Internal Revenue Code Section 162(a)

Section 162(a) is a provision of the Internal Revenue Code, a United States taxation law. It concerns deductions for business expenses. [http://www.fourmilab.ch/ustax/www/t26-A-1-B-VI-162.html] It is one of the most important provisions in the Code, because it is the most widely used authority for deductions. [See Donaldson, Samuel A., Federal Income Taxation of Individuals: Cases, Problems and Materials, 202 (2nd. Ed. 2007).] 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: 1) it must be an ordinary2) and necessary3) expense4) that was paid or incurred during the taxable year5) in carrying on 6) a trade or business activity. [IRC Section 162(a).]

These elements have been interpreted by the courts and administrative agencies to determine if a certain expense 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. [http://en.wikipedia.org/wiki/Midland_Empire_Packing_Company_v._Commissioner] ["Midland Empire Packing Company v. Commissioner", 14 T.C. 635 (195)] For example, in "Welch v. Helvering" [http://en.wikipedia.org/wiki/Welch_v._Helvering] , 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. [290 U.S. 111 (1933).]

In "Jenkins v. Commissioner" [http://en.wikipedia.org/wiki/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. [Tax Court Memo 1983-667.] If a taxpayer makes a payment to preserve his/her business reputation, it can be considered an ordinary business expense. ["Conti v. Commissioner", 31 T.C.M. 348 (1972).] However, if the expenses are inherently personal in nature, they are not deductible under section 162(a). ["Trebilcock v. Commissioner", 64 T.C. 852 (1975).] . 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). ["Harolds Club v. Commissioner", 340 F.2d 861 (9th Cir. 1965).]

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Paid or Incurred

To be deductible under section 162(a), the expense must be paid or incurred during the taxable year at issue. [Donaldson, Samuel A., Federal Income Taxation of Individuals: Cases, Problems and Materials, 216 (2nd. Ed. 2007).] [http://en.wikipedia.org/wiki/Expense#Taxation]

In Carrying On

The next requirement of section 162(a) is that the taxpayer must be carrying on a trade or business. [IRC Section 162(a).] Start up expenses are not entirely deductible, but must be spread out over 15 years. [IRC Section 195.] 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. ["Estate of Rockefeller v. Commissioner",762 F.2d 264 (2nd Cir. 1985).] 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. [IRC Section 162(a).] These words are not defined in the 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.” ["Commissioner v. Groetzinger", 480 U.S. 23 (1987)] 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. [http://en.wikipedia.org/wiki/Commissioner_v._Groetzinger]

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.

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. [ Treasury Regulation 1.162-1 ] However, a new computer or the cost to keep a jet on 24-hour standby are probably not deductible as business expenses.

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