The following cases involve the proper treatment of particular expenditures to purchase income-producing assets – whether immediately deductible, deductible over their useful life, or not deductible because taxpayer never consumes the item.
Welch v. Helvering, 290 U.S. 114 (1933)
MR. JUSTICE CARDOZO delivered the opinion of the Court.
The question to be determined is whether payments by a taxpayer, who is in business as a commission agent, are allowable deductions in the computation of his income if made to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit.
In 1922, petitioner was the secretary of the E.L. Welch Company, a Minnesota corporation, engaged in the grain business. The company was adjudged an involuntary bankrupt, and had a discharge from its debts. Thereafter the petitioner made a contract with the Kellogg Company to purchase grain for it on a commission. In order to reestablish his relations with customers whom he had known when acting for the Welch Company and to solidify his credit and standing, he decided to pay the debts of the Welch business so far as he was able. In fulfillment of that resolve, he made payments of substantial amounts during five successive years. ... The Commissioner ruled that these payments were not deductible from income as ordinary and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the development of reputation and goodwill. The Board of Tax Appeals sustained the action of the Commissioner and the Court of Appeals for the Eighth Circuit affirmed. The case is here on certiorari. ...
We may assume that the payments to creditors of the Welch Company were necessary for the development of the petitioner’s business, at least in the sense that they were appropriate and helpful. [citation omitted]. He certainly thought they were, and we should be slow to override his judgment. But the problem is not solved when the payments are characterized as necessary. Many necessary payments are charges upon capital. There is need to determine whether they are both necessary and ordinary. Now, what is ordinary, though there must always be a strain of constancy within it, is nonetheless a variable affected by time and place and circumstance. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. Cf. Kornhauser v. United States, 276 U.S. 145. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part. At such times, there are norms of conduct that help to stabilize our judgment, and make it certain and objective. The instance is not erratic, but is brought within a known type.
The line of demarcation is now visible between the case that is here and the one supposed for illustration. We try to classify this act as ordinary or the opposite, and the norms of conduct fail us. No longer can we have recourse to any fund of business experience, to any known business practice. Men do at times pay the debts of others without legal obligation or the lighter obligation imposed by the usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity and opulence. Indeed, if language is to be read in its natural and common meaning [citations omitted], we should have to say that payment in such circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in the stimulus evoking it, and none in the response. Here, indeed, as so often in other branches of the law, the decisive distinctions are those of degree, and not of kind. One struggles in vain for any verbal formula that will supply a ready touchstone. The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle.
The Commissioner of Internal Revenue resorted to that standard in assessing the petitioner’s income, and found that the payments in controversy came closer to capital outlays than to ordinary and necessary expenses in the operation of a business. His ruling has the support of a presumption of correctness, and the petitioner has the burden of proving it to be wrong. [citations omitted]. Unless we can say from facts within our knowledge that these are ordinary and necessary expenses according to the ways of conduct and the forms of speech prevailing in the business world, the tax must be confirmed. But nothing told us by this record or within the sphere of our judicial notice permits us to give that extension to what is ordinary and necessary. Indeed, to do so would open the door to many bizarre analogies. One man has a family name that is clouded by thefts committed by an ancestor. To add to his own standing he repays the stolen money, wiping off, it may be, his income for the year. The payments figure in his tax return as ordinary expenses. Another man conceives the notion that he will be able to practice his vocation with greater ease and profit if he has an opportunity to enrich his culture. Forthwith the price of his education becomes an expense of the business, reducing the income subject to taxation. There is little difference between these expenses and those in controversy here. Reputation and learning are akin to capital assets, like the goodwill of an old partnership. [citation omitted]. For many, they are the only tools with which to hew a pathway to success. The money spent in acquiring them is well and wisely spent. It is not an ordinary expense of the operation of a business.
Many cases in the federal courts deal with phases of the problem presented in the case at bar. To attempt to harmonize them would be a futile task. They involve the appreciation of particular situations at times with border-line conclusions. Typical illustrations are cited in the margin. 1
The decree should be
Notes and Questions:
- With this case, if not before, the word “ordinary” as used in the phrase “ordinary and necessary” provides a line of demarcation between expenditures currently deductible and those that
are either never deductible or deductible only over time, i.e., through depreciation or amortization allowances.
- Since the expenses were not “ordinary,” the next question is whether taxpayer could deduct them over time through depreciation or amortization.
- What should be relevant in making this determination?
- Do you think that the expenses in Welch v. Helvering should be recoverable through depreciation or amortization allowances?
- In the second paragraph of the Court’s footnote, the Court cited several cases. Which expenditures should taxpayer be able to deduct as depreciation or amortization, and which should taxpayer not be able deduct at all – probably ever?
- Consider these three rationales of the Court’s opinion: the expenditures were too personal to be deductible, were too bizarre to be ordinary, and were capital so not deductible.
- Personal: Welch felt a moral obligation, as many in Minnesota in such circumstances did at the time, to pay the corporation’s debts. In fact, Welch repaid the debts on the advice of bankers. This would seem to make business the motivation for repaying these debts.
- Bizarre: Others in Minnesota had done exactly the same thing, i.e., repay the debts of a bankrupt predecessor.
- Capital: The expenditures were no doubt capital in nature. However, they were arguably only an investment designed to generate income for a finite period of time. As such, the expenditures should be depreciable or amortizable.
- See Joel S. Newman, The Story of Welch: The Use (and Misuse) of the “Ordinary and Necessary” Test for Deducting Business Expenses, in Tax Stories 197-224 (Paul Caron ed., 2d ed. 2009).
- What should be the tax consequences of making payments to create goodwill? What should be the tax consequences of maintaining or repairing goodwill?
- By paying the debts of a bankrupt, no-longer-in-existence corporation, was Thomas Welch trying to create goodwill or to maintain or repair it? Whose goodwill?
- Consider: Conway Twitty (actually Harold Jenkins) is a famous country music singer. He formed a chain of fast food restaurants (“Twitty Burger, Inc.”). He persuaded seventy-five
friends in the country music business to invest with him. The venture failed. Twitty was concerned about the effect of the adverse publicity on his country music career. He
repaid the investors himself.
- If Twitty were trying to protect the reputation of Twitty Burger, the expenditures would surely have been nondeductible. Twitty Burger after all was defunct.
- The court found as a fact that one’s reputation in the country music business is very important.
- Deductible? SeeHarold L. Jenkins v. Commissioner, T.C. Memo 1983-667, 1983 WL 14653.
- Consider: Conway Twitty (actually Harold Jenkins) is a famous country music singer. He formed a chain of fast food restaurants (“Twitty Burger, Inc.”). He persuaded seventy-five friends in the country music business to invest with him. The venture failed. Twitty was concerned about the effect of the adverse publicity on his country music career. He repaid the investors himself.
- What should be the tax treatment of expenditures incurred to acquire property that has an indefinite useful life?
Woodward v. Commissioner, 397 U.S. 572 (1970)
MR. JUSTICE MARSHALL delivered the opinion of the Court.
Taxpayers owned or controlled a majority of the common stock of the Telegraph-Herald, an Iowa publishing corporation. The Telegraph-Herald was incorporated in 1901, and its charter was extended for 20-year periods in 1921 and 1941. On June 9, 1960, taxpayers voted their controlling share of the stock of the corporation in favor of a perpetual extension of the charter. A minority stockholder voted against the extension. Iowa law requires “those stockholders voting for such renewal . . . [to] purchase at its real value the stock voted against such renewal.” Iowa Code § 491.25 (1966).
Taxpayers attempted to negotiate purchase of the dissenting stockholder’s shares, but no agreement could be reached on the “real value” of those shares. Consequently, in 1962, taxpayers brought an action in state court to appraise the value of the minority stock interest. The trial court fixed a value, which was slightly reduced on appeal by the Iowa Supreme Court, [citations omitted]. In July, 1965, taxpayers purchased the minority stock interest at the price fixed by the court.
During 1963, taxpayers paid attorneys’, accountants’, and appraisers’ fees of over $25,000, for services rendered in connection with the appraisal litigation. On their 1963 federal income tax returns, taxpayers claimed deductions for these expenses, asserting that they were “ordinary and necessary expenses paid ... for the management, conservation, or maintenance of property held for the production of income” deductible under § 212 ... The Commissioner of Internal Revenue disallowed the deduction “because the fees represent capital expenditures incurred in connection with the acquisition of capital stock of a corporation.” The Tax Court sustained the Commissioner’s determination, with two dissenting opinions, and the Court of Appeals affirmed. We granted certiorari to resolve the conflict over the deductibility of the costs of appraisal proceedings between this decision and the decision of the Court of Appeals for the Seventh Circuit in United States v. Hilton Hotels Corp., [397 U.S. 580 (1970)]. 2 We affirm.
Since the inception of the present federal income tax in 1913, capital expenditures have not been deductible. [footnote omitted] See § 263. Such expenditures are added to the basis of the capital asset with respect to which they are incurred, and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is sold. If an expense is capital, it cannot be deducted as “ordinary and necessary,” either as a business expense under § 162 of the Code or as an expense of “management, conservation, or maintenance” under § 212. 3
It has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures. The most familiar example of such treatment is the capitalization of brokerage fees for the sale or purchase of securities, as explicitly provided by a longstanding Treasury regulation, Reg. § 1.263(a)-2(e), and as approved by this Court in Helvering v. Winmill, 305 U.S. 79 (1938), and Spreckels v. Commissioner, 315 U.S. 626 (1942). The Court recognized that brokers’ commissions are “part of the acquisition cost of the securities,” Helvering v. Winmill, supra, at 305 U.S. 84, and relied on the Treasury regulation, which had been approved by statutory reenactment, to deny deductions for such commissions even to a taxpayer for whom they were a regular and recurring expense in his business of buying and selling securities.
The regulations do not specify other sorts of acquisition costs, but rather provide generally that “[t]he cost of acquisition ... of ... property having a useful life substantially beyond the taxable year” is a capital expenditure. Reg. § 1.263(a)-2(a). Under this general provision, the courts have held that legal, brokerage, accounting, and similar costs incurred in the acquisition or disposition of such property are capital expenditures. See, e.g., Spangler v. Commissioner, 323 F.2d 913, 921 (C.A. 9th Cir.1963); United States v. St. Joe Paper Co., 284 F.2d 430, 432 (C.A. 5th Cir.1960). [citation omitted]. The law could hardly be otherwise, for such ancillary expenses incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it.
More difficult questions arise with respect to another class of capital expenditures, those incurred in “defending or perfecting title to property.” Reg. § 1.263(a)-2(c). In one sense, any lawsuit brought against a taxpayer may affect his title to property – money or other assets subject to lien. [footnote omitted] The courts, not believing that Congress meant all litigation expenses to be capitalized, have created the rule that such expenses are capital in nature only where the taxpayer’s “primary purpose” in incurring them is to defend or perfect title. See, e.g., Rassenfoss v. Commissioner, 158 F.2d 764 (C.A. 7th Cir.1946); Industrial Aggregate Co. v. United States, 284 F.2d 639, 645 (C.A. 8th Cir.1960). This test hardly draws a bright line, and has produced a melange of decisions which, as the Tax Court has noted, “[i]t would be idle to suggest ... can be reconciled.” Ruoff v. Commissioner, 30 T.C. 204, 208 (1958). [footnote omitted]
Taxpayers urge that this “primary purpose” test, developed in the context of cases involving the costs of defending property, should be applied to costs incurred in acquiring or disposing of property as well. And if it is so applied, they argue, the costs here in question were properly deducted, since the legal proceedings in which they were incurred did not directly involve the question of title to the minority stock, which all agreed was to pass to taxpayers, but rather was concerned solely with the value of that stock. [footnote omitted]
We agree with the Tax Court and the Court of Appeals that the “primary purpose” test has no application here. That uncertain and difficult test may be the best that can be devised to determine the tax treatment of costs incurred in litigation that may affect a taxpayer’s title to property more or less indirectly, and that thus calls for a judgment whether the taxpayer can fairly be said to be “defending or perfecting title.” Such uncertainty is not called for in applying the regulation that makes the “cost of acquisition” of a capital asset a capital expense. In our view, application of the latter regulation to litigation expenses involves the simpler inquiry whether the origin of the claim litigated is in the process of acquisition itself.
A test based upon the taxpayer’s “purpose” in undertaking or defending a particular piece of litigation would encourage resort to formalism and artificial distinctions. For instance, in this case, there can be no doubt that legal, accounting, and appraisal costs incurred by taxpayers in negotiating a purchase of the minority stock would have been capital expenditures. SeeAtzingen-Whitehouse Dairy Inc. v. Commissioner, 36 T.C. 173 (1961). Under whatever test might be applied, such expenses would have clearly been “part of the acquisition cost” of the stock. Helvering v. Winmill, supra. Yet the appraisal proceeding was no more than the substitute that state law provided for the process of negotiation as a means of fixing the price at which the stock was to be purchased. Allowing deduction of expenses incurred in such a proceeding, merely on the ground that title was not directly put in question in the particular litigation, would be anomalous.
Further, a standard based on the origin of the claim litigated comports with this Court’s recent ruling on the characterization of litigation expenses for tax purposes in United States v. Gilmore, 372 U.S. 39 (1963). This Court there held that the expense of defending a divorce suit was a nondeductible personal expense, even though the outcome of the divorce case would affect the taxpayer’s property holdings, and might affect his business reputation. The Court rejected a test that looked to the consequences of the litigation, and did not even consider the taxpayer’s motives or purposes in undertaking defense of the litigation, but rather examined the origin and character of the claim against the taxpayer, and found that the claim arose out of the personal relationship of marriage.
The standard here pronounced may, like any standard, present borderline cases, in which it is difficult to determine whether the origin of particular litigation lies in the process of acquisition. [footnote omitted] This is not such a borderline case. Here state law required taxpayers to “purchase” the stock owned by the dissenter. In the absence of agreement on the price at which the purchase was to be made, litigation was required to fix the price. Where property is acquired by purchase, nothing is more clearly part of the process of acquisition than the establishment of a purchase price. 4 Thus, the expenses incurred in that litigation were properly treated as part of the cost of the stock that the taxpayers acquired.
Notes and Questions:
1. Will taxpayers be permitted to claim depreciation or amortization deductions for the expenditures in question? Why or why not?
Start-up Expenses of a Business
No deduction is permitted for the start-up expenses of a proprietorship (§ 195), corporation (§ 248), or partnership (§ 709) – except as specifically provided. What would be the rationale of this treatment?
2. M owned certain real estate in Memphis, Tennessee. In 2011, M entered into contracts to lease the properties for a term of fifty years, and in 2011 paid commissions and fees to a real estate broker and attorney for services in obtaining the contracts.
- For tax purposes, how should M treat the real estate brokerage commissions?
- SeeRenwick v. United States, 87 F.2d 123, 125 (7th Cir. 1936); Meyran v. Commissioner, 63 F.2d 986 (3rd Cir. 1933).
3. S owned stock in several different companies. He sold 100 shares of IBM stock for a nice profit and incurred a brokerage commission of $500. For tax purposes, how should S treat the brokerage commissions?
- Does it make any difference whether S treats the brokerage commission as an ordinary and necessary expense of investment activity or as a decrease in his “amount realized?”
- SeeSpreckels v. Commissioner, 315 U.S. 626 (1942).
4. W purchased the IBM stock that S sold, supra. W incurred a brokerage commission of $500. For tax purposes, how should W treat the brokerage commissions?
- Does it make any difference whether W treats the brokerage commission as an ordinary and necessary expense of investment activity or as an increase in his basis?
- SeeHelvering v. Winmill, 305 U.S. 79 (1938).