You are here

Ordinary and Necessary Expenses

30 July, 2015 - 15:41

Section 162(a) allows taxpayer to deduct all ordinary and necessary expenses paid or incurred in carrying on any trade or business. Sections 162 and 274 also limit trade or business deductions incurred for certain purposes.

Section 212 allows a similar deduction for the ordinary and necessary expenses that taxpayer pays or incurs –

  • for the production or collection of income,
  • for the management, conservation, or maintenance of property held for the production of income, or
  • in connection with the determination, collection, or refund of any tax.


Do the CALI Lesson, Basic Federal Income Taxation: Deductions for Income-Producing Activities after reading §§ 212, 215, 62(a)(10).

We consider here a few recurring issues.

1. Personal vs. Trade or Business

We have already seen that § 162(a)(2) implicitly treats taxpayer’s choice of where to live as a personal one. Hence, taxpayer may not deduct expenditures associated with that choice. The Code also implicitly treats certain other choices as “personal.”

Smith v. Commissioner, 40 B.T.A. 1038 (1939), aff’d 113 F.2d 114 (2d Cir. 1940).



Respondent determined a deficiency of $23.62 in petitioner’s 1937 income tax. This was due to the disallowance of a deduction claimed by petitioners, who are husband and wife, for sums spent by the wife in employing nursemaids to care for petitioners’ young child, the wife, as well as the husband, being employed. ...

Petitioners would have us apply the ‘but for’ test. They propose that but for the nurses the wife could not leave her child; but for the freedom so secured she could not pursue her gainful labors; and but for them there would be no income and no tax. This thought evokes an array of interesting possibilities. The fee to the doctor, but for whose healing service the earner of the family income could not leave his sickbed; [footnote omitted] the cost of the laborer’s raiment, for how can the world proceed about its business unclothed; the very home which gives us shelter and rest and the food which provides energy, might all by an extension of the same proposition be construed as necessary to the operation of business and to the creation of income. Yet these are the very essence of those ‘personal’ expenses the deductibility of which is expressly denied. [citation omitted]

We are told that the working wife is a new phenomenon. This is relied on to account for the apparent inconsistency that the expenses in issue are now a commonplace, yet have not been the subject of legislation, ruling, or adjudicated controversy. But if that is true it becomes all the more necessary to apply accepted principles to the novel facts. We are not prepared to say that the care of children, like similar aspects of family and household life, is other than a personal concern. The wife’s services as custodian of the home and protector of its children are ordinarily rendered without monetary compensation. There results no taxable income from the performance of this service and the correlative expenditure is personal and not susceptible of deduction. [citation omitted] Here the wife has chosen to employ others to discharge her domestic function and the services she performs are rendered outside the home. They are a source of actual income and taxable as such. But that does not deprive the same work performed by others of its personal character nor furnish a reason why its cost should be treated as an offset in the guise of a deductible item.

We are not unmindful that, as petitioners suggest, certain disbursements normally personal may become deductible by reason of their intimate connection with an occupation carried on for profit. In this category fall entertainment [citation omitted], and traveling expenses [citation omitted], and the cost of an actor’s wardrobe [citation omitted]. The line is not always an easy one to draw nor the test simple to apply. But we think its principle is clear. It may for practical purposes be said to constitute a distinction between those activities which, as a matter of common acceptance and universal experience, are ‘ordinary’ or usual as the direct accompaniment of business pursuits, on the one hand; and those which, though they may in some indirect and tenuous degree relate to the circumstances of a profitable occupation, are nevertheless personal in their nature, of a character applicable to human beings generally, and which exist on that plane regardless of the occupation, though not necessarily of the station in life, of the individuals concerned. SeeWelch v. Helvering, 290 U.S. 111.

In the latter category, we think, fall payments made to servants or others occupied in looking to the personal wants of their employers. [citation omitted]. And we include in this group nursemaids retained to care for infant children.

Decision will be entered for the respondent.

Notes and Questions:

1. The B.T.A. says that the expenses of a nursemaid “are the very essence of those ‘personal expenses the deductibility of which is expressly denied.”

  • What was the personal choice that taxpayer made in this case that made these expenses non-deductible?

2. We have already noted §§ 21 and 129. These provisions reverse the result of Smith, but not its construction of § 162.

  • What do these provisions say about the underlying rationale of Smith, in particular the role of the wife and mother?


3. Do the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax Computation: Dependent Care Credit.

2. Limitations on Deductibility of Ordinary and Necessary Expenses

Consider the sources of limitation on the deductibility of expenses that taxpayer incurs in order to generate income that the following cases consider:

Commissioner v. Tellier, 383 U.S. 687 (1966).

MR. JUSTICE STEWART delivered the opinion of the Court.

The question presented in this case is whether expenses incurred by a taxpayer in the unsuccessful defense of a criminal prosecution may qualify for deduction from taxable income under § 162(a), which allows a deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. ...” [footnote omitted] The respondent Walter F. Tellier was engaged in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers. In 1956, he was brought to trial upon a 36-count indictment that charged him with violating the fraud section of the Securities Act of 1933 [footnote omitted] and the mail fraud statute, [footnote omitted] and with conspiring to violate those statutes. [footnote omitted] He was found guilty on all counts, and was sentenced to pay an $18,000 fine and to serve four and a half years in prison. The judgment of conviction was affirmed on appeal. [footnote omitted] In his unsuccessful defense of this criminal prosecution, the respondent incurred and paid $22,964.20 in legal expenses in 1956. He claimed a deduction for that amount on his federal income tax return for that year. The Commissioner disallowed the deduction, and was sustained by the Tax Court. The Court of Appeals for the Second Circuit reversed in a unanimous en banc decision, and we granted certiorari. We affirm the judgment of the Court of Appeals.

There can be no serious question that the payments deducted by the respondent were expenses of his securities business under the decisions of this Court, and the Commissioner does not contend otherwise. In United States v. Gilmore, 372 U.S. 39, we held that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal’” within the meaning of § 162(a). Cf. Kornhauser v. United States, 276 U.S. 145; Deputy v. du Pont, 308 U.S. 488. The criminal charges against the respondent found their source in his business activities as a securities dealer. The respondent’s legal fees, paid in defense against those charges, therefore clearly qualify under Gilmore as “expenses paid or incurred ... in carrying on any trade or business” within the meaning of § 162(a).

The Commissioner also concedes that the respondent’s legal expenses were “ordinary” and “necessary” expenses within the meaning of § 162(a). Our decisions have consistently construed the term “necessary” as imposing only the minimal requirement that the expense be “appropriate and helpful” for “the development of the [taxpayer’s] business.” Welch v. Helvering, 290 U.S. 111; cf.Kornhauser v. United States, supra, at 276 U.S. 152; Lilly v. Commissioner, 343 U.S. 90, 93-94; Commissioner v. Heininger, 320 U.S. 467, 320 U.S. 471; McCulloch v. Maryland, 4 Wheat. 316, 17 U.S. 413-415. The principal function of the term “ordinary” in § 162(a) is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset. Welch v. Helvering, supra, at 290 U.S. 113-116. [footnote omitted] The legal expenses deducted by the respondent were not capital expenditures. They were incurred in his defense against charges of past criminal conduct, not in the acquisition of a capital asset. Our decisions establish that counsel fees comparable to those here involved are ordinary business expenses, even though a “lawsuit affecting the safety of a business may happen once a lifetime.” Welch v. Helvering, supra, at 290 U.S. 114. Kornhauser v. United States, supra, at 276 U.S. 152-153; cf.Trust of Bingham v. Commissioner, 325 U.S. 365, 376. [footnote omitted]

It is therefore clear that the respondent’s legal fees were deductible under § 162(a) if the provisions of that section are to be given their normal effect in this case. The Commissioner and the Tax Court determined, however, that, even though the expenditures meet the literal requirements of § 162(a), their deduction must nevertheless be disallowed on the ground of public policy. That view finds considerable support in other administrative and judicial decisions. 1 It finds no support, however, in any regulation or statute or in any decision of this Court, and we believe no such “public policy” exception to the plain provisions of § 162(a) is warranted in the circumstances presented by this case.

We start with the proposition that the federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources. “[T]he fact that a business is unlawful [does not] exempt it from paying the taxes that if lawful it would have to pay.” United States v. Sullivan, 274 U.S. 259. SeeJames v. United States, 366 U.S. 213.

With respect to deductions, the basic rule, with only a few limited and well defined exceptions, is the same. During the Senate debate in 1913 on the bill that became the first modern income tax law, amendments were rejected that would have limited deductions for losses to those incurred in a “legitimate” or “lawful” trade or business. Senator Williams, who was in charge of the bill, stated on the floor of the Senate that

The object of this bill is to tax a man’s net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men’s moral characters; that is not the object of the bill at all. The tax is not levied for the purpose of restraining people from betting on horse races or upon ‘futures,’ but the tax is framed for the purpose of making a man pay upon his net income, his actual profit during the year. The law does not care where he got it from, so far as the tax is concerned, although the law may very properly care in another way.
 50 Cong. Rec. 3849. 2

The application of this principle is reflected in several decisions of this Court. As recently as Commissioner v. Sullivan, 356 U.S. 27, we sustained the allowance of a deduction for rent and wages paid by the operators of a gambling enterprise, even though both the business itself and the specific rent and wage payments there in question were illegal under state law. In rejecting the Commissioner’s contention that the illegality of the enterprise required disallowance of the deduction, we held that, were we to “enforce as federal policy the rule espoused by the Commissioner in this case, we would come close to making this type of business taxable on the basis of its gross receipts, while all other business would be taxable on the basis of net income. If that choice is to be made, Congress should do it.” Id. at 356 U.S. 29. In Lilly v. Commissioner, 343 U.S. 90, the Court upheld deductions claimed by opticians for amounts paid to doctors who prescribed the eyeglasses that the opticians sold, although the Court was careful to disavow “approval of the business ethics or public policy involved in the payments. ...” 343 U.S. at 97. And in Commissioner v. Heininger, 320 U.S. 467, a case akin to the one before us, the Court upheld deductions claimed by a dentist for lawyer’s fees and other expenses incurred in unsuccessfully defending against an administrative fraud order issued by the Postmaster General.

Deduction of expenses falling within the general definition of § 162(a) may, to be sure, be disallowed by specific legislation, since deductions “are a matter of grace and Congress can, of course, disallow them as it chooses.” Commissioner v. Sullivan, 356 U.S. at 28. 3 The Court has also given effect to a precise and longstanding Treasury Regulation prohibiting the deduction of a specified category of expenditures; an example is lobbying expenses, whose nondeductibility was supported by considerations not here present. Textile Mills Securities Corp. v. Commissioner, 314 U.S. 326; Cammarano v. United States, 358 U.S. 498. But where Congress has been wholly silent, it is only in extremely limited circumstances that the Court has countenanced exceptions to the general principle reflected in the Sullivan, Lilly, and Heininger decisions. Only where the allowance of a deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct” have we upheld its disallowance. Commissioner v. Heininger, 320 U.S. at 473. Further, the “policies frustrated must be national or state policies evidenced by some governmental declaration of them.” Lilly v. Commissioner, 343 U.S. at 97. (Emphasis added.) Finally, the “test of nondeductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction.” Tank Truck Rentals v. Commissioner, 356 U.S. 30, 35. In that case, as in Hoover Motor Express Co. v. United States, 356 U.S. 38, we upheld the disallowance of deductions claimed by taxpayers for fines and penalties imposed upon them for violating state penal statutes; to allow a deduction in those circumstances would have directly and substantially diluted the actual punishment imposed.

The present case falls far outside that sharply limited and carefully defined category. No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense. That is not “proscribed conduct.” It is his constitutional right. Chandler v. Fretag, 348 U.S. 3. SeeGideon v. Wainwright, 372 U.S. 335. In an adversary system of criminal justice, it is a basic of our public policy that a defendant in a criminal case have counsel to represent him.

Deductibility of Legal Expenses

In both Woodward, supra, and Tellier, the Court cited United States v. Gilmore, 372 U.S. 39 (1963). In Gilmore, taxpayer and his wife cross-claimed for divorce. Taxpayer owned the controlling stock interests of three corporations, each of which owned a General Motors dealership. He received a substantial income from these corporations. His wife made sensational allegations, and had she prevailed, she could receive more than half of the stock and/or GM would terminate the corporations’ franchises. Fearing such consequences of losing, taxpayer expended large sums to fight his wife’s allegations and eventually prevailed. Taxpayer sought to deduct his legal expenses attributable to successful resistance of his wife’s claims under § 212 (expenses of conserving property held for production of income). The Commissioner argued that such expenses were personal or family expenses. The court of claims allocated 20% of the fees to the divorce and 80% to conservation of property. The CIR argued that deductibility under either § 162 or § 212 turned “not upon the consequences to respondent of a failure to defeat his wife’s community property claims, but upon the origin and nature of the claims themselves.” The Court agreed: “The characterization, as ‘business’ or ‘personal,’ of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer’s profit-seeking activities. It does not depend on the consequences that might result to a taxpayer’s income-producing property from a failure to defeat the claim.” The Court stated its “origin of the claim” test thus: “The origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal.’” None of taxpayer’s legal expenses were deductible. “It is enough to say that ... the wife’s claims stemmed entirely from the marital relationship, and not, under any tenable view of things, from income-producing activity.”

Congress has authorized the imposition of severe punishment upon those found guilty of the serious criminal offenses with which the respondent was charged and of which he was convicted. But we can find no warrant for attaching to that punishment an additional financial burden that Congress has neither expressly nor implicitly directed. 4 To deny a deduction for expenses incurred in the unsuccessful defense of a criminal prosecution would impose such a burden in a measure dependent not on the seriousness of the offense or the actual sentence imposed by the court, but on the cost of the defense and the defendant’s particular tax bracket. We decline to distort the income tax laws to serve a purpose for which they were neither intended nor designed by Congress.

The judgment is


Notes and Questions:

1. Why should the standard of “necessary” under § 162 be a minimal one, i.e., appropriate and helpful? Are there forces other than the rules of § 162 that will provide controls on the amounts that a taxpayer spends to further his/her/its business?

  • Recall the statement in Welch v. Helvering: Taxpayer “certainly thought [payments to creditors of a bankrupt corporation were necessary], and we should be slow to override his judgment.”

2. The income tax is a tax only on net income. The one exception to this – explicitly stated in the Code – is § 280E. The expenses of carrying on the trade or business of trafficking in controlled substances are not deductible.

  • Is § 280E constitutional?
  • Who would want to know?

3. What norms does a refusal to incorporate public policy into the Code further?

  • A refusal to incorporate public policy into the Code hardly means that there is no public policy limitation on deductibility under § 162. Rather, those limitations must be explicitly stated in the statute itself.
  • See Court’s discussion of the point and its third footnote.
  • Note the topics covered in §§ 162(b, c, e, f, g, k, l, and m).

4. The term “ordinary” has a relatively special meaning as used in § 162. What is it?

5. In Tellier, taxpayer was a criminal. He nevertheless could deduct the “ordinary and necessary” trade or business expenses arising from this character flaw.

  • Should taxpayer be permitted to deduct the ordinary and necessary expenses associated with mental “flaws?” Is Gilliam distinguishable from Tellier?

Gilliam v. Commissioner, 51 T.C. Memo. 515 (1986), available at 1986 WL 21482.





[Taxpayer] Gilliam is, and was at all material periods, a noted artist. His works have been exhibited in numerous art galleries throughout the United States and Europe … In addition, Gilliam is, and was at all material periods, a teacher of art. On occasion, Gilliam lectured and taught art at various institutions.

Gilliam accepted an invitation to lecture and teach for a week at the Memphis Academy of Arts in Memphis, Tennessee. On Sunday, February 23, 1975, he flew to Memphis to fulfill this business obligation.

Gilliam had a history of hospitalizations for mental and emotional disturbances and continued to be under psychiatric care until the time of his trip to Memphis. In December 1963, Gilliam was hospitalized in Louisville; Gilliam had anxieties about his work as an artist. For periods of time in both 1965 and 1966, Gilliam suffered from depression and was unable to work. In 1970, Gilliam was again hospitalized. In 1973, while Gilliam was a visiting artist at a number of university campuses in California, he found it necessary to consult an airport physician; however, when he returned to Washington, D.C., Gilliam did not require hospitalization.

Before his Memphis trip, Gilliam created a 225-foot painting for the Thirty-fourth Biennial Exhibition of American Painting at the Corcoran Gallery of Art (hereinafter sometimes referred to as ‘the Exhibition’). The Exhibition opened on Friday evening, February 21, 1975. In addition, Gilliam was in the process of preparing a giant mural for an outside wall of the Philadelphia Museum of Art for the 1975 Spring Festival in Philadelphia. The budget plans for this mural were due on Monday, February 24, 1975.

On the night before his Memphis trip, Gilliam felt anxious and unable to rest. On Sunday morning, Gilliam contacted Ranville Clark (hereinafter sometimes referred to as ‘Clark’), a doctor Gilliam had been consulting intermittently over the years, and asked Clark to prescribe some medication to relieve his anxiety. Clark arranged for Gilliam to pick up a prescription of the drug Dalmane on the way to the airport. Gilliam had taken medication frequently during the preceding 10 years. Clark had never before prescribed Dalmane for Gilliam.

On Sunday, February 23, 1975, Gilliam got the prescription and at about 3:25 p.m., he boarded American Airlines flight 395 at Washington National Airport, Washington, D.C., bound for Memphis. Gilliam occupied a window seat. He took the Dalmane for the first time shortly after boarding the airplane.

About one and one-half hours after the airplane departed Washington National Airport, Gilliam began to act in an irrational manner. He talked of bizarre events and had difficulty in speaking. According to some witnesses, he appeared to be airsick and held his head. Gilliam began to feel trapped, anxious, disoriented, and very agitated. Gilliam said that the plane was going to crash and that he wanted a life raft. Gilliam entered the aisle and, while going from one end of the airplane to the other, he tried to exit from three different doors. Then Gilliam struck Seiji Nakamura (hereinafter sometimes referred to as ‘Nakamura’), another passenger, several times with a telephone receiver. Nakamura was seated toward the rear of the airplane, near one of the exits. Gilliam also threatened the navigator and a stewardess, called for help, and cried. As a result of the attack, Nakamura sustained a one-inch laceration above his left eyebrow which required four sutures. Nakamura also suffered ecchymosis of the left arm and pains in his left wrist. Nakamura was treated for these injuries at Methodist Hospital in Memphis.

On arriving in Memphis, Gilliam was arrested by Federal officials. On March 10, 1975, Gilliam was indicted. He was brought to trial in the United States District Court for the Western District of Tennessee, Western Division, on one count of violation of 49 U.S.C. § 1472(k) (relating to certain crimes aboard an aircraft in flight) and two counts of violation 49 U.S.C. § 1472(j) (relating to interference with flight crew members or flight attendants). Gilliam entered a plea of not guilty to the criminal charges. ... After Gilliam presented all of his evidence, the district court granted Gilliam’s motion for a judgment of acquittal by reason of temporary insanity.

Petitioners paid $8250 and $8600 for legal fees in 1975 and 1976, respectively, in connection with both the criminal trial and Nakamura’s civil claim. In 1975, petitioners also paid $3800 to Nakamura in settlement of the civil claim.

Petitioners claimed deductions for the amounts paid in 1975 and 1976 on the appropriate individual income tax returns. Respondent disallowed the amounts claimed in both years attributable to the incident on the airplane. [footnote omitted].

* * *

Gilliam’s trip to Memphis was a trip in furtherance of his trades or businesses.



Petitioners contend that they are entitled to deduct the amounts paid in defense of the criminal prosecution and in settlement of the related civil claim under § 162. [footnote omitted]. Petitioners maintain that the instant case is directly controlled by our decision in Dancer v. Commissioner, 73 T.C. 1103 (1980). According to petitioners, ‘[t]he clear holding of Dancer is *** that expenses for litigation arising out of an accident which occurs during a business trip are deductible as ordinary and necessary business expenses. ‘ Petitioners also contend that Clark v. Commissioner, 30 T.C. 1330 (1958), is to the same effect as Dancer.

Respondent maintains that Dancer and Clark are distinguishable. Respondent contends that the legal fees paid are not deductible under either § 162 or § 212 because the criminal charges against Gilliam were neither directly connected with nor proximately resulted from his trade or business and the legal fees were not paid for the production of income. Respondent maintains that ‘the criminal charges which arose as a result of *** (the incident on the airplane), could hardly be deemed ‘ordinary,’ given the nature of (Gilliam’s) profession.’ Respondent contends ‘that the provisions of § 262 control this situation.’ As to the settlement of the related civil claim, respondent asserts that since Gilliam committed an intentional tort, the settlement of the civil claim constitutes a nondeductible personal expense.

We agree with respondent that the expenses are not ordinary expenses of Gilliam’s trade or business.

Section 162(a) [footnote omitted] allows a deduction for all the ordinary and necessary expenses of carrying on a trade or business. In order for the expense to be deductible by a taxpayer, it must be an ordinary expense, it must be a necessary expense, and it must be an expense of carrying on the taxpayer’s trade or business. If any one of these requirements is not met, the expense is not deductible under § 162(a). Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933); Kornhauser v. United States, 276 U.S. 145 (1928). In Deputy v. du Pont, the Supreme Court set forth a guide for application of the statutory requirement that the expense be ‘ordinary’, as follows (308 U.S. at 494-497):

[...] Ordinary has the connotation of normal, usual, or customary. To be sure, an expense may be ordinary though it happens but once in the taxpayer’s lifetime. Cf.Kornhauser v. United States, supra. Yet the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved. Welch v. Helvering, supra, 114. Hence, the fact that a particular expense would be an ordinary or common one in the course of one business and so deductible under [§ 162(a)] does not necessarily make it such in connection with another business. *** As stated in Welch v. Helvering, supra, pp. 113-114: ‘... What is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance.’ 22 F. Supp. 589, 597.

One of the extremely relevant circumstances is the nature and scope of the particular business out of which the expense in question accrued. The fact that an obligation to pay has arisen is not sufficient. It is the kind of transaction out of which the obligation arose and its normalcy in the particular business which are crucial and controlling.

Review of the many decided cases is of little aid since each turns on its special facts. But the principle is clear. [...] [T]he fact that the payments might have been necessary ... is of no aid. For Congress has not decreed that all necessary expenses may be deducted. Though plainly necessary they cannot be allowed unless they are also ordinary. Welch v. Helvering, supra.

... It undoubtedly is ordinary for people in Gilliam’s trades or businesses to travel (and to travel by air) in the course of such trades or businesses; however, we do not believe it is ordinary for people in such trades or businesses to be involved in altercations of the sort here involved in the course of any such travel. The travel was not itself the conduct of Gilliam’s trades or businesses. Also, the expenses here involved are not strictly a cost of Gilliam’s transportation. Finally, it is obvious that neither the altercation nor the expenses were undertaken to further Gilliam’s trades or businesses.

We conclude that Gilliam’s expenses are not ordinary expenses of his trades or businesses.

It is instructive to compare the instant case with Dancer v. Commissioner, supra, upon which petitioners rely. In both cases, the taxpayer was traveling on business. In both cases, the expenses in dispute were not the cost of the traveling, but rather were the cost of an untoward incident that occurred in the course of the trip. In both cases, the incident did not facilitate the trip or otherwise assist the taxpayer’s trade or business. In both cases, the taxpayer was responsible for the incident; in neither case was the taxpayer willful. In Dancer, the taxpayer was driving an automobile; he caused an accident which resulted in injuries to a child. The relevant expenses were the taxpayer’s payments to settle the civil claims arising from the accident. 73 T.C. at 1105. In the instant case, Gilliam was a passenger in an airplane; he apparently committed acts which would have been criminal but for his temporary insanity, and he injured a fellow passenger. Gilliam’s expenses were the costs of his successful legal defense, and his payments to settle Nakamura’s civil claim.

In Dancer, we stated as follows (73 T.C. at 1108-1109):

It is true that the expenditure in the instant case did not further petitioner’s business in any economic sense; nor is it, we hope, the type of expenditure that many businesses are called upon to pay. Nevertheless, neither factor lessens the direct relationship between the expenditure and the business. Automobile travel by petitioner was an integral part of this business. As rising insurance rates suggest, the cost of fuel and routine servicing are not the only costs one can expect in operating a car. As unfortunate as it may be, lapses by drivers seem to be an inseparable incident of driving a car. Anderson v. Commissioner (81 F.2d 457 (CA10 1936)). Costs incurred as a result of such an incident are just as much a part of overall business expenses as the cost of fuel. (Emphasis supplied.)

Dancer is distinguishable.

In Clark v. Commissioner, supra, also relied on by petitioners, the expenses consisted of payments of (a) legal fees in defense of a criminal prosecution and (b) amounts to settle a related civil claim. In this regard, the instant case is similar to Clark. In Clark, however, the taxpayer’s activities that gave rise to the prosecution and civil claim were activities directly in the conduct of Clark’s trade or business. In the instant case, Gilliam’s activities were not directly in the conduct of his trades or businesses. Rather, the activities merely occurred in the course of transportation connected with Gilliam’s trades or businesses. And, as we noted in Dancer v. Commissioner, 73 T.C. at 1106, ‘in cases like this, where the cost is an adjunct of and not a direct cost of transporting an individual, we have not felt obliged to routinely allow the expenditure as a transportation cost deduction.’

Petitioners also rely on Commissioner v. Tellier, 383 U.S. 687 (1966), in which the taxpayer was allowed to deduct the cost of an unsuccessful criminal defense to securities fraud charges. The activities that gave rise to the criminal prosecution in Tellier were activities directly in the conduct of Tellier’s trade or business. Our analysis of the effect of Clark v. Commissioner, applies equally to the effect of Commissioner v. Tellier.

In sum, Gilliam’s expenses were of a kind similar to those of the taxpayers in Tellier and Clark; however the activities giving rise to Gilliam’s expenses were not activities directly in the conduct of his trades or businesses, while Tellier’s and Clark’s activities were directly in the conduct of their respective trades or businesses. Gilliam’s expenses were related to his trades or businesses in a manner similar to those of the taxpayer in Dancer; however Gilliam’s actions giving rise to the expenses were not shown to be ordinary, while Dancer’s were shown to be ordinary. Tellier, Clark, and Dancer all have similarities to the instant case; however, Tellier, Clark, and Dancer are distinguishable in important respects. The expenses are not deductible under § 162(a). [footnote omitted].

We hold for respondent.

Notes and Questions:

1. Were the expenses incurred by taxpayer “necessary?”

If not “ordinary”

...: In Welch, the opposite of an “ordinary” expense was a capital expense. What is the opposite of “ordinary” in Gilliam?

2. By what means did the court in fact implement a public policy limitation on taxpayer’s trade or business expense? Why were the deductions that taxpayer claimed denied?

  • because they were “extraordinary” in light of taxpayer’s trade or business?
  • If so, are there trades or businesses in which such expenditures would not be extraordinary?
  • What if airline employees hit taxpayer and incurred tort damages and legal expenses? These expenses would be the very type of expenses that Gilliam could not deduct.

3. Even when taxpayer incurs ordinary and necessary trade or business expense, taxpayer might not be entitled to deduct them.

Walliser v. Commissioner, 72 T.C. 433 (1979).





During the taxable years 1973 and 1974, James [Walliser] was vice president and branch manager of the First Federal Savings & Loan Association (First Federal) of Dallas, Tex., Richardson branch office. James began his career at First Federal as a trainee in mortgage lending and an appraiser. He later became a branch manager and a loan production officer. Subsequent to the taxable years at issue, James was made the head of the interim loan department of First Federal. Prior to his initial association with First Federal in 1964, James was primarily engaged in the business of home building in Dallas County, Tex.

As branch manager of the Richardson office of First Federal, James supervised all aspects of the branch’s operations, but his primary responsibility was the marketing of permanent and interim loans. James was assigned loan production quotas, and he expected to receive annual raises in his salary if he met his yearly quotas, although First Federal was under no commitment to give James a raise in salary or a bonus if a quota was met. ... James met his quotas and received salary raises at the end of 1973 and 1974.

During the taxable years at issue, petitioners traveled abroad in tour groups organized primarily for people involved in the building industry. In 1973, petitioners took two such trips. The first was to Rio de Janeiro and was sponsored by General Electric Co. (General Electric). It began on March 23, 1973, and ended on March 31, 1973. Their second trip, to London and Copenhagen, was sponsored by Fedders Co. (Fedders) and ran from October 3, 1973, to October 15, 1973.

In 1974, petitioners went to Santo Domingo on a tour organized by Fedders which began on September 27, 1974, and ended on October 4, 1974.


The majority of the people on a General Electric or Fedders builders’ tour were builders and developers from Texas and their spouses. The group also included lenders, title company personnel, and other users and distributors of the sponsor’s product. The dealers and builders who participated in the Fedders builders’ tours did so as part of the Fedders incentive program through which they were able to earn the cost of the tours in whole or in part by purchasing or selling a certain amount of central air conditioning equipment in a particular year. Fedders presented awards during the tours to some people it considered outstanding in its sales and promotional programs but conducted no business meetings.

The builders’ tours were arranged as guided vacation trips, with sightseeing and other recreational activities. Petitioners, however, went on the tours because James found that they provided an unusual opportunity to associate with many potential and actual customers and believed that the tours would generate business, thereby helping him to meet his loan production quotas and obtain salary raises. He spent as much time as possible talking with builders whom he already knew and getting acquainted with builders he had not previously met to make them aware of First Federal’s services and of his own skills. His conversations frequently centered on conditions in the building industry and the availability of loans for builders, but he did not negotiate specific business transactions on the tours or conduct formal business meetings. Social relationships formed or renewed on the tours between petitioners and builders and their spouses resulted in a substantial amount of loan business for First Federal.


Prior to 1973, First Federal had paid for James to participate in builders’ tours. During 1973 and 1974, First Federal stopped reimbursing employees for a variety of previously reimbursed expenses as part of a program of overall budget cutbacks. During the taxable years in issue, First Federal’s policy was to pay entertainment costs directly, or to provide reimbursement for expenses, when an officer of First Federal entertained current customers of the company at civic, social, or business meetings. The company did not customarily reimburse officers for the costs of goodwill meetings or trips for current customers along with prospective customers; however, the board of directors expected the officers, especially vice presidents in charge of marketing activities, to be active in cultivating new customers. First Federal did not reimburse petitioners for any travel expenses incurred in connection with the Fedders and General Electric tours taken by them in 1973 and 1974. James was, however, given leave with pay, in addition to his normal 2-week paid vacation, in order to participate in the tours.


On their 1973 and 1974 tax returns, petitioners deducted, as employee business expenses, one-half of the price of each of the tours (the portion attributable to James’ travel) ...


Initially, we must determine whether petitioners are entitled, under § 162, to deduct as employee business expenses costs incurred by James in connection with his travel on tours for builders organized by General Electric and Fedders. If we hold that the requirements of that section are satisfied, then we must face the further question as to the extent to which the limitations of § 274 apply.

Section 162(a)(2) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses incurred while away from home in the pursuit of a trade or business. The question is essentially one of fact. [citations omitted] Petitioners must show that the expenses were incurred primarily for business rather than social reasons and that there was a proximate relation between the cost of the builders’ tours and James’ business as an officer of First Federal. [citations omitted].

James’ primary responsibility as an officer of First Federal was marketing loans. He was assigned loan production quotas and considered yearly increases in his salary to be contingent upon meeting those quotas. The participants in the General Electric and Fedders tours were not a random group of Texas vacationers. On the contrary, they were largely builders and developers from Texas, the area in which First Federal operated. Thus, the tours were a useful means of maintaining relations with existing customers of First Federal and reaching prospective customers. Indeed, the record indicated that some of the participants considered the social relationships with James, including their association with him on the tours, as an influencing factor in their decisions to seek loans from First Federal.

The fact that, during the years at issue, First Federal did not reimburse James for the costs of his travel does not render his expenses nondeductible. Where a corporate officer personally incurs expenditures which enable him to better perform his duties to the corporation and which have a direct bearing on the amount of his compensation or his chances for advancement, unreimbursed expenses may be deductible under § 162. [citations omitted]. 5

First Federal expected its officers in charge of marketing activities to participate in public or social functions without reimbursement and examined their performance in this regard when evaluating their compensation and overall value to the company. [citation omitted]. James met his loan quotas in 1973 and 1974 and received raises in his salary at the end of those years. In a later year, he became head of First Federal’s interim loan department.

Moreover, the evidence tends to show that First Federal considered the trips valuable in generating goodwill. Although First Federal, which was in the midst of a program of budget cutbacks in 1973 and 1974, did not reimburse James for the tours as it had done in prior years, it continued to grant him additional leave with pay for the time he was on the tours.

Finally, the testimony of petitioners, and particularly of Carol, which we found straightforward and credible, tended to show that the tours were strenuous, and not particularly enjoyable, experiences because of the amount of time expended in cultivating business and, therefore, that petitioners did not undertake the tours for primarily personal reasons. [They took family vacations to other destinations.]

We conclude that, under the circumstances of this case, the requisite proximate relation has been shown to constitute James’ travel expenses as “ordinary and necessary” business expenses within the meaning of § 162(a)(2).

We now turn our attention to the applicability of § 274, the issue on which respondent has concentrated most of his fire. That section disallows a deduction in certain instances for expenses which would otherwise be deductible under § 162. Respondent argues that the requirements of § 274 are applicable here and have not been satisfied in that petitioners have failed: (1) To show that James’ trips were “directly related” to the active conduct of his business (§ 274(a)) ...

Section 274(a) provides in part:


(1) IN GENERAL. – No deduction otherwise allowable under this chapter shall be allowed for any item—

(A) ACTIVITY. – With respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, unless the taxpayer establishes that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that such item was associated with, the active conduct of the taxpayer’s trade or business, ***

and such deduction shall in no event exceed the portion of such item directly related to, or, in the case of an item described in subparagraph (A) directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), the portion of such item associated with, the active conduct of the taxpayer’s trade or business.

Petitioners urge that the “directly related” test of § 274(a) is not applicable because the expenditures at issue were incurred for travel, not entertainment. We disagree.

Section 274(a) relates to activities of a type generally considered to constitute “entertainment, amusement, or recreation.” Reg. § 1.274-2(b) defines “entertainment, amusement, or recreation” as follows:

(b) Definitions – (1) Entertainment defined – (i) In general. For purposes of this section, the term “entertainment” means any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family. ***

(ii) Objective test. An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of this section and § 274(a) regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone. This objective test precludes arguments such as that “entertainment” means only entertainment of others or that an expenditure for entertainment should be characterized as an expenditure for advertising or public relations.

(Emphasis added.)

This regulation is squarely based on the language of the legislative history of § 274 and we find it to be valid as it relates to the issue herein. 6

This regulation and the Congressional committee reports from which it is derived leave no doubt that the deductibility of an expenditure for travel, on what would objectively be considered a vacation trip, is subject to the limitations of subsection 274(a), even where the expenditure relates solely to the taxpayer himself. [citations omitted]. Furthermore, Reg. § 1.274-2(b)(1)(iii) provides that “any expenditure which might generally be considered *** either for travel or entertainment, shall be considered an expenditure for entertainment rather than for *** travel.” This regulation too has a solid foundation in the statute, which provides, in [§ 274(o)], authority for the promulgation of regulations necessary to carry out the purpose of § 274 [footnote omitted] and in the committee reports, which provide that rules be prescribed for determining whether § 274(a) should govern where another section is also applicable. H. Rept. 1447, supra; S. Rept. 1881, supra.

Although the participants in the tours that petitioners took were drawn, for the most part, from the building industry, their activities – sightseeing, shopping, dining – were the same as those of other tourists. Fedders presented some awards to persons considered outstanding in its sales or promotional programs on the tours but did not conduct any business meetings. Nor is there any evidence that any business meetings were conducted on the 1973 General Electric tour; on the itinerary for the 1974 tour, for which petitioners canceled their reservation, only 1 hour out of 10 days of guided tours, dinners, and cocktail parties, was set aside for a business meeting. Under the objective test set forth in the regulations, it is irrelevant that petitioners did not regard the trips as vacations or did not find them relaxing. Clearly, the tours were of a type generally considered vacation trips and, thus, under the objective test, constituted entertainment for the purposes of § 274(a). Therefore, the requirements of that section must be satisfied.

For a deduction to be allowed for any item under § 274(a)(1)(A), the taxpayer must establish that the item was directly related to the active conduct of the taxpayer’s trade or business or, in the case of an item directly preceding or following a substantial and bona fide business discussion, that such item was associated with the active conduct of the taxpayer’s trade or business.

The “directly related” test requires that a taxpayer show a greater degree of proximate relationship between an expenditure and the taxpayer’s trade or business than that required by § 162. [citations omitted]. Reg. § 1.274-2(c)(3) provides that, for an expenditure to be directly related to the active conduct of the taxpayer’s trade or business, it must be shown that the taxpayer had more than a general expectation of deriving some income or business benefit from the expenditure, other than the goodwill of the person or persons entertained. While the language of this regulation is awkward and not completely apt in a situation where the entertainment expenditure relates to the taxpayer alone, it is clear, nevertheless, that more than a general expectation of deriving some income at some indefinite future time is necessary for an expenditure to be deductible under § 274(a). [citations omitted].

The record shows that petitioners participated in the builders’ tours because they provided an opportunity for James to meet new people who might be interested in the services he, and First Federal, had to offer and to maintain good personal relations with people already using those services. While James discussed business continually during the tours, his wife testified that this was typical of his behavior during all social activities. He engaged in general discussions about business conditions and the services he could provide to a builder but did not engage in business meetings or negotiations on the tours. James could not directly connect particular business transactions with specific discussions which occurred during the trips. [footnote omitted]. In short, petitioners’ purpose in taking the trips was to create or maintain goodwill for James and First Federal, his employer, in order to generate some future business. Although the evidence tends to indicate that the trips did, in fact, enhance goodwill and contribute to James’ success in loan production and otherwise constituted ordinary and necessary business expenses deductible under § 162, we hold, nevertheless, that Congress intended, by means of the more stringent standard of the “directly related” test in § 274(a), to disallow deductions for this type of activity, which involves merely the promotion of goodwill in a social setting. [citation omitted].

We also hold that the petitioners’ trips do not qualify as entertainment “associated with” the active conduct of a trade or business. To be deductible, entertainment “associated with” the active conduct of a trade or business must directly precede or follow a substantial business discussion. In St. Petersburg Bank & Trust Co. v. United States, [362 F. Supp. 674 (M.D. Fla. 1973), aff’d in an unpublished order, 503 F.2d 1402 (5th Cir. 1974)], a decision affirmed by the Fifth Circuit, the District Court concluded that the phrase “directly preceding or following” in § 274(a)(1)(A) should be read restrictively in cases in which entertainment expenditures are related to the taxpayer’s trade or business only in that they promote goodwill. [footnote omitted]. In view of the legislative history, which reveals that the “associated with” test is an exception to the general rule intended to limit deductions for entertainment which has as its sole business purpose the promotion of goodwill [footnote omitted], we agree with the District Court’s conclusion. Accordingly, we do not consider the costs of the vacation trips to be deductible under § 274(a)(1)(A) as entertainment directly preceded or followed by a substantial and bona fide business discussion merely because James had general discussions of a business nature intended to promote goodwill during the course of the trips. [citation omitted].

We conclude that § 274(a) bars a deduction for the costs of James’ trips. ...

Decision will be entered for the respondent.

Notes and Questions:

  1. Is it appropriate that § 274 denies this taxpayer a deduction when § 162 permits it?
  2. Suppose that taxpayer Walliser could prove that he actually closed a lending deal (except for documentary formalities) with a person he met and conversed with extensively about his bank’s lending services. The borrower came by the bank three days after the end of the tour and signed the necessary documents. Would (should) the result be different?
  • Suppose that at the end of the signing formalities, Walliser gave the borrower two tickets which cost $25 each to that night’s baseball game. The borrower happily accepted. Walliser did not attend the game with the borrower. Should Walliser be permitted to deduct the cost of the baseball tickets?
  • Would it make any difference if the tickets cost $60 each?

Moss v. Commissioner, 758 F.2d 211 (7th Cir. 1985)

POSNER, Circuit Judge

The taxpayers, a lawyer named Moss and his wife, appeal from a decision of the Tax Court disallowing federal income tax deductions of a little more than $1,000 in each of two years, representing Moss’s share of his law firm’s lunch expense at the Café Angelo in Chicago. The Tax Court’s decision in this case has attracted some attention in tax circles because of its implications for the general problem of the deductibility of business meals. See, e.g., McNally, Vulnerability of Entertainment and Meal Deductions Under the Sutter Rule, 62 Taxes 184 (1984).

Moss was a partner in a small trial firm specializing in defense work, mostly for one insurance company. Each of the firm’s lawyers carried a tremendous litigation caseload, averaging more than 300 cases, and spent most of every working day in courts in Chicago and its suburbs. The members of the firm met for lunch daily at the Café Angelo near their office. At lunch the lawyers would discuss their cases with the head of the firm, whose approval was required for most settlements, and they would decide which lawyer would meet which court call that afternoon or the next morning. Lunchtime was chosen for the daily meeting because the courts were in recess then. The alternatives were to meet at 7:00 a.m. or 6:00 p.m., and these were less convenient times. There is no suggestion that the lawyers dawdled over lunch, or that the Café Angelo is luxurious.

The framework of statutes and regulations for deciding this case is simple, but not clear. Section 262 of the Internal Revenue Code disallows, ”except as otherwise expressly provided in this chapter,” the deduction of ”personal, family, or living expenses.” Section 119 excludes from income the value of meals provided by an employer to his employees for his convenience, but only if they are provided on the employer’s premises; and § 162(a) allows the deduction of ‘”all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including – ... (2) traveling expenses (including amounts expended for meals ...) while away from home....’” Since Moss was not an employee but a partner in a partnership not taxed as an entity, since the meals were not served on the employer’s premises, and since he was not away from home (that is, on an overnight trip away from his place of work, seeUnited States v. Correll, 389 U.S. 299 (1967)), neither § 119 nor § 162(a)(2) applies to this case. The Internal Revenue Service concedes, however, that meals are deductible under § 162(a) when they are ordinary and necessary business expenses (provided the expense is substantiated with adequate records, see § 274(d)) even if they are not within the express permission of any other provision and even though the expense of commuting to and from work, a traveling expense but not one incurred away from home, is not deductible. Reg. § 1.262-1(b)(5); Fausner v. Commissioner, 413 U.S. 838 (1973) (per curiam).

The problem is that many expenses are simultaneously business expenses in the sense that they conduce to the production of business income and personal expenses in the sense that they raise personal welfare. This is plain enough with regard to lunch; most people would eat lunch even if they didn’t work. Commuting may seem a pure business expense, but is not; it reflects the choice of where to live, as well as where to work. Read literally, § 262 would make irrelevant whether a business expense is also a personal expense; so long as it is ordinary and necessary in the taxpayer’s business, thus bringing § 162(a) into play, an expense is (the statute seems to say) deductible from his income tax. But the statute has not been read literally. There is a natural reluctance, most clearly manifested in the regulation disallowing deduction of the expense of commuting, to lighten the tax burden of people who have the good fortune to interweave work with consumption. To allow a deduction for commuting would confer a windfall on people who live in the suburbs and commute to work in the cities; to allow a deduction for all business-related meals would confer a windfall on people who can arrange their work schedules so they do some of their work at lunch.

Although an argument can thus be made for disallowing any deduction for business meals, on the theory that people have to eat whether they work or not, the result would be excessive taxation of people who spend more money on business meals because they are business meals than they would spend on their meals if they were not working. Suppose a theatrical agent takes his clients out to lunch at the expensive restaurants that the clients demand. Of course he can deduct the expense of their meals, from which he derives no pleasure or sustenance, but can he also deduct the expense of his own? He can, because he cannot eat more cheaply; he cannot munch surreptitiously on a peanut butter and jelly sandwich brought from home while his client is wolfing down tournedos Rossini followed by souffle au grand marnier. No doubt our theatrical agent, unless concerned for his longevity, derives personal utility from his fancy meal, but probably less than the price of the meal. He would not pay for it if it were not for the business benefit; he would get more value from using the same money to buy something else; hence the meal confers on him less utility than the cash equivalent would. The law could require him to pay tax on the fair value of the meal to him; this would be (were it not for costs of administration) the economically correct solution. But the government does not attempt this difficult measurement; it once did, but gave up the attempt as not worth the cost, see United States v. Correll, supra, 389 U.S. at 301 n. 6. The taxpayer is permitted to deduct the whole price, provided the expense is ‘”different from or in excess of that which would have been made for the taxpayer’s personal purposes.’” Sutter v. Commissioner, 21 T.C. 170, 173 (1953).

Because the law allows this generous deduction, which tempts people to have more (and costlier) business meals than are necessary, the Internal Revenue Service has every right to insist that the meal be shown to be a real business necessity. This condition is most easily satisfied when a client or customer or supplier or other outsider to the business is a guest. Even if Sydney Smith was wrong that ‘”soup and fish explain half the emotions of life,’” it is undeniable that eating together fosters camaraderie and makes business dealings friendlier and easier. It thus reduces the costs of transacting business, for these costs include the frictions and the failures of communication that are produced by suspicion and mutual misunderstanding, by differences in tastes and manners, and by lack of rapport. A meeting with a client or customer in an office is therefore not a perfect substitute for a lunch with him in a restaurant. But it is different when all the participants in the meal are coworkers, as essentially was the case here (clients occasionally were invited to the firm’s daily luncheon, but Moss has made no attempt to identify the occasions). They know each other well already; they don’t need the social lubrication that a meal with an outsider provides – at least don’t need it daily. If a large firm had a monthly lunch to allow partners to get to know associates, the expense of the meal might well be necessary, and would be allowed by the Internal Revenue Service. SeeWells v. Commissioner, 36 T.C.M. 1698, 1699 (1977), aff’d without opinion, 626 F.2d 868 (9th Cir. 1980). But Moss’s firm never had more than eight lawyers (partners and associates), and did not need a daily lunch to cement relationships among them.

It is all a matter of degree and circumstance (the expense of a testimonial dinner, for example, would be deductible on a morale-building rationale); and particularly of frequency. Daily – for a full year – is too often, perhaps even for entertainment of clients, as implied by Hankenson v. Commissioner, 47 T.C.M. 1567, 1569 (1984), where the Tax Court held nondeductible the cost of lunches consumed three or four days a week, 52 weeks a year, by a doctor who entertained other doctors who he hoped would refer patients to him, and other medical personnel.

We may assume it was necessary for Moss’s firm to meet daily to coordinate the work of the firm, and also, as the Tax Court found, that lunch was the most convenient time. But it does not follow that the expense of the lunch was a necessary business expense. The members of the firm had to eat somewhere, and the Café Angelo was both convenient and not too expensive. They do not claim to have incurred a greater daily lunch expense than they would have incurred if there had been no lunch meetings. Although it saved time to combine lunch with work, the meal itself was not an organic part of the meeting, as in the examples we gave earlier where the business objective, to be fully achieved, required sharing a meal.

The case might be different if the location of the courts required the firm’s members to eat each day either in a disagreeable restaurant, so that they derived less value from the meal than it cost them to buy it, cf. Sibla v. Commissioner, 611 F.2d 1260, 1262 (9th Cir. 1980); or in a restaurant too expensive for their personal tastes, so that, again, they would have gotten less value than the cash equivalent. But so far as appears, they picked the restaurant they liked most. Although it must be pretty monotonous to eat lunch the same place every working day of the year, not all the lawyers attended all the lunch meetings and there was nothing to stop the firm from meeting occasionally at another restaurant proximate to their office in downtown Chicago; there are hundreds.

An argument can be made that the price of lunch at the Café Angelo included rental of the space that the lawyers used for what was a meeting as well as a meal. There was evidence that the firm’s conference room was otherwise occupied throughout the working day, so as a matter of logic Moss might be able to claim a part of the price of lunch as an ordinary and necessary expense for work space. But this is cutting things awfully fine; in any event Moss made no effort to apportion his lunch expense in this way.


Notes and Questions:

1. Walliser was a § 274 case. Moss was not. Why not?

2. What requirement of deductibility under § 162 did taxpayer fail to meet?

3. If this firm had only monthly lunches, the court seems to say that the cost of those lunches might have been deductible. Why should such meals be treated differently than the daily lunches at Café Angelo?

4. Another limitation on §§ 162 and 212 is § 280A, which limits taxpayer’s deductions for business use of a home.

Section 280A limits deductions for business use of a dwelling unit that taxpayer (individual or S corporation) uses as a residence. Section 280A(a) provides taxpayer is entitled to no deduction for such use “except as otherwise provided in” § 280A itself. Section 280A(c) provides those exceptions.

  • Section 280A(c)(1) permits deductions when taxpayer regularly uses a portion of the dwelling “exclusively”
    • as a principal place of business, including a place that taxpayer uses for administrative or management activities of taxpayer’s trade or business, and there is no other fixed location where taxpayer conducts substantial management or administrative activities,
    • as a place of business that patients, clients, or customers use to meet with taxpayer “in the normal course of his trade or business,” OR
    • in connection with taxpayer’s trade or business “in the case of a separate structure which is not attached to the dwelling unit.”
  • Section 280A(c)(2) permits deductions when taxpayer regularly uses space in the dwelling unit to store inventory or product samples that taxpayer sells at retail or wholesale, provided the dwelling unit is the only fixed location of taxpayer’s trade or business.
  • Section 280A(c)(3) permits deductions when they are attributable to rental of the dwelling unit.
  • Section 280A(c)(4) permits deductions attributable to use of a portion of the dwelling unit for licensed child or dependent care services.

Section 280A(c)(5) limits the amount of any deductions attributable to business use of the home to the gross income that taxpayer derives from such use. § 280A(c)(5)(A). Section 280A(c)(5) and Prop. Reg. § 1-280A(i) provide a sequence in which taxpayer may claim deductions attributable to the business activity.

1. the gross income that taxpayer derives from use of a dwelling unit in a trade or business does not include “expenditures required for the activity but not allocable to use of the unit itself, such as expenditures for supplies and compensation paid to other persons.” Prop. Reg. § 1.280A-2(i)(2)(iii).

2. deductions attributable to such trade or business and allocable to the portion of the dwelling unit that taxpayer uses that the Code would allow taxpayer even if he/she/it did not conduct a trade or business in the dwelling unit, e.g., real property taxes, § 164(a)(1), mortgage interest, § 163(h)(2)(D).

3. deductions attributable to such trade or business use that do not reduce basis, e.g., utilities, homeowners’ insurance.

4. basis-reducing deductions, i.e., depreciation.

If taxpayer’s deductions exceed his/her/its gross income derived from the business use of the dwelling unit that he/she/it uses as a home, taxpayer may carry those deductions forward to succeeding years.

  • Notice that unless taxpayer operates a trade or business in the home that is genuine, in the sense that it is profitable, it is unlikely that taxpayer will ever be able to exploit all of the deductions that business use of a home would generate. A taxpayer who does not carry on a profitable trade or business in the home will likely carry forward unused deductions forever.
  • Notice also that the sequence of deductions that § 280A(c)(5) and Prop. Reg. § 1.280A-2(i) mandate requires taxpayer to “use up” the deductions to which he/she/it would be entitled – even if taxpayer did not use his/her/its dwelling unit for business activities, i.e., direct expenses of the business itself followed by deductions to which taxpayer is entitled in any event.
    • The deductions that might motivate taxpayer to claim business use of a home are the ones to which he/she/it would not otherwise be entitled to claim, e.g., a portion of homeowners’ insurance, utilities, other expenses of home ownership, and (perhaps most importantly) depreciation. Those deductions may be effectively out of reach.


5. Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Trade or Business Deductions. Hopefully, you will find some of it to be in the nature of review.

3. Education Expenses


Do CALI Lesson, Basic Federal Income Taxation: Deductions: Education Expenses

  • Read Reg. § 1.162-5.
  • Read §§ 274(m)(2), 274(n).

A taxpayer may incur expenses for various educational activities, e.g., training, that he/she/it may deduct as ordinary and necessary business expenses. Recall that in Welch v. Helvering, the Court indicated that investment in one’s basic education is a nondeductible investment in human capital. Not surprisingly, then, the regulations draw lines around education undertaken to meet the minimum requirements of a particular trade or business or to qualify for a new trade or business. Reg. § 1.162-5 implements these distinctions.

Reg. § 1.162-5(a) states the general rule that expenditures made for education are deductible, even when those expenditures may lead to a degree, if the education –

“(1) Maintains or improves skills required by the individual in his employment or other trade or business, or

(2) Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship status, or rate of compensation.”

Id. However, even expenditures that meet one of these two conditions are nevertheless not deductible if –

  • the expenditures are “made by an individual for education which is required of him in order to meet the minimum educational requirements for qualification in his employment or other trade or business. ... The fact that an individual is already performing service in an employment status does not establish that he has met the minimum educational requirements for qualification in that employment. Once an individual has met the minimum educational requirements for qualification in his employment or other trade or business (as in effect when he enters the employment or trade or business), he shall be treated as continuing to meet those requirements even though they are changed.” Reg. § 1.162-5(b)(2)(i). OR
  • the expenditures are “made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.” Reg. § 1.162-5(b)(3)(i).


Pere Alegal works for a downtown Memphis law firm. He works under the supervision of attorneys, but in many respects he does the same type of work that attorneys do. The firm’s partners advise Alegal that if he does not obtain a law license, he will not be retained. Alegal therefore enrolled in one of the nation’s best-value law schools. Pere will continue to work for the firm. Alegal incurs costs for tuition, books, etc. At the end of the educational program, Alegal passed the bar examination and obtained a license to practice law. Alegal continues to work for the firm and in fact his job functions did not change at all.

  • If Alegal sought to deduct the expenses of his legal education, could he argue that his job functions did not change at all once he obtained his law license?
  • Is it relevant that a law license did not cause Alegal to take up a new trade or business?

4. Section 172

The costs of earning taxable income are offset against that income. Ours is a system that taxes only “net income.” The Tax Code requires an annual accounting of income and deductible expenses. A taxpayer’s income may fluctuate between losses and profitability from one year to the next. This could raise serious problems of fairness if losses cannot offset gross income. Section 172 permits some netting of business gains and losses between different tax years.

  • Read § 172(c). It defines a “net operating loss” (NOL) to be the excess of deductions allowed over gross income.
  • Read § 172(d). Its effect is to limit the deductions that would “take taxpayer’s taxable income negative” to essentially trade or business expenses. For individual taxpayers, capital losses are deductible only to the extent of capital gains, § 172(d)(2)(A); no deduction is allowed for personal exemptions, § 172(d)(3); nonbusiness deductions are allowed only to the extent of taxpayer’s non-trade or business income, § 172(d)(4); the § 199 domestic production deduction is not allowed, § 172(d)(7).
  • Section 172(a) permits NOL carryovers and carrybacks to reduce taxpayer’s taxable income.
    • An NOL carryback is first allowed against the taxable income of each of the two taxable years preceding the taxable year of the net loss. § 172(b)(1)(A)(i).
    • An NOL carryover is allowed against the taxable income of each of the 20 years following the taxable year of the net loss. § 172(b)(1)(A)(ii). 7
    • A taxpayer must use carrybacks and carryovers beginning with the earliest taxable year and then apply them to each succeeding year. § 172(b)(2). The taxable income against which an NOL may be used is computed without regard to capital losses or personal exemptions. § 172(b)(2)(A). A taxpayer may waive the entire carryback period. § 172(b)(3). •The carryback period is extended to three years in the case of NOLs caused by casualties, federally declared disasters, and certain farming losses. § 172(b)(1)(F).
      • The effect of any extension of the carryback period is to get money into the pockets of the affected taxpayer(s) quickly. A casualty or natural disaster likely causes significant losses to the affected taxpayer in the year of the disaster. A carryforward deduction will only benefit such taxpayers in the future. Such taxpayers may have been (quite) profitable in the immediately preceding years and paid a significant amount in federal income tax. An extension of the carryback period permits affected taxpayers to recoup more of such income taxes paid sooner.
    • One measure to deal with the economic crisis is § 172(b)(1)(H). This provision permits a taxpayer to extend the carryback period to 3, 4, or 5 years for an operating loss occurring in 2008 or 2009. § 172(b)(1)(H)(i and ii). Taxpayer may make this election only with respect to one taxable year. § 172(b)(1)(H)(iii)(I).
      • A 5-year carryback is limited to 50% of the taxpayer’s taxable income as of the carryback year, computed without regard to the NOL for the loss year or any other succeeding loss year whose NOL would be carried back. § 172(b)(2)(H)(iv)(I).
      • Presumably, a taxpayer would choose a carryback period that would maximize his/her refund.


In 2011, taxpayer had net losses of $500,000. Redetermine taxpayer’s taxable income under the rules of § 172 if taxpayer’s taxable income would otherwise have been the following amounts for the years in question.

  • 2009: $50,000
  • 2010: $75,000
  • 2011: ?
  • 2012: $110,000
  • 2013: $165,000
  • 2014: $200,000
  • 2015: $100,000
  • 2016: $60,000