Our income tax system taxes only “net income.” Hence it is important that the Code incorporate principles that prevent taxing as income the expenses of deriving that income. Section 162 provides a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Read § 162(a).
The Tax Formula
➔MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
The Code does not provide a definition of “trade or business.” 1 The Supreme Court observed the following when it held that a full-time gambler was engaged in a “trade or business:”
Of course, not every income-producing and profit-making endeavor constitutes a trade or business. The income tax law, almost from the beginning, has distinguished between a business or trade, on the one hand, and “transactions entered into for profit but not connected with ... business or trade,” on the other. See Revenue Act of 1916, § 5(a), Fifth, 39 Stat. 759. Congress “distinguished the broad range of income or profit producing activities from those satisfying the narrow category of trade or business.” We accept the fact 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 diversion does not qualify. 2
This excerpt informs that there is a distinction between a “trade or business” and “transactions entered into for profit but not connected with” a trade or business. For most taxpayers, investing fits this description. Moreover, there is another distinction between a “trade or business” and a hobby or amusement. The Code limits deductions for an activity “not engaged in for profit” to the gross income derived from the activity. 3
Congress extended the principles of § 162(a) to “expenses for the production of income” when it added § 212 to the Code. However, expenses for the production of income – as contrasted with a trade or business – are not deductible “above the line.” § 62(a)(1). In addition, § 163(a) allows a deduction for interest paid or accrued. Section 165(a) allows a deduction for losses.
Section 162 allows a deduction only for expenses of “carrying on” a trade or business. Hence, the costs of searching for a business to purchase, pre-opening organization costs, etc. are not deductible. § 195. On the other hand, an existing business that incurs the same expenses in order to expand its business may deduct them. Whether an existing business is seeking merely to expand or to enter a new trade or business “depends on the facts and circumstances of each case.” 4
Taxpayer may purchase an input that enables him/her/it to earn income and immediately consume that item in the production of taxable income. We would expect that such expenditures would be immediately deductible in full. We sometimes call this treatment “expensing.”
Alternatively, taxpayer may purchase an input that enables him/her/it to earn income for more than the current tax year. For example, taxpayer might purchase a machine that will enable him/her/it to generate income for the next ten years. Taxpayer has made an “investment” rather than an expenditure on an item that he/she/it immediately consumes. A mere change in the form in which taxpayer holds wealth is not a taxable event; we implement this principle by crediting taxpayer with basis equal to the money removed from his/her/its store of property rights in order to make the investment (i.e., purchase). Taxpayer (might) then consume only a part of the item that he/she/it purchased in order to generate income, i.e., to “de-invest” it. The Code implements in several places a scheme that (theoretically) matches such consumption with the income that the expenditure actually generates. The Code permits a deduction for such partial consumption under the headings of depreciation, amortization, or more recently, cost recovery. Since such consumption represents a deinvestment, taxpayer must adjust his/her/its basis in the productive asset downward. We sometimes call this tax treatment of the purchase and use of a productive asset “capitalization.”
- The Code also implements such a matching principle when taxpayer derives gross income by selling from inventory. Taxpayer may not build up deductions by purchasing inventory in advance of the time he/she/it actually makes sales.
Yet another possibility is that taxpayer may purchase an input that enables him/her/it to produce income but never in fact consumes that input, e.g., land. There should logically be no deduction – immediately or in the future – for such expenditures. Taxpayer will have a basis in such an asset, but could only recover it for income purposes upon sale of the asset. Some of these assets may not even be capable of sale, e.g., a legal education or other investments in human capital. We sometimes also call this tax treatment of the purchase and use of such an asset “capitalization.”
Both the Commissioner and taxpayers are aware of the time value of money. For this reason, taxpayer usually wants to classify purchases of inputs that enable him/her/it to generate income in a manner that permits the greatest immediate deduction. The Commissioner of course wants the opposite result.
In the materials ahead, we very roughly consider first the placement of particular expenditures into one group or another – whether expense or capital. We then consider some of the basic principles and recurring issues in each of these groups.