilliam’s expenses are not ordinary expenses of his trades or businesses.

It is instructive to compare the instant case with Dancer v. Commissioner, supra, upon which petitioners rely. In both cases, the taxpayer was traveling on business. In both cases, the expenses in dispute were not the cost of the traveling, but rather were the cost of an untoward incident that occurred in the course of the trip. In both cases, the incident did not facilitate the trip or otherwise assist the taxpayer’s trade or business. In both cases, the taxpayer was responsible for the incident; in neither case was the taxpayer willful. In Dancer, the taxpayer was driving an automobile; he caused an accident which resulted in injuries to a child. The relevant expenses were the taxpayer’s payments to settle the civil claims arising from the accident. 73 T.C. at 1105. In the instant case, Gilliam was a passenger in an airplane; he apparently committed acts which would have been criminal but for his temporary insanity, and he injured a fellow passenger. Gilliam’s expenses were the costs of his successful legal defense, and his payments to settle Nakamura’s civil claim.

In Dancer, we stated as follows (73 T.C. at 1108-1109):

It is true that the expenditure in the instant case did not further petitioner’s business in any economic sense; nor is it, we hope, the type of expenditure that many businesses are called upon to pay. Nevertheless, neither factor lessens the direct relationship between the expenditure and the business. Automobile travel by petitioner was an integral part of this business. As rising insurance rates suggest, the cost of fuel and routine servicing are not the only costs one can expect in operating a car. As unfortunate as it may be, lapses by drivers seem to be an inseparable incident of driving a car. Anderson v. Commissioner (81 F.2d 457 (CA10 1936)). Costs incurred as a result of such an incident are just as much a part of overall business expenses as the cost of fuel.

(Emphasis supplied.)

Dancer is distinguishable.

In Clark v. Commissioner, supra, also relied on by petitioners, the expenses consisted of payments of (a) legal fees in defense of a criminal prosecution and (b) amounts to settle a related civil claim. In this regard, the instant case is similar to Clark. In Clark, however, the taxpayer’s activities that gave rise to the prosecution and civil claim were activities directly in the conduct of Clark’s trade or business. In the instant case, Gilliam’s activities were not directly in the conduct of his trades or businesses. Rather, the activities merely occurred in the course of transportation connected with Gilliam’s trades or businesses. And, as we noted in Dancer v. Commissioner, 73 T.C. at 1106, ‘in cases like this, where the cost is an adjunct of and not a direct cost of transporting an individual, we have not felt obliged to routinely allow the expenditure as a transportation cost deduction.’

Petitioners also rely on Commissioner v. Tellier, 383 U.S. 687 (1966), in which the taxpayer was allowed to deduct the cost of an unsuccessful criminal defense to securities fraud charges. The activities that gave rise to the criminal prosecution in Tellier were activities directly in the conduct of Tellier’s trade or business. Our analysis of the effect of Clark v. Commissioner, applies equally to the effect of Commissioner v. Tellier.

In sum, Gilliam’s expenses were of a kind similar to those of the taxpayers in Tellier and Clark; however the activities giving rise to Gilliam’s expenses were not activities directly in the conduct of his trades or businesses, while Tellier’s and Clark’s activities were directly in the conduct of their respective trades or businesses. Gilliam’s expenses were related to his trades or businesses in a manner similar to those of the taxpayer in Dancer; however Gilliam’s actions giving rise to the expenses were not shown to be ordinary, while Dancer’s were shown to be ordinary. Tellier, Clark, and Dancer all have similarities to the instant case; however, Tellier, Clark, and Dancer are distinguishable in important respects. The expenses are not deductible under § 162(a). .

We hold for respondent.

Notes and Questions:

1. Were the expenses incurred by taxpayer “necessary?”

2. By what means did the court in fact implement a public policy limitation on taxpayer’s trade or business expense? Why were the deductions that taxpayer claimed denied?

• because they were “extraordinary” for taxpayer’s trade or business?

• If so, are there trades or businesses in which such expenditures would not be extraordinary?

• What if airline employees hit taxpayer in order to control him and incurred legal expenses and paid tort damages? Should their expenses be deductible? These expenses would be the very type of expenses that Gilliam could not deduct.

3. Even when taxpayer incurs ordinary and necessary trade or business expenses, taxpayer might not be entitled to deduct them.

TANNENWALD, Judge:

….

FINDINGS OF FACT

….

During the taxable years 1973 and 1974, James [Walliser] was vice president and branch manager of the First Federal Savings & Loan Association (First Federal) of Dallas, Tex., Richardson branch office. James began his career at First Federal as a trainee in mortgage lending and an appraiser. He later became a branch manager and a loan production officer. Subsequent to the taxable years at issue, James was made the head of the interim loan department of First Federal. Prior to his initial association with First Federal in 1964, James was primarily engaged in the business of home building in Dallas County, Tex.

As branch manager of the Richardson office of First Federal, James supervised all aspects of the branch’s operations, but his primary responsibility was the marketing of permanent and interim loans. James was assigned loan production quotas, and he expected to receive annual raises in his salary if he met his yearly quotas, although First Federal was under no commitment to give James a raise in salary or a bonus if a quota was met. … James met his quotas and received salary raises at the end of 1973 and 1974.

During the taxable years at issue, petitioners traveled abroad in tour groups organized primarily for people involved in the building industry. In 1973, petitioners took two such trips. The first was to Rio de Janeiro and was sponsored by General Electric Co. (General Electric). It began on March 23, 1973, and ended on March 31, 1973. Their second trip, to London and Copenhagen, was sponsored by Fedders Co. (Fedders) and ran from October 3, 1973, to October 15, 1973.

In 1974, petitioners went to Santo Domingo on a tour organized by Fedders which began on September 27, 1974, and ended on October 4, 1974.

….

The majority of the people on a General Electric or Fedders builders’ tour were builders and developers from Texas and their spouses. The group also included lenders, title company personnel, and other users and distributors of the sponsor’s product. The dealers and builders who participated in the Fedders builders’ tours did so as part of the Fedders incentive program through which they were able to earn the cost of the tours in whole or in part by purchasing or selling a certain amount of central air conditioning equipment in a particular year. Fedders presented awards during the tours to some people it considered outstanding in its sales and promotional programs but conducted no business meetings.

The builders’ tours were arranged as guided vacation trips, with sightseeing and other recreational activities. Petitioners, however, went on the tours because James found that they provided an unusual opportunity to associate with many potential and actual customers and believed that the tours would generate business, thereby helping him to meet his loan production quotas and obtain salary raises. He spent as much time as possible talking with builders whom he already knew and getting acquainted with builders he had not previously met to make them aware of First Federal’s services and of his own skills. His conversations frequently centered on conditions in the building industry and the availability of loans for builders, but he did not negotiate specific business transactions on the tours or conduct formal business meetings. Social relationships formed or renewed on the tours between petitioners and builders and their spouses resulted in a substantial amount of loan business for First Federal.

….

Prior to 1973, First Federal had paid for James to participate in builders’ tours. During 1973 and 1974, First Federal stopped reimbursing employees for a variety of previously reimbursed expenses as part of a program of overall budget cutbacks. During the taxable years in issue, First Federal’s policy was to pay entertainment costs directly, or to provide reimbursement for expenses, when an officer of First Federal entertained current customers of the company at civic, social, or business meetings. The company did not customarily reimburse officers for the costs of goodwill meetings or trips for current customers along with prospective customers; however, the board of directors expected the officers, especially vice presidents in charge of marketing activities, to be active in cultivating new customers. First Federal did not reimburse petitioners for any travel expenses incurred in connection with the Fedders and General Electric tours taken by them in 1973 and 1974. James was, however, given leave with pay, in addition to his normal 2-week paid vacation, in order to participate in the tours.

….

On their 1973 and 1974 tax returns, petitioners deducted, as employee business expenses, one-half of the price of each of the tours (the portion attributable to James’ travel) …

OPINION

Initially, we must determine whether petitioners are entitled, under § 162, to deduct as employee business expenses costs incurred by James in connection with his travel on tours for builders organized by General Electric and Fedders. If we hold that the requirements of that section are satisfied, then we must face the further question as to the extent to which the limitations of § 274 apply.

Section 162(a)(2) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses incurred while away from home in the pursuit of a trade or business. The question is essentially one of fact. [citations omitted] Petitioners must show that the expenses were incurred primarily for business rather than social reasons and that there was a proximate relation between the cost of the builders’ tours and James’ business as an officer of First Federal. [citations omitted].

James’ primary responsibility as an officer of First Federal was marketing loans. He was assigned loan production quotas and considered yearly increases in his salary to be contingent upon meeting those quotas. The participants in the General Electric and Fedders tours were not a random group of Texas vacationers. On the contrary, they were largely builders and developers from Texas, the area in which First Federal operated. Thus, the tours were a useful means of maintaining relations with existing customers of First Federal and reaching prospective customers. Indeed, the record indicated that some of the participants considered the social relationships with James, including their association with him on the tours, as an influencing factor in their decisions to seek loans from First Federal.

First Federal expected its officers in charge of marketing activities to participate in public or social functions without reimbursement and examined their performance in this regard when evaluating their compensation and overall value to the company. [citation omitted]. James met his loan quotas in 1973 and 1974 and received raises in his salary at the end of those years. In a later year, he became head of First Federal’s interim loan department.

Moreover, the evidence tends to show that First Federal considered the trips valuable in generating goodwill. Although First Federal, which was in the midst of a program of budget cutbacks in 1973 and 1974, did not reimburse James for the tours as it had done in prior years, it continued to grant him additional leave with pay for the time he was on the tours.

Finally, the testimony of petitioners, and particularly of Carol, which we found straightforward and credible, tended to show that the tours were strenuous, and not particularly enjoyable, experiences because of the amount of time expended in cultivating business and, therefore, that petitioners did not undertake the tours for primarily personal reasons. [They took family vacations to other destinations.]

We conclude that, under the circumstances of this case, the requisite proximate relation has been shown to constitute James’ travel expenses as “ordinary and necessary” business expenses within the meaning of § 162(a)(2).

We now turn our attention to the applicability of § 274, the issue on which respondent has concentrated most of his fire. That section disallows a deduction in certain instances for expenses which would otherwise be deductible under § 162. Respondent argues that the requirements of § 274 are applicable here and have not been satisfied in that petitioners have failed: (1) To show that James’ trips were “directly related” to the active conduct of his business (§ 274(a)) …

[(a) ENTERTAINMENT, AMUSEMENT, OR RECREATION, OR QUALIFIED TRANSPORTATION EXPENSES.—

(1) IN GENERAL. – No deduction otherwise allowable under this chapter shall be allowed for any item—

(A) ACTIVITY. – With respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation …]

Petitioners urge that … § 274(a) is not applicable because the expenditures at issue were incurred for travel, not entertainment. We disagree.

Section 274(a) relates to activities of a type generally considered to constitute “entertainment, amusement, or recreation.” Reg. § 1.274-2(b) defines “entertainment, amusement, or recreation” as follows:

(b) Definitions – (1) Entertainment defined – (i) In general. For purposes of this section, the term “entertainment” means any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family. ***

(ii) Objective test. An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of this section and § 274(a) regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone. This objective test precludes arguments such as that “entertainment” means only entertainment of others or that an expenditure for entertainment should be characterized as an expenditure for advertising or public relations.

(Emphasis added.)

This regulation and the Congressional committee reports from which it is derived leave no doubt that the deductibility of an expenditure for travel, on what would objectively be considered a vacation trip, is subject to the limitations of subsection 274(a), even where the expenditure relates solely to the taxpayer himself. [citations omitted]. Furthermore, Reg. § 1.274-2(b)(1)(iii) provides that “any expenditure which might generally be considered *** either for travel or entertainment, shall be considered an expenditure for entertainment rather than for *** travel.” This regulation too has a solid foundation in the statute, which provides, in [§ 274(p)], authority for the promulgation of regulations necessary to carry out the purpose of § 274 and in the committee reports, which provide that rules be prescribed for determining whether § 274(a) should govern where another section is also applicable. H. Rept. 1447, supra; S. Rept. 1881, supra.

Although the participants in the tours that petitioners took were drawn, for the most part, from the building industry, their activities – sightseeing, shopping, dining – were the same as those of other tourists. Fedders presented some awards to persons considered outstanding in its sales or promotional programs on the tours but did not conduct any business meetings. … Under the objective test set forth in the regulations, it is irrelevant that petitioners did not regard the trips as vacations or did not find them relaxing. Clearly, the tours were of a type generally considered vacation trips and, thus, under the objective test, constituted entertainment for the purposes of § 274(a). Therefore, the [deduction is not allowed.]

….

We conclude that § 274(a) bars a deduction for the costs of James’ trips. …

Decision will be entered for the respondent.

Notes and Questions:

1. Is it appropriate that § 274 denies this taxpayer a deduction when § 162 permits it?

2. Suppose that Walliser’s employer re-instituted its policy of paying for these trips provided that Walliser present documentation of all his expenses, consistent with § 62(a)(2). What should be the tax consequences to Walliser’s employer and to Walliser when the bank reimburses him for the expense of such a tour?

• Suppose that Walliser’s employer reimbursed Walliser for an employee trade or business expense that is not for entertainment. Let’s say that the bank paid for Walliser’s personal subscription to a trade journal. Such expenditures would be deductible “below the line,” but the deduction has been suspended until 2026. Tax consequences to Walliser and to the bank?

POSNER, Circuit Judge

The taxpayers, a lawyer named Moss and his wife, appeal from a decision of the Tax Court disallowing federal income tax deductions of a little more than $1,000 in each of two years, representing Moss’s share of his law firm’s lunch expense at the Café Angelo in Chicago. …

Moss was a partner in a small trial firm specializing in defense work, mostly for one insurance company. Each of the firm’s lawyers carried a tremendous litigation caseload, averaging more than 300 cases, and spent most of every working day in courts in Chicago and its suburbs. The members of the firm met for lunch daily at the Café Angelo near their office. At lunch the lawyers would discuss their cases with the head of the firm, whose approval was required for most settlements, and they would decide which lawyer would meet which court call that afternoon or the next morning. Lunchtime was chosen for the daily meeting because the courts were in recess then. The alternatives were to meet at 7:00 a.m. or 6:00 p.m., and these were less convenient times. There is no suggestion that the lawyers dawdled over lunch, or that the Café Angelo is luxurious.

The framework of statutes and regulations for deciding this case is simple, but not clear. Section 262 of the Internal Revenue Code disallows, “except as otherwise expressly provided in this chapter,” the deduction of “personal, family, or living expenses.” Section 119 excludes from income the value of meals provided by an employer to his employees for his convenience, but only if they are provided on the employer’s premises; and § 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, including – … (2) traveling expenses (including amounts expended for meals …) while away from home….’” Since Moss was not an employee but a partner in a partnership not taxed as an entity, since the meals were not served on the employer’s premises, and since he was not away from home (that is, on an overnight trip away from his place of work, see United States v. Correll, 389 U.S. 299 (1967)), neither § 119 nor § 162(a)(2) applies to this case. The Internal Revenue Service concedes, however, that meals are deductible under § 162(a) when they are ordinary and necessary business expenses (provided the expense is substantiated with adequate records, see § 274(d)) even if they are not within the express permission of any other provision and even though the expense of commuting to and from work, a traveling expense but not one incurred away from home, is not deductible. Reg. § 1.262-1(b)(5); Fausner v. Commissioner, 413 U.S. 838 (1973) (per curiam).

The problem is that many expenses are simultaneously business expenses in the sense that they conduce to the production of business income and personal expenses in the sense that they raise personal welfare. This is plain enough with regard to lunch; most people would eat lunch even if they didn’t work. Commuting may seem a pure business expense, but is not; it reflects the choice of where to live, as well as where to work. Read literally, § 262 would make irrelevant whether a business expense is also a personal expense; so long as it is ordinary and necessary in the taxpayer’s business, thus bringing § 162(a) into play, an expense is (the statute seems to say) deductible from his income tax. But the statute has not been read literally. There is a natural reluctance, most clearly manifested in the regulation disallowing deduction of the expense of commuting, to lighten the tax burden of people who have the good fortune to interweave work with consumption. To allow a deduction for commuting would confer a windfall on people who live in the suburbs and commute to work in the cities; to allow a deduction for all business-related meals would confer a windfall on people who can arrange their work schedules so they do some of their work at lunch.

Although an argument can thus be made for disallowing any deduction for business meals, on the theory that people have to eat whether they work or not, the result would be excessive taxation of people who spend more money on business meals because they are business meals than they would spend on their meals if they were not working. Suppose a theatrical agent takes his clients out to lunch at the expensive restaurants that the clients demand. Of course he can deduct the expense of their meals, from which he derives no pleasure or sustenance, but can he also deduct the expense of his own? He can, because he cannot eat more cheaply; he cannot munch surreptitiously on a peanut butter and jelly sandwich brought from home while his client is wolfing down tournedos Rossini followed by souffle au grand marnier. No doubt our theatrical agent, unless concerned for his longevity, derives personal utility from his fancy meal, but probably less than the price of the meal. He would not pay for it if it were not for the business benefit; he would get more value from using the same money to buy something else; hence the meal confers on him less utility than the cash equivalent would. The law could require him to pay tax on the fair value of the meal to him; this would be (were it not for costs of administration) the economically correct solution. But the government does not attempt this difficult measurement; it once did, but gave up the attempt as not worth the cost, see United States v. Correll, supra, 389 U.S. at 301 n. 6. The taxpayer is permitted to deduct the whole price, provided the expense is “‘different from or in excess of that which would have been made for the taxpayer’s personal purposes.’” Sutter v. Commissioner, 21 T.C. 170, 173 (1953).

Because the law allows this generous deduction, which tempts people to have more (and costlier) business meals than are necessary, the Internal Revenue Service has every right to insist that the meal be shown to be a real business necessity. This condition is most easily satisfied when a client or customer or supplier or other outsider to the business is a guest. Even if Sydney Smith was wrong that “‘soup and fish explain half the emotions of life,’” it is undeniable that eating together fosters camaraderie and makes business dealings friendlier and easier. It thus reduces the costs of transacting business, for these costs include the frictions and the failures of communication that are produced by suspicion and mutual misunderstanding, by differences in tastes and manners, and by lack of rapport. A meeting with a client or customer in an office is therefore not a perfect substitute for a lunch with him in a restaurant. But it is different when all the participants in the meal are coworkers, as essentially was the case here (clients occasionally were invited to the firm’s daily luncheon, but Moss has made no attempt to identify the occasions). They know each other well already; they don’t need the social lubrication that a meal with an outsider provides – at least don’t need it daily. If a large firm had a monthly lunch to allow partners to get to know associates, the expense of the meal might well be necessary, and would be allowed by the Internal Revenue Service. See Wells v. Commissioner, 36 T.C.M. 1698, 1699 (1977), aff’d without opinion, 626 F.2d 868 (9th Cir. 1980). But Moss’s firm never had more than eight lawyers (partners and associates), and did not need a daily lunch to cement relationships among them.

It is all a matter of degree and circumstance (the expense of a testimonial dinner, for example, would be deductible on a morale-building rationale); and particularly of frequency. Daily – for a full year – is too often, perhaps even for entertainment of clients, as implied by Hankenson v. Commissioner, 47 T.C.M. 1567, 1569 (1984), where the Tax Court held nondeductible the cost of lunches consumed three or four days a week, 52 weeks a year, by a doctor who entertained other doctors who he hoped would refer patients to him, and other medical personnel.

We may assume it was necessary for Moss’s firm to meet daily to coordinate the work of the firm, and also, as the Tax Court found, that lunch was the most convenient time. But it does not follow that the expense of the lunch was a necessary business expense. The members of the firm had to eat somewhere, and the Café Angelo was both convenient and not too expensive. They do not claim to have incurred a greater daily lunch expense than they would have incurred if there had been no lunch meetings. Although it saved time to combine lunch with work, the meal itself was not an organic part of the meeting, as in the examples we gave earlier where the business objective, to be fully achieved, required sharing a meal.

The case might be different if the location of the courts required the firm’s members to eat each day either in a disagreeable restaurant, so that they derived less value from the meal than it cost them to buy it, cf. Sibla v. Commissioner, 611 F.2d 1260, 1262 (9th Cir. 1980); or in a restaurant too expensive for their personal tastes, so that, again, they would have gotten less value than the cash equivalent. But so far as appears, they picked the restaurant they liked most. Although it must be pretty monotonous to eat lunch the same place every working day of the year, not all the lawyers attended all the lunch meetings and there was nothing to stop the firm from meeting occasionally at another restaurant proximate to their office in downtown Chicago; there are hundreds.

An argument can be made that the price of lunch at the Café Angelo included rental of the space that the lawyers used for what was a meeting as well as a meal. There was evidence that the firm’s conference room was otherwise occupied throughout the working day, so as a matter of logic Moss might be able to claim a part of the price of lunch as an ordinary and necessary expense for work space. But this is cutting things awfully fine; in any event Moss made no effort to apportion his lunch expense in this way.

AFFIRMED.

Notes and Questions:

1. Walliser was a § 274 case. Moss was not. Why not?

• What requirement of deductibility under § 162 did taxpayer fail to meet?

2. If this firm had only monthly lunches, the court seems to say that the cost of such lunches might have been deductible. Why should such meals be treated differently than the daily lunches at Café Angelo?

3. Section 274 does not preclude deduction of 50% of the expense of food and beverage during or at entertainment events if purchased separately, provided their cost is separately stated. Notice 2018-76, I.R.B. 2018-195.

4. Another limitation on §§ 162 and 212 is § 280A, which limits taxpayer’s deductions for business use of a home.

Note: Business Use of Taxpayer’s Home: Section 280A limits deductions for business use of a dwelling unit that taxpayer (individual or S corporation) uses as a residence. Section 280A(a) provides taxpayer is entitled to no deduction for such use “[e]xcept as otherwise provided in” § 280A itself. Section 280A(c) provides those exceptions.

• Section 280A(c)(1) permits deductions when taxpayer regularly uses a portion of the dwelling “exclusively” –

• as a principal place of business, including a place that taxpayer uses for administrative or management activities of taxpayer’s trade or business, and there is no other fixed location where taxpayer conducts substantial management or administrative activities,

• as a place of business that patients, clients, or customers use to meet with taxpayer “in the normal course of his trade or business,” OR

• in connection with taxpayer’s trade or business “in the case of a separate structure which is not attached to the dwelling unit.”

• Section 280A(c)(2) permits deductions when taxpayer regularly uses space in the dwelling unit to store inventory or product samples that taxpayer sells at retail or wholesale, provided the dwelling unit is the only fixed location of taxpayer’s trade or business.

• Section 280A(c)(3) permits deductions when they are attributable to rental of the dwelling unit.

• Section 280A(c)(4) permits deductions attributable to use of a portion of the dwelling unit for licensed child or dependent care services.

Section 280A(c)(5) limits the amount of any deductions attributable to business use of the home to the gross income that taxpayer derives from such use. § 280A(c)(5)(A). Section 280A(c)(5) and Prop. Reg. § 1-280A-2(i)(5) provide a sequence in which taxpayer may claim deductions attributable to the business activity, namely –

1. deductions attributable to such trade or business and allocable to the portion of the dwelling unit that taxpayer uses that the Code would allow taxpayer even if he did not conduct a trade or business in the dwelling unit, e.g., real property taxes, § 164(a)(1), mortgage interest, § 163(h)(2)(D).

2. deductions attributable to such trade or business use that do not reduce basis, e.g., utilities, homeowners’ insurance.

3. basis-reducing deductions, i.e., depreciation.

If taxpayer’s deductions exceed his gross income derived from the business use of the dwelling unit that he uses as a home, taxpayer may carry those deductions forward to succeeding years.

• Notice that unless taxpayer operates a trade or business in the home that is genuine, in the sense that it is profitable, it is unlikely that taxpayer will ever be able to exploit all the deductions that business use of a home would generate. A taxpayer who does not carry on a profitable trade or business in the home will likely carry forward unused deductions forever.

• Notice also that the sequence of deductions that § 280A(c)(5) and Prop. Reg. § 1.280A-2(i)(5) mandate requires taxpayer first to “use up” the deductions to which he would be entitled even if he did not use his dwelling unit for business activities.

• The deductions that might motivate taxpayer to claim business use of a home are the ones to which he would not otherwise be entitled to claim, e.g., a portion of homeowners’ insurance, utilities, other expenses of home ownership, and (perhaps most importantly) depreciation. Those deductions may be effectively out of reach.

Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Trade or Business Deductions.

3. Education Expenses

Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Education Expenses.

• Read Reg. § 1.162-5.

• Read §§ 274(m)(2), 274(n).

A taxpayer may incur expenses for various educational activities, e.g., training, that he may deduct as ordinary and necessary business expenses. Recall that in Welch v. Helvering, the Court indicated that investment in one’s basic education is a nondeductible investment in human capital. Not surprisingly, then, the regulations draw lines around education undertaken to meet the minimum requirements of a trade or business or to qualify for a new trade or business. Reg. § 1.162-5 implements these distinctions.

Reg. § 1.162-5(a) states the general rule that expenditures made for education are deductible, even when those expenditures may lead to a degree, if the education –

“(1) Maintains or improves skills required by the individual in his employment or other trade or business, or

(2) Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship status, or rate of compensation.”

Id.

However, even expenditures that meet one of these two conditions are nevertheless not deductible if –

• the expenditures are “made by an individual for education which is required of him in order to meet the minimum educational requirements for qualification in his employment or other trade or business. … The fact that an individual is already performing service in an employment status does not establish that he has met the minimum educational requirements for qualification in that employment. Once an individual has met the minimum educational requirements for qualification in his employment or other trade or business (as in effect when he enters the employment or trade or business), he shall be treated as continuing to meet those requirements even though they are changed.” Reg. § 1.162-5(b)(2)(i). OR

• the expenditures are “made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.” Reg. § 1.162-5(b)(3)(i).

Consider:

Pere Alegal works for a downtown Memphis law firm. He works under the supervision of attorneys and does the same type of work that the firm’s attorneys do. The firm’s partners advise Alegal that if he does not obtain a law license, he will not be retained. Alegal therefore enrolled in one of the nation’s best-value law schools. Pere will continue to work for the firm. Alegal incurs the expenses of tuition, books, etc. At the end of the educational program, Alegal passed the bar examination and obtained a license to practice law. Alegal continues to work for the firm and in fact his job functions did not change at all.

• If Alegal sought to deduct the expenses of his legal education, could he argue that his job functions did not change at all once he obtained his law license?

• Is it relevant that a law license did not cause Alegal to take up a new trade or business?

The costs of earning taxable income are offset against that income. Ours is a system that taxes only “net income.” The Tax Code requires an annual accounting of income and deductible expenses. A taxpayer’s income may fluctuate between losses and profitability from one year to the next. This could raise serious problems of fairness if losses cannot offset gross income. Section 172 permits some netting of business gains and losses between different tax years by permitting taxpayer to deduct net operating losses incurred in one tax year against his taxable income in a succeeding tax year.

• Read § 172(c). It defines a “net operating loss” (NOL) to be the excess of deductions allowed over gross income.

• Read § 172(d). Its effect is to limit the deductions that would “take taxpayer’s taxable income negative” to essentially trade or business expenses. For individual taxpayers, capital losses are deductible only to the extent of capital gains, § 172(d)(2)(A); no deduction is allowed for personal exemptions, § 172(d)(3); nonbusiness deductions are allowed only to the extent of taxpayer’s non-trade or business income, § 172(d)(4); the § 199A qualified business income deduction is not allowed, § 172(d)(8).

• Section 172(a) permits NOL carryovers and limited carrybacks to reduce taxpayer’s taxable income. Taxpayer may deduct the lesser of –

• net operating loss carryovers to the taxable year plus net operating loss carrybacks

• OR

• 80% of taxpayer’s taxable income computed without regard to the NOL deduction. § 172(a).

• Unused NOLs carry over indefinitely. § 172(b)(1)(A)(ii). Taxpayer must carry an NOL to the earliest taxable year to which it can be carried. § 170(b)(2).

• The effect of allowing a carryback is to get money into the pockets of the affected taxpayer(s) quickly.

Consider:

In 2018, taxpayer had net losses of $500,000. Taxpayer is neither a farmer nor an insurance company. Determine taxpayer’s taxable income under the rules of § 172 if taxpayer’s taxable income would otherwise have been the following amounts for the years in question.

• 2017: $100,000

• 2018: ($500,000)

• 2019: $50,000.

• 2020: $75,000.

• 2021: $120,000.

• 2022: $165,000

• 2023: $200,000

• 2024: $100,000

• 2025: $60,000

D. Special Rules to Encourage Business Activity and Exploitation of Natural Resources

1. Section 199A: “Qualified Business Income” Deduction

• The second of the two amounts named by § 199A(a) is fairly easily measured. Section 199A measures the first of the two amounts (CQBIA) more granularly. Once measured, § 199A(a) requires a comparison.

• Observation: If a taxpayer has no income from a business that he owns, his “combined qualified business income amount” will be $0. Obviously that amount will be the lesser of two figures. Thus § 199A only helps taxpayers who own a trade or business.

• Defining the taxpayer’s “combined qualified business income amount” requires us to dive into the middle of Section 199A and then to work our way back up.

• Initially, note that a taxpayer’s CQBIA is 20% of the sum of a taxpayer’s “qualified business income” subject to conditions applicable to each “qualified trade or business,” plus 20% of his [qualified REIT dividends income plus qualified publicly traded partnership income]. § 199A(b)(1).

• Section 199A defines “qualified trade or business” as any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. § 199A(d)(1). BUT: the definition of “qualified trade or business” varies, depending on the level of a taxpayer’s “taxable income.”

Threshold Income Amounts: Relevance to Specified Trade or Businesses, and to CQBIA. Section 199A(e)(2) defines a “threshold amount,” which serves as the threshold at which restrictions on the § 199A deduction “phase in.” The “threshold amount” is $157,500, indexed for inflation, § 199A(e)(2)(B), and twice that amount for a joint return. § 199A(e)(2)(A). The “threshold amount” is relevant for two purposes:

• (1) Special rules limit that availability of the § 199A deduction for taxpayers engaged in a “specified service trade or business” (SSTB). A “specified service trade or business” is a “trade or business involving the performance of services in the fields of” health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage service, and any trade or business where the principal asset is the reputation of one or more of its employees or owners, § 1202(e)(3)(A), cross-referenced and as modified by § 199A(d)(2) (not including engineering or architecture). Additionally, a “specified trade or business” is any trade or business “which involves performance of services that consist of investing, trading, or dealing in securities …, partnership interests, or commodities …” § 199A(d)(2)(B). A taxpayer engaged in an SSTB whose “taxable income” is greater than the threshold amount will see the availability of a § 199A phase out altogether. See § 199A(d)(1)(A), § 199A(d)(2).

• (2) Taxpayers engaged in any trade or business (including an SSTB) that generates QBI whose “taxable income” is less than the threshold amount may include 20% of that QBI in their CQBIA, irrespective of conditions applicable to taxpayers whose “taxable income” is more than the threshold amount. See § 199A(d)(3) (SSTB), § 199A(b)(3)(A) (wage and basis requirements). But: wage and property restrictions “phase in” as the “taxable income” of the owner of a non-SSTB rises above the threshold amount by $50,000 (or $100,000 for taxpayers married filing jointly), infra.

Taxpayer’s CQBIA: A taxpayer’s CQBIA is the sum of –

• 20% of the QBI of each qualified trade or business, but not more than the greater of

There are three different treatments of taxpayer’s QBI – the treatment is dependent on the level of taxpayer’s “taxable income.”

• (1) Taxpayers who own a “qualified trade or business” that is not a “specified service trade or business” may deduct their CQBIA computed without regard to the W-2 and/or qualified property conditions if the taxpayer’s taxable income does not exceed the indexed threshold amount. § 199A(b)(3)(A).

• (2) If taxpayer’s taxable income does exceed the indexed threshold amount by less than $50,000 ($100,000 for a taxpayer married filing jointly), and if taxpayer’s QBI determined without regard to the W-2 and qualified property conditions would be greater than the relevant W-2 wage/property basis limitation, then taxpayer must reduce his QBI by the percentage of $50,000 ($100,000 for taxpayers married filing jointly) by which 20% of his QBI exceeds the otherwise applicable W-2 and qualified property conditions. § 199A(b)(3)(B).

• Example: Same facts except that taxpayer paid $0 in W-2 wages. The W-2 wage limitation is $0. Taxpayer’s potential § 199A deduction exceeds the wage limitation by $200,000. 35% of $200,000 = $70,000. Taxpayer may claim a § 199A deduction of $130,000.

• (3) When a taxpayer’s “taxable income” exceeds the “threshold amount” plus $50,000 ($100,000 for taxpayers married filing jointly), taxpayer computes his § 199A deduction by applying the W-2/property basis rules noted above.

Specified Service Trade or Business (SSTB:) Taxpayers engaged in a “specified service trade or business” may include the income they derive from such a trade or business in their CQBIA if their “taxable income” is less than the threshold level. The amount of SSTB income that they may include in the CQBIA decreases to $0 as their taxable income rises above the threshold. See § 199A(b)(3)(A), § 199A(d)(3). Thus, there are three levels of § 199A deduction for a taxpayer engaged in an SSTB:

• (1) Taxpayers whose “taxable income” is less than the threshold amount and are engaged in an SSTB may treat all of their trade or business income as QBI without restrictions.

• (2) Taxpayers engaged in an SSTB whose “taxable income” is greater than the threshold amount but less than the threshold amount plus $50,000 ($100,000 for taxpayers married filing jointly) may include in their QBI the “applicable percentage” of all the SSTB income items. The same “applicable percentage” applies to the wage/basis limitations restrictions applicable to CQBIA, infra. The “applicable percentage” is 100% minus the percentage that taxpayer’s excess “taxable income” is relative to $50,000 ($100,000 for taxpayers married filing jointly). § 199A(d)(3). Taxpayer’s excess “taxable income” is the amount by which taxpayer’s “taxable income” exceeds the threshold amount.

1 – [($200,000 – $157,500)/$50,000]

1 -$42,500/$50,000

1 – 0.85

0.15, or 15%

20% of $18,750, i.e., $3750 or

50% of $6000, i.e., $3000.

Taxpayer may take a § 199A deduction of $3000.

• (3) Taxpayers engaged in an SSTB with taxable income greater than the threshold amount plus $50,000 ($100,000 for taxpayers married filing jointly) are not entitled to any § 199A deduction.

See generally Robert E. Ward, Tax Cuts and Jobs Act of 2017 – Individual Tax Provisions, Taxes the Tax Magazine 49, 51-53 (July 2018).

QBI is of course included in a taxpayer’s “taxable income.” The difference between taxpayer’s “taxable income” and “net capital gain” will be greater than a taxpayer’s CQBIA when the taxpayer derives a substantial portion of his taxable income from capital gains and “qualified dividends.” As a taxpayer’s net capital gain increases, eventually the taxpayer’s CQBIA becomes the greater figure.

• Describe a typical taxpayer for whom the CQBIA would be the greater amount.

Comment: Section 199A replaced § 199, a measure designed to encourage all taxpayers, including corporations, to engage in manufacturing trades or businesses in the United States. Section 199A, on the other hand, provides benefits only to “pass-through” entities and sole proprietorships. The justification for this different treatment for corporations lies in the fact that the TCJA reduced the top corporate tax rate from 35% to 21%. By defining the limits of the § 199A deduction through reference to W-2 wages and depreciable property used to generate income effectively connected with a trade or business within the United States, Congress clearly aims to encourage certain forms of economic activity within the United States. Notice that § 199A is not part of the Code’s methods of determining a taxpayer’s net income. Rather, it provides a reward for doing something that Congress wants pass-through entities that own a trade or business to do, i.e., generate taxable income in the United States. And: the more profit such a taxpayer can derive from his domestic economic activities, the greater his deduction.

Problems:

*In these problems, use the figures that appear in the text of § 199A, not the figures that have been indexed for inflation.

1. Mary Taxpayer lives in a medium-sized town with a large university. Mary and her husband live only a few blocks from the university. She and her husband file their income tax return married filing jointly. Taxpayer and husband both have jobs from which they derive employment income. Their wage income from these jobs is $250,000. They have $50,000 of net capital gain. In addition, Mary has a t-shirt silk screening business that she runs out of her garage. The university has athletic teams that participate in several sports. When there is a home game, thousands of people descend on the town to attend the games. Mary pays attention to the athletic schedules and designs and produces t-shirts in only a few hours with timely messages. She sells the t-shirts to persons that pass by several kiosks that she rents. Her gross revenue from t-shirt sales for the tax year is $180,000. Deductions for supplies and kiosk rental come to $30,000. She pays two employees a total of $40,000 in wages. She has no “qualified REIT dividends” or “qualified publicly-traded partnership income.”

1A. How much can Mary and her husband claim as a § 199A deduction?

1B. What if Mary and her husband had total taxable wages income from their other jobs of $100,000, and still had the same capital gain and business income from the sale of t-shirts?

1C. What if Mary and her husband had total taxable income from their other jobs of $500,000?

2. Mike Perch is a baseball player for the Rockville Hellions. He makes a minor league salary and works in the off-season in a brewery where his employer paid him wages. His “taxable income” from these jobs is $50,000. He also made $10,000 of net capital gain. On the side, he has his own business as a personal trainer “to the stars.” He grossed $85,000 as a personal trainer. He paid an assistant, Lopez Schaden, an illegal immigrant, $20,000 cash under-the-table. These are all of his expenses. Hence, he netted $65,000 as a personal trainer. Perch lives alone in an apartment and his tax filing status is single. Perch has no “qualified REIT dividends” or “qualified publicly-traded partnership income.”

2A. How much can Perch claim for a § 199A deduction?

2B. Suppose Perch’s “taxable income” from his wages as a baseball player and brewery worker was $100,000. Furthermore, suppose that Lopez Schaden is not an illegal immigrant and that the wages Perch paid him are W-2 wages. How much could Perch claim as a § 199A deduction?

2C. Suppose Perch made the major leagues and quit his job at the brewery. His salary jumped to $500,000. He continued his trade or business of being a personal trainer with the same revenue and expenses. How much could Perch claim as a § 199A deduction?

2. Section 611: The Depletion Deduction

We have encountered at several points the principle that taxpayer’s consumption of only a part of a productive asset to generate taxable income entitles taxpayer to a deduction for only that amount of consumption. Such consumption represents a taxpayer’s de-investment in the asset and so must result in a reduction of basis. We take up here the actual mechanics of some of the Code’s depreciation provisions. The following case provides a good review of depreciation principles and congressional tinkering with them as a means of pursuing certain economic policies.

McKEE, Circuit Judge:

In this appeal from a decision of the United States Tax Court we are asked to decide if a valuable bass viol can be depreciated under the Accelerated Cost Recovery System when used as a tool of trade by a professional musician even though the instrument actually increased in value while the musician owned it. We determine that, under the facts before us, the taxpayer properly depreciated the instrument and therefore affirm the decision of the Tax Court.

I.

Brian Liddle, the taxpayer here, is a very accomplished professional musician. Since completing his studies in bass viol at the Curtis Institute of Music in 1978, he has performed with various professional music organizations, including the Philadelphia Orchestra, the Baltimore Symphony, the Pennsylvania ProMusica and the Performance Organization.

In 1984, after a season with the Philadelphia Orchestra, he purchased a 17th century bass viol made by Francesco Ruggeri (c. 1620-1695), a luthier who was active in Cremona, Italy. Ruggeri studied stringed instrument construction under Nicolo Amati, who also instructed Antonio Stradivari. Ruggeri’s other contemporaries include the craftsmen Guadanini and Guarneri. These artisans were members of a group of instrument makers known as the Cremonese School.

Liddle paid $28,000 for the Ruggeri bass, almost as much as he earned in 1987 working for the Philadelphia Orchestra. The instrument was then in an excellent state of restoration and had no apparent cracks or other damage. Liddle insured the instrument for its then-appraised value of $38,000. This instrument was his principal instrument and he used it continuously to earn his living, practicing with it at home as much as seven and one-half hours every day, transporting it locally and out of town for rehearsals, performances and auditions. Liddle purchased the bass because he believed it would serve him throughout his professional career – anticipated to be 30 to 40 years.

Despite the anticipated longevity of this instrument, the rigors of Liddle’s profession soon took their toll upon the bass and it began reflecting the normal wear and tear of daily use, including nicks, cracks, and accumulations of resin. At one point, the neck of the instrument began to pull away from the body, cracking the wood such that it could not be played until it was repaired. Liddle had the instrument repaired by renown [sic] artisans. However, the repairs did not restore the instrument’s “voice” to its previous quality. At trial, an expert testified for Liddle that every bass loses mass from use and from oxidation and ultimately loses its tone, and therefore its value as a performance instrument decreases. Moreover, as common sense would suggest, basses are more likely to become damaged when used as performance instruments than when displayed in a museum. Accordingly, professional musicians who use valuable instruments as their performance instruments are exposed to financial risks that do not threaten collectors who regard such instruments as works of art, and treat them accordingly.

There is a flourishing market among nonmusicians for Cremonese School instruments such as Mr. Liddle’s bass. Many collectors seek primarily the “label”, i.e., the maker’s name on the instrument as verified by the certificate of authenticity. As nonplayers, they do not concern themselves with the physical condition of the instrument; they have their eye only on the market value of the instrument as a collectible. As the quantity of these instruments has declined through loss or destruction over the years, the value of the remaining instruments as collectibles has experienced a corresponding increase.

Eventually, Liddle felt the wear and tear had so deteriorated the tonal quality of his Ruggeri bass that he could no longer use it as a performance instrument. Rather than selling it, however, he traded it for a Domenico Busan 18th century bass in May of 1991. The Busan bass was appraised at $65,000 on the date of the exchange, but Liddle acquired it not for its superior value, but because of the greater tonal quality.

Liddle and his wife filed a joint tax return for 1987, and claimed a depreciation deduction of $3,170 for the Ruggeri bass under the Accelerated Cost Recovery System (“ACRS”), § 168. The Commissioner disallowed the deduction asserting that the “Ruggeri bass in fact will appreciate in value and not depreciate.” Accordingly, the Commissioner assessed a deficiency of $602 for the tax year 1987. The Liddles then filed a petition with the Tax Court challenging the Commissioner’s assertion of the deficiency. A closely divided court entered a decision in favor of the Liddles. This appeal followed.

II.

The Commissioner originally argued that the ACRS deduction under § 168 is inappropriate here because the bass actually appreciated in value. However, the Commissioner has apparently abandoned that theory, presumably because an asset can appreciate in market value and still be subject to a depreciation deduction under tax law. Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277 (1966) (“tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation.”); Noyce v. Commissioner, 97 T.C. 670, 1991 WL 263146 (1991) (taxpayer allowed to deduct depreciation under § 168 on an airplane that appreciated in economic value from the date of purchase to the time of trial).

Here, the Commissioner argues that the Liddles can claim the ACRS deduction only if they can establish that the bass has a determinable useful life. Since Mr. Liddle’s bass is already over 300 years old, and still increasing in value, the Commissioner asserts that the Liddles can not establish a determinable useful life and therefore can not take a depreciation deduction. In addition, the Commissioner argues that this instrument is a “work of art” which has an indeterminable useful life and is therefore not depreciable.

… Prior to 1981, § 167 governed the allowance of depreciation deductions with respect to tangible and intangible personality. Section 167 provided, in relevant part, as follows:

Sec. 167. DEPRECIATION

(a) General Rule. – There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) –

(1) of property used in the trade or business, or

(2) of property held for the production of income.

26 U.S.C. § 167(a).

The regulations promulgated under § 167 provided that in order to qualify for the depreciation deduction, the taxpayer had to establish that the property in question had a determinable useful life. Reg. § 1.167(a)-1(a) and (b). The useful life of an asset was not necessarily the useful life “inherent in the asset but [was] the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business….” Reg. § 1.167(a)-1(b). Nonetheless, under § 167 and its attendant regulations, a determinable useful life was the sine qua non for claiming the deduction. See, Harrah’s Club v. United States, 661 F.2d 203, 207 (1981) (“Under the regulation on depreciation, a useful life capable of being estimated is indispensable for the institution of a system of depreciation.”).

Under § 167, the principal method for determining the useful life of personalty was the Asset Depreciation Range (“ADR”) system. Personalty eligible for the ADR system was grouped into more than 100 classes and a guideline life for each class was determined by the Treasury Department. See Reg. § 1.167(a)-11. A taxpayer could claim a useful life up to 20% longer or shorter than the ADR guideline life. Reg.§ 1.167(a)-11(4)(b). The ADR system was optional with the taxpayer. Reg. § 1.167(a)-11(a). For personalty which was not eligible for ADR, and for taxpayers who did not choose to use ADR, the useful life of an asset was determined according to the unique circumstances of the particular asset or by an agreement between the taxpayer and the Internal Revenue Service. Staff of the Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, 97th Cong. …

In 1981, convinced that tax reductions were needed to ensure the continued economic growth of the country, Congress passed the Economic Recovery Tax Act of 1981, P. L. 97-34 (“ERTA”). Id. It was hoped that the ERTA tax reduction program would “help upgrade the nation’s industrial base, stimulate productivity and innovation throughout the economy, lower personal tax burdens and restrain the growth of the Federal Government.” Id. Congress felt that prior law and rules governing depreciation deductions need to be replaced “because they did not provide the investment stimulus that was felt to be essential for economic expansion.” Id. Further, Congress believed that the true value of the depreciation deduction had declined over the years because of high inflation rates. Id. As a result, Congress believed that a “substantial restructuring” of the depreciation rules would stimulate capital formation, increase productivity and improve the country’s competitiveness in international trade. Id. Congress also felt that the prior rules concerning the determination of a useful life were “too complex”, “inherently uncertain” and engendered “unproductive disagreements between taxpayers and the Internal Revenue Service.” Id. To remedy the situation, Congress decided

that a new capital cost recovery system should be structured which de-emphasizes the concept of useful life, minimizes the number of elections and exceptions and is easier to comply with and to administer.

Id.

Accordingly, Congress adopted the Accelerated Cost Recovery System (“ACRS”) in ERTA. The entire cost or other basis of eligible property is recovered under ACRS eliminating the salvage value limitation of prior depreciation law. General Explanation of the Economic Recovery Tax Act of 1981 at 1450. ACRS was codified in I.R.C. § 168, which provided, in relevant part, as follows:

Sec. 168. Accelerated cost recovery system

(a) Allowance of Deduction. – There shall be allowed as a deduction for any taxable year the amount determined under this section with respect to recovery property.

(b) Amount of Deduction.—

(1) In general. – Except as otherwise provided in this section, the amount of the deduction allowable by subsection (a) for any taxable year shall be the aggregate amount determined by applying to the unadjusted basis of recovery property the applicable percentage determined in accordance with the following table:

* * * * * *

(c) Recovery Property. – For purposes of this title –

(1) Recovery Property Defined. – Except as provided in subsection (e), the term “recovery property” means tangible property of a character subject to the allowance for depreciation –

(A) used in a trade or business, or

(B) held for the production of income.

26 U.S.C. § 168.

The Commissioner argues that ERTA § 168 did not eliminate the pre-ERTA § 167 requirement that tangible personalty used in a trade or business must also have a determinable useful life in order to qualify for the ACRS deduction. She argues that the phrase “of a character subject to the allowance for depreciation” demonstrates that the pre-ERTA § 167 requirement for a determinable useful life is the threshold criterion for claiming the § 168 ACRS deduction.

Much of the difficulty inherent in this case arises from two related problems. First, Congress left § 167 unmodified when it added § 168; second, § 168 contains no standards for determining when property is “of a character subject to the allowance for depreciation.” In the absence of any express standards, logic and common sense would dictate that the phrase must have a reference point to some other section of the Internal Revenue Code. Section 167(a) would appear to be that section. As stated above, that section provides that “[t]here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear … of property used in a trade or business….” The Commissioner assumes that all of the depreciation regulations promulgated under § 167 must, of necessity, be imported into § 168. That importation would include the necessity that a taxpayer demonstrate that the asset have a demonstrable useful life, and (the argument continues) satisfy the phrase “tangible property of a character subject to the allowance for depreciation” in § 168.

However, we do not believe that Congress intended the wholesale importation of § 167 rules and regulations into § 168. Such an interpretation would negate one of the major reasons for enacting the Accelerated Cost Recovery System. Rather, we believe that the phrase “of a character subject to the allowance for depreciation” refers only to that portion of § 167(a) which allows a depreciation deduction for assets which are subject to exhaustion and wear and tear. Clearly, property that is not subject to such exhaustion does not depreciate. Thus, we hold that “property of a character subject to the allowance for depreciation” refers to property that is subject to exhaustion, wear and tear, and obsolescence. However, it does not follow that Congress intended to make the ACRS deduction subject to the § 167 useful life rules, and thereby breathe continued life into a regulatory scheme that was bewildering, and fraught with problems, and required “substantial restructuring.”

We previously noted that Congress believed that prior depreciation rules and regulations did not provide the investment stimulus necessary for economic expansion. Further, Congress believed that the actual value of the depreciation deduction declined over the years because of inflationary pressures. In addition, Congress felt that prior depreciation rules governing the determination of useful lives were much too complex and caused unproductive disagreements between taxpayers and the Commissioner. Thus, Congress passed a statute which “de-emphasizes the concept of useful life.” General Explanation of the Economic Recovery Tax Act of 1981 at 1449. Accordingly, we decline the Commissioner’s invitation to interpret § 168 in such a manner as to re-emphasize a concept which Congress has sought to “de-emphasize.”

The Commissioner argues that de-emphasis of useful life is not synonymous with abrogation of useful life. As a general statement, that is true. However, the position of the Commissioner, if accepted, would reintroduce unproductive disputes over useful life between taxpayers and the Internal Revenue Service. Indeed, such is the plight of Mr. Liddle.

Congress de-emphasized the § 167 useful life rules by creating four short periods of time over which taxpayers can depreciate tangible personalty used in their trade or business. These statutory “recovery periods … are generally unrelated to, but shorter than, prior law useful lives.” General Explanation of the Economic Recovery Tax Act of 1981 at 1450. The four recovery periods are, in effect, the statutorily mandated useful lives of tangible personalty used in a trade or business.

The recovery periods serve the primary purpose of ERTA. Once a taxpayer has recovered the cost of the tangible personalty used in a trade or business, i.e., once the taxpayer has written off the asset over the short recovery period, his or her basis in that asset will be zero and no further ACRS deduction will be allowed. To avail himself or herself of further ACRS deductions, the taxpayer will have to purchase a new asset. Thus, because the recovery period is generally shorter than the pre-ERTA useful life of the asset, the taxpayer’s purchase of the new asset will increase capital formation and new investment and, as a result, promote the Congressional objective for continued economic expansion.

Thus, in order for the Liddles to claim an ACRS deduction, they must show that the bass is recovery property as defined in § 168(c)(1). It is not disputed that it is tangible personalty which was placed in service after 1980 and that it was used in Brian Liddle’s trade or business. What is disputed is whether the bass is “property of a character subject to the allowance for depreciation.” We hold that that phrase means that the Liddles must only show that the bass was subject to exhaustion and wear and tear. The Tax Court found as a fact that the instrument suffered wear and tear during the year in which the deduction was claimed. That finding was not clearly erroneous. Accordingly, the Liddles are entitled to claim the ACRS deduction for the tax year in question.

Similarly, we are not persuaded by the Commissioner’s “work of art” theory, although there are similarities between Mr. Liddle’s valuable bass, and a work of art. The bass, is highly prized by collectors; and, ironically, it actually increases in value with age much like a rare painting. Cases that addressed the availability for depreciation deductions under § 167 clearly establish that works of art and/or collectibles were not depreciable because they lacked a determinable useful life. See Associated Obstetricians and Gynecologists, P.C. v. Commissioner, 762 F.2d 38 (6th Cir.1985) (works of art displayed on wall in medical office not depreciable); Hawkins v. Commissioner, 713 F.2d 347 (8th Cir.1983) (art displayed in law office not depreciable); Harrah’s Club v. United States, 661 F.2d 203 (1981) (antique automobiles in museum not depreciable). See also, Rev. Rul. 68-232 (“depreciation of works of art generally is not allowable because ‘[a] valuable and treasured art piece does not have a determinable useful life.’”).

… In Brian Liddle’s professional hands, his bass viol was a tool of his trade, not a work of art. It was as valuable as the sound it could produce, and not for its looks. Normal wear and tear from Liddle’s professional demands took a toll upon the instrument’s tonal quality and he, therefore, had every right to avail himself of the depreciation provisions of the Internal Revenue Code as provided by Congress.

III.

Accordingly, for the reasons set forth above, we will affirm the decision of the tax court.

Notes and Questions:

1. Note the court’s account of the evolution of depreciation law. In its first footnote, the court noted that “recovery property” is no longer part of § 168. Section 168 now applies to “any tangible property.”

2. The Second Circuit reached a similar result in Simon v. Commissioner, 68 F.3d 41 (2d Cir. 1995), Nonacq. 1996-29 I.R.B. 4, 1996-2 C.B. 1, 1996 WL 33370246 (cost recovery allowance for a violin bow).

Note: Sections 167 and 168

Section 167 still governs depreciation. It has been supplemented – to the point that it has been replaced – by § 168 for tangible property – but not for intangible property. The allowable depreciation deduction of § 167(a) is what is described in § 168 when it is applicable. § 168(a). When § 168 is applicable, its application is mandatory. § 168(a) (“shall be determined”). Application of § 168 is much more mechanical and predictable than application of § 167. The Third Circuit described the mechanics of applying § 167 – and of course, the greater accuracy that § 167 (may have) yielded came at a high administrative cost, both to the taxpayer and to the IRS. The Commissioner’s argument that taxpayer must demonstrate that an asset has a “determinable useful life” in order to claim a deduction for depreciation is an accurate statement of the law of § 167. Applying § 167 required placing an asset into an “Asset Depreciation Range” (ADR), deriving its useful life, determining its future “salvage value,” and then calculating the actual depreciation deduction according to an allowable method. The court in Liddle described this system as “bewildering, and fraught with problems[.]” While ADRs are no longer law, they are still used to determine the “class life” of an asset which in turn determines the type of property that it is – whether 3-year, 5-year, 7-year, 10-year, 15-year, or 20-year property. § 168(e)(1).

The late 1970s and early 1980s was a time of slow economic growth and very high inflation. The court describes the congressional response, i.e., the Economic Recovery Tax Act of 1981 (ERTA). Clearly, Congress – at the urging of President Reagan – was using tax rules as a device to stimulate the economy. Congress modified the system so that property placed in service in 1986 and after would be subject to the “Modified Accelerated Cost Recovery System” (MACRS). Sufficient time has passed that we do not often have to distinguish between ACRS and MACRS; often we simply refer to the current system as ACRS. Notice that § 168 uses the phrase “accelerated cost recovery system” (ACRS) – implying that we no longer consider this to be “depreciation.” As we see in the succeeding paragraphs, taxpayers who place property in service to which § 168 applies may “write it off” much faster than they could under the old rules. The Third Circuit in Liddle explained what Congress was trying to accomplish by adopting these rules.

Section 168(e) requires that we identify the “classification of property.” Certain property is classified as 3-year property, 5-year property, 7-year property, 10-year property, 15-year property, and 20-year property. § 168(e)(3). Property not otherwise described is first defined according to the old class life rules, § 168(e)(1), § 168(i)(1), and then placed into one of these classifications. For such properties, the recovery period corresponds to the classification of the property. See § 168(c). In addition, § 168(b)(3) names certain properties whose recovery period is prescribed in § 168(c).

• You should read through these sub-sections – particularly (and in this order) § 168(e)(3), § 168(e)(1), and § 168(c).

• Notice that § 168(e)(3)(C)(v) provides that property without a class life and not otherwise classified is classified as 7-year property. Section 168(e)(3)(C)(v) thus serves as a sort of “default” provision when taxpayers purchase items such as bass viols. At the time the Liddles filed their tax return, the default period was five years.

Section 168(b)(4) treats salvage value as zero. This eliminates one point of dispute between taxpayers and the IRS. The basis for depreciation is the adjusted basis provided in § 1011. § 167(c)(1).

Section 168(d) prescribes certain “conventions.” We generally treat all property to which § 168 applies as if it were placed in service or disposed of at the midpoint of the taxpayer’s taxable year. § 168(d)(1 and 4(A) (“half-year convention”)). In the case of real property, we treat it as if it were placed in service or disposed of at the midpoint of the month in which it was placed in service or disposed of. § 168(d)(2 and (4)(B) (“mid-month convention”)). A special rule precludes the abuse of these conventions through back-loading. We treat all property to which § 168 applies as if it were placed in service at the midpoint of the quarter in which it was placed in service if more than 40% of the aggregate bases of such property was placed in service during the last quarter of the taxpayer’s tax year. § 168(d)(3)(A). In making this 40% determination, taxpayer does not count nonresidential real property, residential rental property, a railroad grading or tunnel bore, and property placed in service and disposed of during the same taxable year. § 168(d)(3)(B).

Section 168(b) prescribes three cost recovery methods. The straight-line method applies to certain property for which the recovery period is relatively long. § 168(b)(3). This of course means that taxpayer divides the item’s basis by the applicable recovery period. In the first and last year of ownership, taxpayer applies the applicable convention to determine his “cost recovery” deduction. A more rapid method of cost recovery applies to property whose classification is 15 or 20 years, i.e., 150% of declining balance. § 168(b)(2)(A). This method also applies to specifically named property. § 168(b)(2)(B and C). A still more rapid method of cost recovery applies to 3-year, 5-year, 7-year, and 10-year property, i.e., 200% of declining balance. § 168(a).

• A taxpayer may irrevocably elect to apply one of the slower methods of cost recovery to one or more classes of property. § 168(b)(2)(C), § 168(b)(3)(D), § 168(b)(5).

• Rather than work through the 150% and 200% of declining balance methods of cost recovery, we are fortunate that the IRS has promulgated Rev. Proc. 87-57. This revenue procedure has several tables that provide the appropriate multiplier year by year for whatever the recovery period for certain property is. The tables incorporate and apply the depreciation method and the appropriate convention.

• Familiarize yourself with these tables.

Section 168(g)(2) provides an “alternate depreciation system” which provides for straight-line cost recovery over a longer period than the rules of § 168 noted thus far. Taxpayer may irrevocably elect to apply the “alternate depreciation system” to all the property in a class placed in service during the taxable year. § 168(g)(7). Taxpayer may make this election separately with respect to each nonresidential real property or residential rental property. § 168(g)(7).

• A taxpayer might make such an election to avoid paying the alternative minimum tax. See § 56(a)(1).

Accelerating cost recovery is one policy tool that Congress may use to encourage investment in certain types of property at certain times. See § 168(k), infra.

Consider:

1. Taxpayer purchased a racehorse on January 2, 2019 for $10,000 and “placed it in service” immediately. Taxpayer purchased no other property subject to ACRS allowances during the year.

• What is Taxpayer’s ACRS allowance for 2021?

Taxpayer sold the horse on December 31, 2021 for $9000.

• What is Taxpayer’s adjusted basis in the racehorse?

• What is Taxpayer’s taxable gain from this sale?

2. Taxpayer purchased a “motorsports entertainment complex” on October 1, 2019 for $10M. See § 168(e)(3)(C)(ii). Assume that there is no backloading problem.

• What is Taxpayer’s ACRS allowance for 2019?

• What is Taxpayer’s ACRS allowance for 2020?

• What is Taxpayer’s ACRS allowance for 2021?

• What is Taxpayer’s ACRS allowance for 2022?

• What is Taxpayer’s ACRS allowance for 2023?

• What is Taxpayer’s ACRS allowance for 2024?

• What is Taxpayer’s ACRS allowance for 2025?

• What is Taxpayer’s ACRS allowance for 2026?

Section 179 and § 168(k) Bonus Depreciation

• To encourage small business investment during the recent recession, Congress dramatically increased the § 179 limit.

• § 179 property is tangible property to which § 168 applies or § 1245 property purchased “for use in the active conduct of a trade or business.” § 179(d)(1). § 179 property also includes computer software. § 179(d)(1)(A)(ii). The taxpayer may elect to include “qualified real property” in his § 179 property. § 179(d)(1)(B)(ii). “Qualified real property” includes various improvements to existing real property. See § 179(e), § 168(e)(6).

• After taking a § 179 deduction, taxpayer may apply the rules of § 168 to his remaining basis.

The original use of the property must begin with the taxpayer. § 168(k)(2)(A)(ii). Alternatively, taxpayer may claim bonus depreciation for the acquisition and placing in service of used property, § 168(k)(2)(A)(ii) and § 168(k)(2)(E)(ii)(I), so long as taxpayer did not acquire the used property from a related party or in a carryover basis transaction or by inheritance. § 168(k)(2)(A)(ii), § 168(k)(2)(E)(ii)(II), § 179(d)(2 and 3). Taxpayer must place the property in service before 2027. § 168(k)(2)(iii). Moreover, the benefits that §§ 179 and 168(k) provide are cumulative – so a taxpayer may “write off” very substantial investments in productive assets.

Section 197

Section 197 permits the amortization of “§ 197 intangibles.” § 197(a). A “§ 197 intangible” includes such intangibles as goodwill, going concern value, intellectual property, a license or permit granted by a government, etc. § 197(d)(1). Section 197 permits ratable amortization over 15 years of the purchase price (as opposed to the cost of self-creation) of such intangibles. § 197(a), § 197(c)(2).

• Congress intended that § 197 put an end to expensive contests between the IRS and taxpayers over whether such items could be amortized at all, and if so, the applicable useful life. Now a “one-size-fits-all” approach applies to all such intangibles.

Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Basic Depreciation, ACRS, and MACRS Concepts.

Section 280F: Mixing Business and Personal

A taxpayer may make expenditures to purchase items that are helpful in earning income and useful in taxpayer’s personal life as well. An automobile may fit this description. These points may lead some taxpayers to purchase items that they might not otherwise purchase, or to purchase items that are more expensive than they might otherwise purchase. Congress has addressed these points in § 280F. It provides limitations on deductions associated with purchase and use of so-called “listed property.”

Section 280F provides the following types of limitations on cost recovery and § 179 expensing deductions: an absolute dollar limit on such deductions for listed property, a percentage limitation on such deductions for listed property, and a combination of a percentage limitation on an absolute dollar limit on such deductions.

• Read §§ 280F(a)(1)(A and B). Consider this to be 2018. Taxpayer was a real estate agent and purchased a Mercedes-Benz for $100,000 to squire clients around from property to property. An automobile is 5-year property. § 168(e)(3)(B)(i). Assume that taxpayer uses the automobile only for trade or business purposes. For the first four years (i.e., 2018 to 2021), Taxpayer’s total cost recovery as limited by § 280F(a)(1)(A) is $41,360. Assume that Taxpayer will not be able to use § 179. See § 280F(d)(1). When would taxpayer have recovered all the cost of the automobile? See § 280F(a)(1)(B)(ii).

• Percentage limitation on cost recovery and § 179 expensing deductions for listed property: If a taxpayer uses property partly for business and partly for personal purposes, he must determine the percentage of total use that is trade or business use. See §§ 280F(d)(6)(A and B). Only the trade or business use portion of the allowable cost recovery is deductible if the percentage of total use is more than 50% for trade or business. See § 280F(b)(3). If the percentage of total use is not more than 50% trade or business, then Section 280F(b)(1) provides that the alternative depreciation system of § 168(g) applies. Sections 168(g) of course prescribes less favorable straight-line cost recovery over a longer recovery period. If taxpayer used an item predominantly for trade or business, elected to use an accelerated method of cost recovery, and subsequently made a use of it that is not predominantly for trade or business, then taxpayer must recapture the cost recovery that exceeded what would have been allowed under § 168(g) in prior years. § 280F(b)(2).

• Consider: Taxpayer purchased a Hummer – which is not a passenger automobile. See § 280F(d)(5)(A). However, it is property used for transportation. Assume that a Hummer is 7-year property under § 168(e)(3)(B) with a class life of 10 years. Taxpayer paid $100,000 for the Hummer. Taxpayer used the Hummer 75% for trade or business in both 2019 and 2020. In 2021, Taxpayer used the Hummer 25% for trade or business. In 2022, and all subsequent years, Taxpayer used the Hummer 75% for trade or business. What is Taxpayer’s cost recovery allowance for 2019? – 2020? 2021? 2022? – 2023? – 2024? – 2025? – 2026? – 2027? – 2028? – 2029?

• Perhaps we have discovered another reason to elect cost recovery under the alternative depreciation system of § 168(g).

In computing the cost recovery allowance for any given year, we assume that all of taxpayer’s use of listed property over the recovery period was for trade or business purposes. § 280F(d)(2). Thus, a pro rata reduction of allowable cost recovery for less than predominantly business use does not extend the cost recovery period.

• Combination of a percentage limitation on an absolute dollar limit on cost recovery deductions: In the case of passenger automobiles, the absolute dollar limit on cost recovery deductions is applied first. Then limitations based on less-than-predominant trade or business use are applied. § 280F(a)(2).

1. What is the relationship between depreciation and basis? Why does the relationship have to be what it is? Feel free to state your answer in Haig-Simons terms.

2. This chapter has offered three different tax treatments of expenses. What are they? What rationales support each?

3. We tax net income? What economic distortions would occur if we taxed gross receipts?

4. What economic distortions occur if we accelerate depreciation allowances? – if we give deductions to certain activities when they are profitable, for example § 199A?

5. Do depletion allowances encourage (too much) exploitation of natural resources?

Can you explain or define –

• What makes a trade or business expenditure “necessary?” What makes a trade or business expenditure (extra) “ordinary?”

• How acquisition costs of an asset should be treated under §§ 162, 212, and 263?

• What is the “origin of the claim” standard for determining the deductibility of litigation expenses?

• What is the importance of the ordering rule of §§ 161/261?

• What is the difference between deductibility under § 162 or § 212 and capitalization under § 263?

• What is the Tax Code’s treatment of business bad debts? What is the Tax Code’s treatment of non-business bad debts?

• What is the Tax Code’s treatment of expenditures for repairs? What is the Tax Code’s treatment of expenditures for improvements?

• What does it mean to be “away from home” for purposes of § 162(a)(2)?

• How should a taxpayer determine what is a reasonable salary that he may deduct under § 162(a)(1)?

• Why might a taxpayer prefer to deduct expenses as ordinary and necessary to carrying on a trade or business rather as ordinary and necessary for income-producing activities? Distinguish a trade or business from an income-producing activity.

• Why are child care expenses not deductible as an ordinary and necessary trade or business expense?

• What is the source of public policy limitations on deductions under § 162?

• What is the “role” of §§ 261 to 280H of the Code?

• What is “cost recovery?”

• How does rapid cost recovery generate economic growth?

• What is “listed property?”