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Unformatted text preview: H Chapter Seven H OVERVIEW OF DEDUCTIONS AND LOSSES SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 7-1 The general requirements for a deduction are contained in §§ 162 and 212. If these requirements are met and the expense is not disallowed (or limited) by some other provision of the Code, the expense normally is deductible. Sections 162 and 212 set forth four requirements (see pp. 7-3 and 7-4): 1. Related to carrying on either a trade or business (§ 162) or an income-producing activity (§ 212). This requirement is satisfied only if (1) the expense is incurred in the proper activity (e.g., a trade or business or an income-producing activity), (2) the expense is properly related to the activity, and (3) the activity is being ‘‘carried on’’ by the taxpayer. Proper Activity. The expense must be incurred in a trade or business or an income-producing activity. The purpose underlying this requirement is to deny deductions for expenses that are primarily of a personal nature. The major factor distinguishing business and income-producing activities from personal activities is existence of a profit motive . Thus, this requirement demands that the expense be incurred in an activity entered into with an expectation of profit. The expectation, however, need not be reasonable. [See pp. 7-4 through 7-6 and Reg. § 1.183-2(a).] Proper Relationship. The expense also must be properly related to the profit-oriented activity. Satisfaction of this test occurs when the expense was motivated by business needs. (For an interesting example illustrating the difficulty in determining whether the proper relationship exists, compare Example 4 with footnote 14, p. 7-7.) Carrying On. Expenses are deductible only if they are incurred while the taxpayer is carrying on the profit-oriented activity (e.g., expenses of investigating a business may not be deductible when the taxpayer is not carrying on the activity that he is investigating). [See p. 7-33 and § 162(a).] 2. Ordinary and necessary. An expense is considered ordinary if it is customary to incur such expense in the type of business in which the taxpayer is engaged. The expense need not be recurring. It need only be routine for taxpayers in similar situations. Expenses are considered necessary if they are appropriate, helpful, or capable of making a contribution to the success of the taxpayer’s profit- seeking activities. One interesting case when these criteria were applied to deny a deduction was Kenneth M. Wells, 36 TCM 1698, T. C. Memo 197527-419. Here, the head of a public defender’s office was not allowed to deduct the costs of lunch expenses for his staff that he paid for personally because it was not ‘‘ordinary’’ for a public defender to pay for such expenses vis-vis the head of a private law firm. (See pp. 7-7 and 7-8.) 3. Reasonable. According to § 162(a)(1), only compensation must be reasonable. There is no explicit reasonableness requirement for other business expenses under § 162(a). Inreasonableness requirement for other business expenses under § 162(a)....
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- Spring '09