Internal Revenue Code Section 162(a)
Encyclopedia
Section 162 of the Internal Revenue Code
, is part of United States taxation law. It concerns deductions
for business expenses. It is one of the most important provisions in the Code, because it is the most widely used authority for deductions. If an expense is not deductible, then Congress
considers the cost to be a consumption expense. Section 162(a) requires six different elements in order to claim a deduction. It must be an
These elements have been interpreted by the courts and administrative agencies to determine if an expenditure is deductible as a business expense.
, the United States Supreme Court found that payments must be both ordinary and necessary to be business expenses; it held that although payments made to a creditor by a taxpayer may have been necessary, they were not ordinary because the circumstances under which they were paid were outside the norms of conduct in society. The Welch case is frequently cited for its dictum describing the meaning of the term "necessary" in Section 162 as requiring that expenses merely be "appropriate and helpful [in] the development of the [taxpayer's] business."
In Jenkins v. Commissioner
, the Tax Court determined that in order to determine if expenditures are deductible under § 162(a), the Court must first ascertain the motive of the taxpayer in making the expenditures, and then determine if there is a sufficient connection between the expenditures and his/her trade or business. If a taxpayer makes a payment to preserve his/her business reputation, it can be considered an ordinary business expense. However, if the expenses are inherently personal in nature, they are not deductible under section 162(a). In addition, the amount expended must be considered to be reasonable by the court; therefore, if compensation is deemed unreasonable, it exceeds the amount allowable under section 162(a)(1).
. The United States Supreme Court held that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. . . . A sporadic activity, a hobby, or an amusement does not qualify.” In deciding if an activity is a trade or business, the taxpayer should consider if he/she devoted his full-time exertions to that activity on a regular, continuous and substantial basis.
More information can be found on how to determine if the taxpayer's expenditures are for carrying on his trade or business by examining Treasury Regulation 1.183-2
.
, the cost incurred would be amortized as a capital expense.
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
, is part of United States taxation law. It concerns deductions
Tax deduction
Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions...
for business expenses. It is one of the most important provisions in the Code, because it is the most widely used authority for deductions. If an expense is not deductible, then Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
considers the cost to be a consumption expense. Section 162(a) requires six different elements in order to claim a deduction. It must be an
-
- 1) ordinary
- 2) and necessary
- 3) expense
- 4) that was paid or incurred during the taxable year
- 5) in carrying on
- 6) a trade or business activity.
These elements have been interpreted by the courts and administrative agencies to determine if an expenditure is deductible as a business expense.
Ordinary and Necessary
In general, the expense should be routine and directly related to the business activity. Ordinary does not require be habitual or made often; the court only requires that the expense is one that is ordinary and necessary for that business. For example, in Welch v. HelveringWelch v. Helvering
Welch v. Helvering, 290 U.S. 111 , was decision by the United States Supreme Court on the difference between business and personal expenses, and the difference between ordinary business deductions and capital expenses. It is one of the most important income tax law cases.Thomas Welch and his father...
, the United States Supreme Court found that payments must be both ordinary and necessary to be business expenses; it held that although payments made to a creditor by a taxpayer may have been necessary, they were not ordinary because the circumstances under which they were paid were outside the norms of conduct in society. The Welch case is frequently cited for its dictum describing the meaning of the term "necessary" in Section 162 as requiring that expenses merely be "appropriate and helpful [in] the development of the [taxpayer's] business."
In Jenkins v. Commissioner
Jenkins v. Commissioner
In Jenkins v. Commissioner, T.C. Memo 1983-667 , the U.S. Tax Court held that the payments Conway Twitty, a legendary country singer, made to investors in a defunct restaurant business known as “Twitty Burger, Inc.” were deductible under § 162 as ordinary and necessary business expenses of...
, the Tax Court determined that in order to determine if expenditures are deductible under § 162(a), the Court must first ascertain the motive of the taxpayer in making the expenditures, and then determine if there is a sufficient connection between the expenditures and his/her trade or business. If a taxpayer makes a payment to preserve his/her business reputation, it can be considered an ordinary business expense. However, if the expenses are inherently personal in nature, they are not deductible under section 162(a). In addition, the amount expended must be considered to be reasonable by the court; therefore, if compensation is deemed unreasonable, it exceeds the amount allowable under section 162(a)(1).
Paid or Incurred
To be deductible under section 162(a), the expense must be paid or incurred during the taxable year at issue. Expense#TaxationIn Carrying On
The next requirement of section 162(a) is that the taxpayer must be carrying on a trade or business. Start up expenses are not entirely deductible, but must be spread out over 15 years. Because business expenses are fully deductible under section 162, taxpayers try to argue that expenses were not start up expenses. The Second Circuit Court of Appeals found that the Tax Court should look at if employment of the taxpayer is in the same trade or business to determine if it is a start-up expense, or a carrying on expense. If there is a substantial difference between the activities of the occupations of the taxpayer, then they are considered to be separate trades or businesses, and the expenses for the new trade or business activity are not deductible under 162(a).Trade or Business
Finally, the expense must also be paid or incurred in carrying on the taxpayer’s trade or business. These words are not defined in the CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
. The United States Supreme Court held that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. . . . A sporadic activity, a hobby, or an amusement does not qualify.” In deciding if an activity is a trade or business, the taxpayer should consider if he/she devoted his full-time exertions to that activity on a regular, continuous and substantial basis.
More information can be found on how to determine if the taxpayer's expenditures are for carrying on his trade or business by examining Treasury Regulation 1.183-2
Treasury Regulation 1.183-2
Treasury Regulation 1.183-2 is a Treasury Regulation in the United States, outlining the taxes owed from income deriving from non-business, non-investment activity. Expenses relating to for profit activities, such as business and investment activities, are generally tax deductible under sections...
.
Application
The following are some examples of types of expenses that may be deducted as a business expense: repairs to a damaged office conference table, an annual premium for personal medical insurance, traveling expenses solely related to business, and advertising expenses. The cost to keep a jet on 24-hour standby for business needs was found deductible in Palo Alto Town & Country Village, Inc. v. Commissioner (9th Cir. 1978)http://bulk.resource.org/courts.gov/c/F2/565/565.F2d.1388.74-2585.html. By contrast the purchse of a new computer for a business would not be a decuctible expense; instead, because a computer is probably a capital assetCapital asset
The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...
, the cost incurred would be amortized as a capital expense.
See also
- Pevsner v. CommissionerPevsner v. CommissionerPevsner v. Commissioner, 628 F.2d 467 is a United States federal income tax case before the Fifth Circuit. It dealt with the issue of whether clothes purchased solely for use at work could be treated as a business expense deduction on a taxpayer's return.HELD:*An "objective" test is used to...
- Midland Empire Packing Company v. CommissionerMidland Empire Packing Company v. CommissionerMidland Empire Packing Company v. Commissioner., 14 T.C. 635 , was a case in which the United States Tax Court ruled that Midland Empire Packing Company was permitted to deduct the costs of lining its basement walls and floor...
- Commissioner v. GroetzingerCommissioner v. GroetzingerCommissioner v. Groetzinger, is a decision of the Supreme Court of the United States, which addressed the issue of what qualifies as being either a trade or business under Section 162 of the Internal Revenue Code...