The deductibility of a trade expense or ordinary and necessary business expense has long been among the ten Most Litigated Issues identified in the Annual Report from the Taxpayer Advocate Service (TAS). In a recent report, the TAS identified 134 cases involving a trade or business expense issue that were litigated between June 1, 2012, and May 31, 2013. The courts affirmed the IRS position in the vast majority (approximately 74 percent) of cases, while taxpayers fully prevailed only about two percent of the time. The remaining cases resulted in split decisions.
Internal Revenue Code (IRC or the “Code”) § 162 allows deductions for ordinary and necessary trade or business expenses paid or incurred during the course of a taxable year. Rules regarding the practical application of IRC § 162 have evolved largely from case law and administrative guidance. When a taxpayer seeks judicial review of the IRS’s determination of a tax liability stemming from the deductibility of a particular expense, the courts must often address a series of questions, including those discussed below.
What Is a Trade or Business Expense Under § 162?
Although “trade or business” is one of the most widely used terms in the IRC, neither the Code nor the Treasury Regulations provide a definition. The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts. The Supreme Court has interpreted “trade or business” for purposes of IRC § 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit.
What Is an Ordinary and Necessary Business Expense?
IRC § 162(a) requires a trade or business expense to be both “ordinary” and “necessary” in relation to the taxpayer’s trade or business in order to be deductible. In a 1933 case known as Welch v. Helvering, the Supreme Court stated that the words “ordinary” and “necessary” have different meanings, both of which must be satisfied for the taxpayer to benefit from the deduction. The Supreme Court describes an “ordinary” expense as customary or usual and of common or frequent occurrence in the taxpayer’s trade or business. The Court describes a “necessary” expense as one that is appropriate and helpful for development of the business.
Common law also requires that in addition to being ordinary and necessary, the amount of the expense must be reasonable for the expense to be deductible. In the 1949 case of Commissioner v. Lincoln Electric Co., the Court of Appeals for the Sixth Circuit held “the element of reasonableness is inherent in the phrase ‘ordinary and necessary.’ Clearly it was not the intention of Congress to automatically allow as deductions operating expenses incurred or paid by the taxpayer in an unlimited amount.”
Is the Expense a Currently Deductible Expense or a Capital Expenditure?
A currently deductible expense is an ordinary and necessary expense paid or incurred during the taxable year in the course of carrying on a trade or business.9 No deductions are allowed for the cost of acquisition, construction, improvement, or restoration of an asset expected to last more than one year. Instead, capital expenditures may be subject to amortization, depletion, or depreciation over the useful life of the property.
Whether an expenditure is deductible under IRC § 162(a) or is a capital expenditure under IRC § 263 is a question of fact. Courts have adopted a case-by-case approach to applying principles of capitalization and deductibility.
Contact an IRS Attorney Today
As you see, the questions may be simple, but the answers may not be. So, if you have questions about trade or business expense and whether an expense is currently deductible or should be classified as a capital expenditure, see a qualified professional before making the claim on a tax return. A simple consultation now could save you much grief and money later on by avoiding a challenge by the IRS to your claim.