Fed tax - ToB/income seeking DDs, bad debt/losses

§ 62 - Adjusted gross income provision

Lists the exclusive ATL DDs a TP may take

Includes (1) ToB DDs (unless ToB of being an employee), (4) DDs attributable to maintaining property for use in ToB or production of income, (20) costs involving any unlawful discrimination suit

§ 67(a) - 2-percent floor on MIDs

MIDs may only be DD IF in total they add up to more than 2% of TP’s AGI

§ 67(b) - MIDs

List under (b) are NOT MIDs

Everything else NOT on the list are MIDs… so since § 212 is not on the list expenses for production of income are DD BTL

pre-TCJA treatment of MIDs

Only DD if sum of MIDs > 2% of TP’s AGI (after ATL DDs taken off GI)

Result is TP’s w/ lots of MIDs take a 2% “hair cut” off AGI - they have to just expense this amount of MIDs w/out taking a DD

Impact of § 67(g) / TCJA

MIDs are disallowed from Dec 31, 2017 - Jan 1, 2026

“Notwithstanding subsection (a), no miscellaneous itemized DD shall be allowed for any taxable year from [range above].”

Puts us back in a Higgins world where § 212 expenses are not DD (unless it's for production of income related to rental properties - see § 62(a)(4))

“Ordinary” expense

Customary, expected (Welch v. Helvering)

Can happen once in a business’s lifetime

Goedel

Securities firm purchasing life insurance on FDR’s life =/= ordinary

Giliam vs. Dancer

Mental breakdown on plane =/= ordinary, but cost of defending neg’l suit was ordinary b/c risk of accidents are “inseparable incident of driving”

Necessary expense

“Appropriate and helpful” (Welch v. Helvering) —> courts give great deference to business owners

Palo Alto

Plane on standby = necessary b/c helped save significant $$ in one case

Henry - yacht case

1040 yacht maintenance/insurance NOT “necessary” b/c primarily personal use, no evidence TP actually attracted/generated clients through “advertising” in this way

Distinct from advertising in a way that doesn’t involve an element of personal enjoyment (e.g., paying $5,000 for scoreboard to say “choose our tax business”)

Dobbe

Landscaping to beautify personal residence adjacent to the nursery =/= necessary

Topping

Costs of competing in horse shows was necessary to TP, b/c evidence that traditional marketing was “tacky,” needed to show personal prowess, and also have evidence her strategy of going out to these shows actually attracted new customers (distinguishable from Henry)

“Carrying on” in ToB

Investigatory stage =/= carrying on

Spending $ to prepare … “start up phase” =/= carrying on

Frank

Costs on traveling to cities and legal fees related to investigating new potential newspaper/radio stations to buy were not DD under § 162, b/c “in pursuit of ToB” =/= pre-ToB … it must be existing. Word “pursuit” here means “in connection with”

Richmond TV

Personnel training expenses prior to opening day (business had not received its license to operate by the FTC yet) were NOT DD under § 162

Need business functioning as a going concern for § 162 to apply

How can TP treat start up costs, if not DD under § 162?

TP may elect to DD start-up costs as per § 195

Types of start up costs

EXAMPLES: Investigating creation or acquisition of ToB, in an anticipation of ToB - advertising, rent, employee training, wages during pre-opening day period

NOT START UP COSTS: Capital expenditures (coffee machines, franchise fee, building/factory, equipment lasting more than 1 year) b/c must be “allowable as a DD for the taxable year in which paid or incurred”

What is a “trade or business”?

Primary purpose of earning a livelihood, generating income to support yourself (Groetzinger)

“Continuity and regularity”

“Sporadic activity, hobby, or amusement diversion does not qualify”

Groetzinger

Dog-racing betting

“Skill was required and was applied”

Even though he wasn’t successful at it, “this was not a hobby or a passing fancy or an occasional bet for amusement”

Higgins (1941)

Personal investing in your own portfolio to generate income for yourself =/= ToB

Even though full time and required a lot of skill, not a ToB

Led to creation of § 212

Distinct from day-traders

Primuth

ToB of being an employee

Secretary wanted to find a new job w/ more responsibilities

Court held expenses paid to recruiter were ordinary and necessary to the ToB of being a secretary

Same ToB, “albeit with a different employer”

Types of expenses related to ToB of being an employee

Continuing education, union dues, talent search/recruiters, professional societies, licensing fees, home office expenses, travel expenses

ToB of being an employee - BTL or ATL?

BTL, b/c § 62(a)(1) specifically says ATL DDs under § 162 are not allowed “if such ToB does not consist of the performance of services by the TP as an employee”

Types of ToB expenses listed in § 162(a)

Reasonable allowance for salaries, travel expenses (airfare, meals, lodging) that are not lavish/extravagant, rent for equipment used in the ToB (renting a sewing machine)

Types of expenses listed in remainder of § 162 that are NOT DD as ToB expenses

(C) illegal payments/Kickbacks, (f) fines/penalties paid to govt entities for breaking the law, (g) antitrust payments, (q) settlement amounts and attorney’s fees associated w/ sexual harassment claims that are subject to NDA

“Reasonable allowance for salaries”

Independent investor test - like services, like employees, under like circumstances

If part of salary is considered “excessive” that part is not DD under § 162(1)

Maybe be considered a “constructive dividend” to employee if they work for a corp - this is what’s rlly going on (corp is trying to distribute earnings, but doing so as a deductible “salary” instead of distributing a dividend which it distributes after paying taxes)

Voluntary payments to creditors (contrasting Welch and Jenkins)

If TP is trying to protect existing business reputation, rather than rebuild from scratch, then payments are DD under § 162

Show connection btwn success of business and personal reputation

Look for fact patterns where celebrity has a side business that flops, adjacent to their main line of work (acting, singing, sports) AND that main line of work depends on likability

Clothing test

Particular clothing is required or essential

Not in fact used for everyday wear

Not suitable for everyday wear (objective = IRS/5th, subjective = tax court)

Entertainment expenses

Not DD under § 162 as per § 274(a)(1)

Unless ToB itself is an amusement/recreation activity (e.g., food critic)

Travel expenses

if trip is entirely for ToB purposes, airfare, meals, and lodging are all DD under § 162

if trip is primarily for ToB purposes, but includes some personal, 100% of airfare is DD, but meals/lodging associated w/ personal days are not DD

if trip is primarily for personal purposes, airfare is not DD, and only expenses related to business activities (e.g., 1 day conference during a 6 week vacation)are DD

Settling suits - physical injuries, plaintiff side

Expenses not DD b/c physical injury awards not included in GI as per § 104(a)(2)

§ 265 says no DDs for expenses related to producing income that is tax-exempt

Settling suits - non-physical injuries, plaintiff side

Damages amount included in GI (b/c only physical excluded from GI)

Thus, expenses related to settling suits DD as § 212 expense (related to “collection of income”) —> all BTL … unless non-physical injury is unlawful discrimination, which may be DD ATL (§ 62(a)(20))

Defendant/employer side - settling suits

Generally deduct expenses/attorney’s fees/settlement amounts under § 162(a) b/c “ordinary and necessary” for businesses to get sued

But if settlement relates to sexual harassment w/ an NDA, can’t deduct any associated expenses

If sexual harassment w/ an NDA —> may DD all expenses as normal

If settlement relates to other instances of wrongdoing, even with an NDA —> may DD all expenses as normal

How to determine what % of total settlement award may be DD or non-DD if there is sexual harassment + other claims?

Look to pleadings —> what % of total damages did P associate w/ the sexual harassment claim

§ 212 expenses - 3 categories

Production or collection of income

Mgm’t, conservation, or maintenance of property held for production of income

Expenses in connection w/ determination, collection, or refund of any tax (lawyers, accountants)

Are § 212 DDs ATL or BTL?

Most are BTL, b/c not in list under § 67(b), unless the expense is related to maintaining property (see § 62(a)(4))

Expenses that are NEVER DD

Personal, living, or family (commuting)

Capital improvements

Expenses related to production of tax-free income (book on “how to invest in tax free bonds”)

Losses btwn related parties

Entertainment/amusement/recreation