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" ,3 ', _ AN ANALYSIS OF THE DICHOTOMOUS
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THE INCOME—PRODUCING EXPENSES OF INDIVIDUALS
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ABSTRACT

AN ANALYSIS OF THE DICHOTOMOUS
FEDERAL INCOME TAX TREATMENT OF
THE INCOME-PRODUCING EXPENSES OF INDIVIDUALS

By

Kevin Mark Misiewicz

The income-producing expenses of individuals have been subject
to a dichotomous treatment for the past 30 years. Some expenses
are deductible for adjusted gross income while others may only be
deducted from adjusted gross income by taxpayers who itemized
deductions. The purpose of this research was to determine the
appropriateness of the present dichotomous Federal income tax treat-
ment of the income-producing expenses of individuals. The main
criteria applied were horizontal and vertical equity achievement.

The explicit reasons advanced for making some expenses deduct—
ible for adjusted gross income have been inconsistent and conflicting.
Justifications have ranged from "directly incurred in a trade or
business" or "administrative simplicity" to "substantial relative
to income" or "similar to business expenses and likely to be rela-
tively large."

An analysis of individual expense categories derived a few
distinctions between income-producing expenses deductible for

adjusted gross income and those which must be itemized. Two

Kevin Mark Misiewicz
deductions for adjusted gross income have maximum time and minimum
location constraints while itemized income-producing expenses do not.
No other consistent differences existed between these two expense
groups in regard to length of acceptance, amount constraints, minimum
time constraints, maximum location limits, personal versus business
allocation, motivation determining criteria, substantiation require—
ments, implications of employer requests or income-producing status.

An analysis of court cases concerning income—producing expenses
from 1969 through 1974 identified only one consideration which differed
greatly without explanation between these two deduction groups. Deduc-
tions for adjusted gross income had a larger proportion of cases
decided in Courts of Appeals and a smaller preportion of cases
decided in the Tax Court than did cases concerning itemized income-
producing expenses. Differences in frequency of occurrence between
groups of expenses of other considerations were largely explained by
the nature of one expense within a group. There was only a slight
tendency for amounts of expense or tax in dispute to be higher in
cases involving deductions for adjusted gross income.

These groups did not significantly differ in regard to average
numbers of government and taxpayer lawyers and frequency of reference
to Section 262, the meanings of ordinary and necessary, the meaning
of a trade or business, poor substantiation and whether the expense
was reasonable.

The impact of the present dichotomous treatment is contrary to
the principles of horizontal and vertical equity. Taxpayers may have

to pay more tax than others in equal economic circumstances because

Kevin Mark Misiewicz
of differences in occupations, types of income-producing expenses
incurred, the existence of direct reimbursement, revenue patterns
or incidence of home ownership. Vertical inequity is present to
the extent that lower income taxpayers itemize less often because
they, consequently, are less often able to deduct many income—
producing expenses. The impact is also vertically inequitable
because low-income taxpayers are discouraged from deducting income-
producing expenses for adjusted gross income by the structure of
Form 1040A. Non-itemizers apparently deduct income-producing expenses
less frequently and in smaller amounts for adjusted gross income than
do itemizers, who tend to have larger incomes, also probably because
they keep poorer records and are less knowledgeable concerning what
is deductible since so few of their expenses are presently deductible.

Two most probable alternatives would provide more horizontal
and vertical equity for the treatment of income-producing expenses.
Each choice, however, leads to an increase in some administrative

costs and to a loss in tax revenues unless tax rates are changed.

AN ANALYSIS OF THE DICHOTOMOUS
FEDERAL INCOME TAX TREATMENT OF
THE INCOME-PRODUCING EXPENSES OF INDIVIDUALS

BY

Kevin Mark Misiewicz

A DISSERTATION

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

1974

 

ACKNOWLEDGMENT

I am deeply grateful for the many helpful comments of the
members of my guidance committee who were Professors Charles Gaa
and Steven Dilley of the Department of Accounting and Financial
Administration and Professor Milton Taylor of the Department of
Economics. Their encouragement and devotion to excellence con-
tributed substantially to the completion and quality of this thesis.

Special thanks is due Professor Gaa for his willingness to
spend many hours discussing research and teaching concepts in tax
accounting, thus guiding and stimulating my interest and abilities
in that area.

Great appreciation is due the Ernst & Ernst Foundation for its
financial assistance during my dissertation endeavor.

I will be eternally grateful for the encouragement and wisdom
shown me by my parents throughout my academic development, especially
during those first rocky college years.

But most of all, I acknowledge my loving super-wife, Kathy,
and all our K's, Kassie, Kristi, Kaycee, and Kuddles, whose prayers

and sacrifices made it possible to have a doctor in the house.

ii

TABLE OF CONTENTS

Page

LIST OF TABLES. O O O O 0 O O O O O O O O O O O O O O O O O 0 v
Chapter

I 0 INT RODU CT I ON 0 O O O O O O O O O O O O O I O O O O O 1-

BaCkground. O O O O O O O O O O O O O O O O O O O 1

Present Law . . . . . . . . . . . . . . . . . . . 2

Statement of the Problem. . . . . . . . . . . . . 4

Objectives of the Study . . . . . . . . . . . . . 7

Methodology . . . . . . . . . . . . . . . . . . . 7

Limitations of the Study. . . . . . . . . . . . . 8

sumary O O O O O O O O O O O O O O O O O O O O O 9

II. BACKGROUND OF DICHOTOMOUS TREATMENT . . . . . . . . ll

Basis For the Deduction . . . . . . . . . . . . . ll

Dichotomous Deduction Evolution . . . . . . . . . 13

sumary O I O O I I O O O O O O O O O O O O O O O 2]-

III. DEDUCTIONS FOR ADJUSTED GROSS INCOME. . . . . . . . 26

Self-EmployEd Expenses. o o o o o o o o o o o o o 26

Employee Expenses . . . . . . . . . . . . . . . . 27

Travel 0 O O O O O O O O O O O O O O O O O O O 27

Reimbursed o o o o o o o o o o o o o o o o o o 34

Transportation . . . . . . . . . . . . . . . . 39

Outside Salesman . . . . . . . . . . . . . . . 42

MOVing O O O O O O O O O O O O O O O O I I I O 43

Investor Expenses . . . . . . . . . . . . . . . . 46

sumarYQooococo-000000000000 49

IV. DEDUCTIONS FROM ADJUSTED GROSS INCOME . . . . . . . 62

Household and Dependent Care Expenses . . . . . . 62

Employee Expenses O O O O O O O O O O O O O O O O 66

Entertainment. 0 I I O O I O O O O O O O O O O 67

Education. I O I O O O O O O O O O O O O O O C 72

OffiCE-in-Home o o o o o o o o o o o o o o o o 75

Employment Seeking or Securing . . . . . . . . 77

Investor Expenses . . . . . . . . . . . . . . . . 79

sumary O O O O O I O O O O O O O O O O O O O O O 80

Chapter

V. ANALYSIS OF CONSIDERATIONS IN COURT DECISIONS
INVOLVING INCOME-PRODUCING EXPENSES. . . . . .

Deduction Substantially Disallowed. . . . . .
Deduction Substantially Allowed . . . . . . .
Aggregate Analysis of Case Factors. . . . . .
Summary . . . . . . . . . . . . . . . . . . .

VI. THE IMPACT AND ALTERNATIVES OF THE DICHOTOMOUS
TREATMENT PROBLEM. . . . . . . . . . . . . . .

The Impacts of the Present Dichotomous
Treatment. . . . . . . . . . . . . . . . . .
Possible Justification for th Present
Dichotomous Treatment. . . . . . . . . . . .
Alternative Treatments for Income—Producing
Expenses . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . .

VII. SUMMARY, CONCLUSIONS, RECOMMENDATIONS, AND
SUGGESTIONS FOR FUTURE RESEARCH. . . . . . . .

Brief Summary of Purpose and Methodology. . .
Summary of Findings . . . . . . . . . . . . .
Conclusions and Recommendations . . . . . . .
Suggestions for Future Research . . . . . . .

BIBLIOGRAPHY. O O O O O O O O O O O O O I O O O O O O O 0

iv

Page

93
97
103

103
107

110

110
130
132
135
138
138
139
141
141

143

Table

3.1

4.1

4.2

5.1

5.2

5.3

5.4

5.5

6.1

6.2

LIST OF TABLES

Factors Pertaining to the Deduction for Adjusted
Gross Income of Certain Income-Producing Expenses
Of IndiVidualSo o o o o o o o o o o o o o o o o 0

Factors Pertaining to the Deduction from Adjusted
Gross Income of Certain Income-Producing Expenses
OfIndiViduaISoo000.00.00.00coo.

A Summary of the Occurrence of Factors Pertaining
to the Deduction of Certain Income-Producing
Expenses of Individuals . . . . . . . . . . . . .

Significant Considerations in Court Decisions
from November, 1969, through July, 1974, Which
Substantially Disallowed the Deduction for
Adjusted Gross Income of Income-Producing
Expenses of Individuals . . . . . . . . . . . . .

Significant Considerations in Court Decisions
from November, 1969, through July, 1974, Which
Substantially Disallowed the Itemized Deduction
of Income-Producing Expenses of Individuals . . .

Significant Considerations in Court Decisions
from November, 1969, through July, 1974,Which
Substantially Allowed the Deduction for Adjusted
Gross Income of Income-Producing Expenses of
Individuals . . . . . . . . . . . . . . . . . . .

Significant Considerations in Court Decisions
from November, 1969, through July, 1974, Which
Substantially Allowed the Itemized Deduction

of Income-Producing Expenses of Individuals . . .

Significant Considerations in Court Decisions
from November, 1969, through July, 1974,
Concerning the Deduction of the Income-Producing
Expenses of Individuals . . . . . . . . . . . . .

Percentage of Individuals Itemizing Deductions. .

Average Amounts Claimed as Wage and
salaIYReveneroooooooo00.000000

V

Page

51

81

83

98

100

104

105

106

111

112

Table

6.3

6.4

6.5

6.6

6.7

6.8

6.9
6.10
6.11
6.12
6.13
6.14

6.15

6.16

6.17

6.18

6.19

6.20

Average Gross

Percentage of
and Salaries.

Percentage of
and Salaries.

Percentage of
Net Income. .

Percentage of
Net Loss. . .

Percentage of
Net Income. .

Percentage of
Percentage of
Percentage of
Percentage of
Percentage of
Percentage of

Percentage of

Income.

Revenue

Returns

Returns

Returns

Revenue

Returns

Returns

Revenue

Returns

Revenue

Returns

Returns

Derived From Wages

Claiming Wages

with Self-Employment

with Self-Employment

from Farming

Having Farm Net Income.

Having Rental Net Income.

from Rental Net Income.

Having Rental Net Loss.

from Pensions and Annuities

Having Dividend Income.

Having Net Gain from

Sale Of Capital ASSEtSo o o o o o o o o o o 0

Percentage of Returns Having Net Loss from
Sale of Capital Assets. . . . . . . . . . . .

Percentage of Returns Having Interest Revenue

A Comparison of Frequency of Itemization
With Frequencies of Moving Expenses and
Employee Business Expenses Claims on

Returns Itemizing Deductions. . . . . . . . .

A Comparison of Frequency of Itemization With

the Percentage of Total Mbving Expenses and
Total Employee Business Expenses Claimed
on Returns Itemizing Deductions . . . . . . .

Impact of Homeowner Expenses on the 1970
Decision to Itemize Compared With the
1974 Alternative Deduction. . . . . . . . . .

vi

Page

113

113

114

115

115

116
116
117
117
118
118

119

120

120

121

123

124

126

Table
6.21
6.22

6.23

Page
Household and Dependent Care Expenses . . . . . . . . 129
Education Expenses Deducted in 1966 . . . . . . . . . 129

Income-Producing Expenses Deductible for
Adjusted Gross Income . . . . . . . . . . . . . . . . 135

vii

CHAPTER I

INTRODUCTION

Background

 

The basic structure of our income tax law has stayed intact since
its modern adoption in 1913. However, over time it has assumed a
growing role in federal revenues and concurrently it has probably be-
come one of the most complicated tax statutes ever devised by man.
These developments have led to difficulty in assessing its ramifica—
tions, but also to an increase in the importance of this assessment.

An analysis of any tax or tax system is complicated by its
interrelated objectives. Objectives such as allocation, stabilization,
revenue collection, and redistribution, which appear to be among the
principal aims of federal tax policy, are often in conflict with each
other.

The principle of equity is a common function of these differing
objectives. Equity is defined as "the quality of being fair or im—
partial."1 From this definition come the concepts of vertical equity
and horizontal equity.

Vertical equity "describes the treatment of taxpayers who are
unequal with the appropriate degree of inequality."2 Judgments
about the exact appropriate degree of unequal treatment depend on
economic measurements of equal sacrifice, equal marginal utility,

and other measurement criteria. However, this research will deal

1

2
with vertical equity to the extent that present law or alternatives
appear to favor one income group over another.

"Perhaps the most widely accepted principle of equity in taxa—
tion is that people in equal positions should be treated equally."3
This is horizontal equity. "Without such equity, taxes may as well
be assessed at random."4 The two problems with achieving this ideal
are determining the index of equality to be used and then defining
it. Income has become the main 20th century index for measuring
equality. "There is widespread agreement that the basic principle of
equity underlying individual income taxation is that equal amounts of
income should bear equal tax liabilities."5 Income's definition for
tax purposes has been the subject of much debate and legislation.

Tax policy objectives are basically achieved through directives
(a) determining which gross revenues are taxable, (b) determining what
can be deducted from taxable gross revenues to obtain taxable income,
(c) specifying where in the computation process these items should be
subtracted, and (d) prescribing at what rates the taxable income is to
be taxed. This research will confine itself to the middle 2 areas
insofar as they apply to the horizontally and vertically equitable

treatment of expenses incurred by individuals to produce gross income.

Present Law

 

Basically, the structure of the computation of an individual's
taxable income is as follows:

Gross Revenues

- Exclusions
Gross Income

- Deductions for Adjusted Gross Income
Adjusted Gross Income

 

- Personal Exemptions

Itemized Deductions
- Largest of <Percentage Standard Deduction

Low-income Allowance

Taxable Income

The main deductions for adjusted gross income are:

1.
2.
3.
4.
5.

6.
7.
8.
9.
10.
11.

I?

mNO\U14-‘UONH
0

moving expenses,

travel expenses,

local transportation expenses,

outside salesmen expenses,

other reimbursed expenses incurred in connection with
employment where the reimbursement is included in gross
income.

trade or business expenses of self-employed individuals,
expenses attributable to rents or royalties,

payments by a self-employed person to a retirement plan,
losses from sale or exchange of property,

long-term capital gains deduction, and

losses from nonbusiness bad debts.

main itemized deductions from adjusted gross income are:

medical expenses,

tax expenses,

charitable contributions,

interest expenses,

personal casualty losses,

alimony payments,

tax counseling and assistance fees,

miscellaneous deductions related to the production of income:

a) entertainment expenses,

b) education expenses,

c) work clothes and uniforms (including upkeep),

d) union dues,

e) protective clothing,

f) residence expenses related to employment,

g) fees paid in seeking or obtaining employment,

h) small tools and supplies,

1) subscriptions to professional journals,

j) membership dues in professional societies,

k) surety bond premiums,

1) certain household and dependent care services,

m) cost of physical exams paid by the taxpayer and
required by the employer,

n) cost of business gifts,

0) telephone expenses,

p) expenses of planning and maintaining investments, and

q) gambling losses to the extent of gambling gains.

4
Sections 62, 162, 212, 214, and 217 of the Internal Revenue Code
of 1954, as amended, cover the income-producing expenses of indi-
viduals. Sections 162, 212, 214, and 217 cover deductible expenses.
Section 162 allows as a deduction all of the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any
trade or business. Sections 214 and 217 allow the deduction of cer-
tain household and dependent care services and moving expenses, respec-
tively. The deduction of expenses incurred in the production or collec-
tion of nontrade or nonbusiness income is allowed by Section 212.
Section 62 limits the deduction for adjusted gross income of these
expenses to:
l. trade and business expenses of self-employed persons
in trade, business, or profession,
2. travel, local transportation, outside salesmen, moving,
and reimbursed expenses (where the reimbursement is
included in gross income) of employees, and

3. expenses attributable to the production of rents or
royalties.

Statement of the Problem

 

Expenses incurred by individuals to produce income as they are
presently defined by Sections 162, 212, 214, and 217 of the Internal
Revenue Code of 1954, as amended, are deductible in either of two
different places for some taxpayers and some cannot be deducted at

all by other taxpayers because they do not itemize deductions.

The present structure of the law means that many expenses which
individuals incur to produce income are deductible only if they
itemize deductions. Taxpayers only find it beneficial to itemize
when their itemized deductions exceed the $1,300 low~income allowance

and the percentage standard deduction which is 15 per cent of their

5
adjusted gross income with a $2,000 maximum. If either of the latter
is largest, the taxpayer does not itemize and therefore gets no deduc-
tion for some of his income-producing expenses. In 1971, the most
recent year for which statistics are available, only 41 per cent of
all individual returns contained itemized deductions. For returns
with adjusted gross income less than $5,000, 10 per cent of returns
contained itemized deductions. Returns with an adjusted gross income
greater than $15,000 contained itemized deductions 87 per cent of the
time.6 Thus only a minority of all taxpayers itemize deductions and
only one-tenth of the lowest income taxpayers itemize. These expenses
which non-itemizers are not allowed to deduct amount to $3 to $4
billion.7 On the other hand, for those non-itemizers who have a per-
centage standard deduction between $1,300 and $2,000, their percentage
standard deduction is higher than it would have been if they had been
able to deduct all of their income-producing expenses for adjusted
gross income. This somewhat offsets their inability to deduct some
income-producing expenses.

Both itemizers and non-itemizers are affected by this dichotomous
treatment of income-producing expenses in some states and localities
which use federal adjusted gross income as a base for their income
taxes. Some of these, such as Michigan and Illinois, do not then
allow a deduction for income-producing expenses which would have been
itemized deductions on a federal income tax return. Thus, the inability
to deduct some of his expenses incurred to produce income for adjusted
gross income on the federal return can result in higher state and city
income tax bills for the taxpayer. However, this impact is lessened

for federal itemizers since these increased state and local income

6

taxes can be deducted on their federal income tax return.

Even if the taxpayer itemizes, other parts of his computation

of tax process are affected by the present dichotomous treatment of

income-producing expenses:

1.

2.

Basically, only medicine and drugs in excess of

1 per cent of adjusted gross income and total medical
expenses in excess of 3 per cent of adjusted gross
income may be deducted.

Charitable contributions can only be deducted to the
extent they do not exceed a percentage of adjusted
gross income.

The maximum tax on earned income is based on gross
income from wages, etc., less any deductions for
adjusted gross income which are connected with this
earned income.

The maximum allowable deduction for certain household
and dependent care services is reduced by $1 for
every $2 of adjusted gross income in excess of $18,000.

Adjusted gross income is used as a base to obtain the
deductible state and local sales tax from tables pro-
vided by the Internal Revenue Service.

This dichotomous treatment also discriminates in favor of self—

employed taxpayers and certain groups of employees and investors.

I.

Reimbursed employee expenses may be deducted for adjusted
gross income where the reimbursement is included in

gross income even though they otherwise would be deductible
only if the taxpayer itemized deductions. This treatment
favors the employees who have expense allowances over the
employee who receives the same total compensation but in
the form of a larger salary with no expense allowance.

The self-employed person and the employee who is an out-
side salesman may deduct all of their income-producing
expenses for adjusted gross income. Employees, other
than outside salesmen, may deduct many of their income-
producing expenses only if they itemize deductions.

Dealers in income-producing property are considered to
be in a trade or business so all of their expenses are
deductions for adjusted gross income. Investors in
income—producing property, except for property producing
rent or royalties, can only deduct their Section 212

7
expenses if they itemize deductions.

Expenses attributable to the production of rent or
royalties are deductions for adjusted gross income.
Expenses to produce other types of investment income
can only be deducted by itemizers. Thus, the expenses
of direct investment in real estate are favored over
expenses of indirect investment in real estate, such
as through stock.

Objectives of the Study

 

1.

determine whether and how the present federal income
tax treatment of income-producing expenses of indi-
viduals is horizontally equitable.

determine the attainment of other tax policy or admin-
istrative objectives, other than horizontal equity,
and analyze their combined attainment.

provide an analysis of the impact of present law con-
cerning individual income-producing expenses and of
alternatives which would bring the law more in accord
with principles of equity.

Methodology

 

1.

2.

research the tax treatment of income-producing expenses

of individuals up to the present to accomplish the first

objective.

a) determine the development of the dichotomous treat-
ment of income-producing expenses.

b) examine the specific development of income-producing
expenses which are deductions for adjusted gross
income and those which are itemized deductions to
ascertain any systematic differences in deduction
criteria.

investigate possible achievement of other objectives

which could balance a lack of horizontal equity to

accomplish the second objective.

a) analyze for factors which are systematically
different in recent court cases concerning income—
producing expenses of individuals which are deduc-
tions for adjusted gross income and those which are
itemized deductions.

b) determine the non-horizontal equity impacts of
present law on taxpayers using published tax data.

8

achieve the third objective by comparing the present
law with alternatives and their probable impacts using
tax data and other information available from the U.S.
Treasury Department.

Limitations of the Study

 

This research will have a number of specific limitations such

as the following:

1.

2.

Income-producing expenses of individuals will be limited

to those as indicated by Sections 62, 162, 212, 214, and
217 of the Internal Revenue Code of 1954, as amended.

A further step would be to look beyond the Congressionally
dictated definition to the determination of the appropriate
definition of what should be a deductible income-producing
expense of an individual and what should be personal and
not deductible. However, this study should be a useful
input in that definitional process.

Only expenses of individuals to produce gross income will
be considered here. Section 265 of the Internal Revenue
Code of 1954, as amended, only allows the deduction of
expenses related to tax-exempt income for business expenses
to produce tax-exempt interest. All other expenses to
produce tax-exempt income are not deductible. This research
will confine itself to expenses incurred to produce income
which is taxable.

Section 183 of the Internal Revenue Code of 1954, as amended,
limits the deduction of income-producing expenses in the
case of a hobby, which is an activity deemed not to be
carried on for profit. Only profit-seeking expenses are
considered here, notwithstanding the definitional problem

of where a tax shelter becomes a hobby.

This study will not consider the deductibility of income-
producing expenses which frustrate public policy, such as
bribes and penalties, as determined by the courts.

Only costs whose value is used up in the present year are
covered in this work. Section 263 of the Internal Revenue
Code of 1954, as amended, determines when these expenses

are incurred. The line between capital expenditures and
expenses is important but not to the results determined here.

Some areas of individual income-producing expenses, such as
employee lobbying expenses and repayment of insider profits,
are not mentioned further due to their insignificant specific
impact on taxpayers.

9
7. Although an earned-income credit existed in various forms
in most years from 1924 to 1943 supposedly to counter the
discrimination of the tax law against earned income, it
had no relation to actual income-producing expenses
incurred, so this research will not cover its computation
and effects.

Other more specific limitations will be pointed out in the subse-

quent chapters.

Summary

Horizontal equity is desirable and it does not appear to be
attained in the present tax treatment of the income-producing expenses
of individuals. The research discussed in subsequent chapters will
determine the degree to which horizontal equity exists, why it does
not exist in some areas, and the implications of the present treatment

contrasted with that of various alternative treatments.

2.

3.

5.

6.

10

FOOTNOTES--CHAPTER I

The American College Dictionary (New York: Random House, Inc.,
1963), p. 406.

 

Allan, Charles M., The Theory of Taxation (Manchester:
C. Nicholls & Co., Ltd., 1971), p. 36.

 

Musgrave, Richard A., The Theory of Public Finance (New York:
McGraw-Hill, 1959), p. 160.

 

Musgrave, Richard A., A Comprehensive Income Tax Base?,
(Branford: Federal Tax Press, 1968), p. 114.

 

Ture, Norman B., "The Federal Revenue System: Facts and
Problems 1959," Hearings of the Joint Economic Committee,
86th Congress, lst Session, p. 12.

U.S. Treasury Department, Internal Revenue Service, Statistics
of Income - 1971, Individual Income Tax Returns (Washington:
U.S. Government Printing Office, 1973), p. 78.

 

 

Ibid., p. 332.

Surrey, Stanley 8., Pathways to Tax Reform (Cambridge: Harvard
University Press, 1973), p. 312.

 

CHAPTER II

BACKGROUND OF DICHOTOMOUS TREATMENT

Before looking at the specifics of the deductions for income-
producing expenses, it is important to look at the basis for their
deduction. A subsequent tracing of the development of our present
dichotomous treatment of these expenses provides possible reasons

for the present tax law structure.

Basis for the Deduction

 

From the first U.S. income tax legislation in 1861, only the
word income has been mentioned as the base for this tax. It is
important to know whether the law is referring to gross income, net
income, or some base between these two. The term net income implies
that expenses incurred to produce that income are deductible. Unfor-
tunately, the determination of the appropriate base is not easily
discerned.

In drafting our first two income tax laws in 1861 and 1862,
members of Congress were not sure whether gross or net income was
what should be taxed. They were afraid to say net income for fear
that taxpayers would take too many personal expenses.1 Senator Clark
referred to the ambiguity in the amendment because of the failure to
explain whether income meant gross or net income, but Simmons stated

that the desire of the committee was simply to give the government

11

12

the power to levy the tax, but that all the details should be worked
out by the Secretary of the Treasury.2 These statements, inconclu-
sive as they are, are important because much of the phraseology of
the Civil War laws was carried over into the laws written after the
adoption of the Sixteenth Amendment.3

Even in the 20th century, arguments continue concerning the
appropriate base of our income tax law. Lutz stated that even though
the word income was used in the Sixteenth Amendment without defining
it, it was assumed, from the start that the only proper way of
applying the amendment was to levy upon some vague but emotionally
satisfactory base called net income.4 However, the Supreme Court
has said that the authority conferred upon Congress by Section 8 of
Article I of the Constitution to lay and collect taxes is exhaustive,
embraces every conceivable power of taxation, and that this authority
is not limited by the 16th Amendment.5 The Tax Court has ruled that
"regardless of theory, gross income as we are here concerned with it
is gross income according to the statute. . .deductions from gross
income are matters of legislative grace and are allowable only where
the conditions which have been prescribed by Congress have been met
and satisfied."6 Some people concluded that so far as the Constitution
is concerned, the income tax could be levied on gross income.7 Others,
such as Seligman,8 Rice,9 Haden,10 Pechman,11 Surrey,12 Griswold,13
and the American Institute of Accountants14 concluded that a constitu-
tional right exists to deduct expenses incurred to produce income.
However, their arguments appear to be based on the expressed inten-
tions of Congress rather than on the inherent power which the Constitu-

tion gives our lawmakers should they choose to use it.

13
Although the number of vocal advocates favors the constitutional
right argument, the controversy is not at present resolved. It,
therefore, can only be assumed that individual expenses to produce
income are deductible only insofar as and wherever Congress allows
them to be deducted. Any other conclusion at this late stage would
leave open the possibility of attributing modern meanings to those

words which they did not possess at the time they were written.15

Dichotomous Deduction Evolution

Concluding that these income-producing expenses are deductible
only insofar as and wherever Congress deems, necessitates the deter-
mination of the evolution of the present treatment by law of these
expenses. This will produce a general historical perspective and,
more importantly, it will divulge the express and some of the implied
reasons for the structure of our income tax concerning this area.

The first U.S. income tax was passed by Congress in 1861,
although it was never implemented. Subsequent acts were passed and
put into effect from 1862 through 1871. These first attempts to tax
income failed to define income precisely and they allowed for very
few deductions other than taxes and rent paid. It was left to the
Secretary of the Treasury to determine what should be deducted.16
Apparently, he allowed the deduction of ordinary and necessary busi-
ness expenses.17 Tax rates during this period were low and compliance
was increasingly lax. The Act of 1894 made the same sketchy reference
to income—producing expenses. This law was determined to be uncon-
stitutional before it was put into force.

Our modern U.S. income tax was authorized with the ratification

14

of the 16th Amendment. Section 2(B) of the subsequent Revenue Act of
1913 allowed the deduction of ordinary and necessary expenses incurred
in carrying on any trade or business. The Revenue Acts of 1916 and
1918 retained that language in their Sections 5(a)(1) and 214(a)(1),
respectively. Subtracting deductible expenses from the total of
revenues, which was called gross income, resulted in net income. Tax
due was computed by multiplying tax rates by net income. Article 291,
concerning office-in—home expenses, and Article 292, concerning travel
expenses, of Regulations 45 issued by what is now the Internal Revenue
Service, were initial attempts to interpret the tax legislation con-
cerning income-producing expenses. The increasing tax rates and lower
exemptions made this interpretation important for larger groups of
taxpayers.

subsequent revenue acts, regulations, rulings, and court decisions
developed and refined the basic deductibility criteria of ordinary,
necessary and reasonable which are now applied to individual income-
producing expenses. These sources indicate an increasing number of
expenses which were felt to exist in conformance with these criteria.
Allowing the deduction of all of these income-producing expenses was
accepted as horizontally equitable. An occasional voice advocated
their limitation, but even then the dissents were conditioned upon a
decrease in tax rates and the achievement of simplification.18

The Revenue Act of 1941 initiated the concept of deducting a
given amount or a percentage of income rather than actual expenses
which were otherwise deductible. This amounted to a 10 per cent tax
reduction in lieu of deductions for those with incomes of $3,000 or

less derived from salaries, wages, dividends, interest and rent.

15
The purpose of this alternate tax computation was to simplify compli-
ance for the added millions of people paying income tax due to the law
changes initiated to help finance World War II.19

In 1942, Congress added Section 23(a)(2) to the Internal Revenue
Code of 1939. It, like its successor, Section 212 of the Internal
Revenue Code of 1954, extended the deductibility of income-producing
expenses to activities not involving a trade or business.

The Individual Income Tax Act of 1944 modified the 1941 tax
reduction option by defining a new term, adjusted gross income, and
by allowing either itemized actual expenses or 10 per cent of adjusted
gross income to be deducted from adjusted gross income. This standard
deduction was introduced to reduce the complexity of the income tax
for the vast majority of taxpayers.20 Taxable income was computed by
determining gross income, subtracting certain actual expenses to obtain
adjusted gross income, and then subtracting personal exemptions plus
the larger of the standard deduction or certain other actual expenses.
This basic structure remains intact today.

Reports of the House of Representatives' Ways and Means Committee
and the Senate Finance Committee provide the best insight into the
formulation of adjusted gross income. Concerning income-producing
expenses, House Report No. 1365 and Senate Report No. 885 said that
Section 22(n) provided for adjusted gross income to be gross income
less trade or business expenses of self—employed people, employee
travel or reimbursed expenses, and investor expenses to produce rents
or royalties.21 Section 22(n) amended the Internal Revenue Code of
1939 and corresponds to Section 62 of the Internal Revenue Code of

1954. Both reports indicated that these expenses are those which

16

are necessary to make as nearly equivalent as practicable the concept
of adjusted gross income, when that concept is applied to different
types of taxpayers deriving their incomes from various sources. The
committee felt that such equivalence is necessary for equitable appli-
cation of a mechanical tax table or a standard deduction which does
not depend on the source of income. The committee reports gave the
example of a store proprietor needing to reduce his gross income by
his business expenses before his income becomes comparable, for the
purposes of a tax table or standard deduction, to the salary of an
employee in the usual case. Their other example stated that expenses
to produce rents or royalties are deductions for adjusted gross income
while expenses to produce interest or dividends are not, so the
resulting adjusted gross incomes will be on a parity. No further
explanation indicates in what manner the deduction for adjusted
gross income of all self-employed expenses but only travel and
reimbursed expenses of employees produces comparability. They also
do not explain how allowing taxpayers the deduction for adjusted gross
income of rent or royalty producing expenses puts them on a parity
with taxpayers whose expenses attributable to other types of invest—
ment income can only be deducted if they itemize deductions.

The reports justify this dichotomous treatment by indicating
that income-producing expenses deductible for adjusted gross income
are those directly incurred in the carrying on of a trade or business.
They do not indicate why, for instance, office-in-home expenses of a
self-employed person are inherently more directly related to his

income-producing activities than the same expenses of an employee.

Section 23(a)(1)(A) of the Internal Revenue Code of 1939 and its

l7
successor, Section 162 of the 1954 Code, authorized the deduction of
expenses incurred in a trade or business and considered an employee
to be in a trade or business insofar as allowing the deduction of
income-producing expenses is concerned. No explanation is directly
given concerning the decision to allow self-employed taxpayers to
deduct all of their trade or business expenses for adjusted gross
income while some employee trade or business expenses could only be
deducted as itemized deductions.

It is also unclear why at that time employee income-producing
expenses, other than travel, were made deductible for adjusted gross
income only if they were reimbursed. An inference can be made that
if an employer pays an employee for an expense he incurred, it is
more likely to fit the criteria for tax deduction. It is probable
that the employer could be viewed as an intial auditor, also, so
that the Internal Revenue Service doesn't have to worry so much
about auditing reimbursed employee expenses. The reports shed no
further light on these matters.

The only other information concerning Section 22(n) in this
Congress was provided by Representative Doughton on the floor of the
House of Representatives. Unfortunately, his statement merely
described how the bill allowed taxpayers to deduct certain business
expenses separately before taking the standard deduction without
saying more about why the deduction for all income-producing expenses
wasn't allowed before taking the standard deduction.22

subsequent I.R.S. rulings and court decisions from 1945 to 1954
upheld and reinforced this dichotomous treatment. Outside salesmen

had to deduct entertainment, transportation, and commissions to other

l8
. . . 23 .

salesmen as itemized deductions. That also applied to the cost
of army officer insignias24 and nonreimbursed employee transportation
expenses.25 The courts held that employee transportation26 and mis-
cellaneous27 expenses had to be deducted from adjusted gross income.
One case held that Section 22(n) prohibited the itemized deduction
of expenses which it states are to be deducted for adjusted gross
income.28 These judicial decisions referred only to the language
used by the 1944 committee reports to justify the dichotomous treat-
ment of income—producing expenses.

In 1953, a number of people recommended at Congressional hearings
that the law be changed.

It is difficult to see what, if any, basis exists in logic

or equity for this distinction and for the preferential

treatment which it affords to one group of taxpayers as

distinguished from another.29

The employee should be treated as an earning entity, and

the expenses he incurs in earning his salary income should

be allowed to him to the same extent as the business

expenses allowed to his self-employed neighbor.3O

Sec. 23 of the IRC should be modified so that deductions

from gross income will be divided into two separate and

basic categories: namely, (1) those attributable to gainful

activity and the production of income and (2) personal deduc-

tions. Many disputes have arisen as to which deductions are

allowable in addition to the optional standard deduction. A

division of the deductions permitted by the Code into two

separate and distinct categories would be an improvement over

the present arrangement. 1
The hearings reflected no testimony in favor of the status quo.

However, the 1954 Congress only made employee transportation and
outside salesman expenses additionally deductible for adjusted gross
income. Their reasoning was that these expenses, when incurred,

usually are substantial, regarding transportation,32 or substantial

relative to their incomes, regarding outside salesmen.33 Both

19
committee reports used this wording.

The 1954 Code also added a new income-producing expense deduc-
tion, Section 214, for the costs of child care incurred to allow
the taxpayer to be gainfully employed. The deduction can only be
taken by taxpayers not using the standard deduction.34 Testimony
at the 1953 hearings was in favor of deducting child care expenses
for adjusted gross income because they are "directly related to the

production of income."35

No reason was stated for the tax writing
committees' acting in conflict with that testimony.

From 1955 to 1963, I.R.S. rulings and court decisions reflected
the wording and reasoning of the 1944 and 1953 Congressional committee
reports. They indicated that Section 62 does not create any new
deductions,36 nor does it impose additional requirements for the
deduction of the business expenses of employees.37 The I.R.S. empha-
sized that education expenses were deductible for adjusted gross
income only for self-employed individuals.38 This language was cited
in the case where the judiciary held that a taxpayer can still deduct
the standard deduction even though he mistakenly deducted for adjusted
gross income some income-producing expenses which could only be sub-
tracted as itemized deductions.39

Other sources indicate misunderstanding of or lack of agreement
with this treatment during this period. One knowledgeable tax lawyer
stated that the standard deduction "is in lieu of the deductions

40

without a source of gain connection." This is not true for investors
or employees. An expert economist had an incorrect idea of the effect

of this provision, thus:

20

Adjusted gross income is a statutory concept which is

intended to approximate net income after allowing for

expenses incurred in earning such income. For admin-

istrative reasons, expenses incurred in earning non-

business incomes (i.e. wages and salaries, interest,

and dividends) are generally not allowed as deductions

in arriving at adjusted gross income. This deficiency

is corrected by permitting taxpayers to deduct such

- 4

expenses in arriv1ng at taxable income.

The rationale of administrative reasons does not agree with the com—
mittee reports previously cited and this deficiency is not made up
for people who do not itemize deductions. Another economist recom-
mended a change in the law.

Those deductions that may be regarded as reducing

income taxpaying capacity as charges against income

that are designed to refine the income concept, it

seems to me, ought, in any event, whatever else the

committee may do, be removed from the personal expense

deduction and be made expenses for adjusted gross

income.

Another tax expert's View was that the present treatment negates that
an employee is in a trade or business except as to the four specific
categories of travel, transportation, outside salesman, and reimbursed
expenses.

In 1964, Section 217 was added to the 1954 Code. It allowed a
deduction for moving expenses of employees. These expenses were made
deductible for adjusted gross income by amending Section 62. The
Congressional committee reports show that this treatment was due to a
determination that these expenses are substantially similar to business
expenses and because, when they are incurred, they are likely to be
relatively large.44 The committees felt that it would be undesirable
to, in effect, make taxpayers choose between taking this deduction

and the standard deduction in lieu of itemized personal deductions.45

In 1967, Bittker, who views the tax law as resisting any

21

underlying theory base other than being the result of conflicting
pressures, expressed the feeling that the costs of earning a living
should be deductible despite the definitional and allocative problems
caused by the personal benefits these costs inextricably confer.4
He did not include Section 62 in his list of sections which he
deemed were the only operative provisions needed for an ideal compu-
tation of taxable income.47

The 1969 Tax Reform Act modified the moving expense and house-
hold and dependent care expense deductions. It also initiated the
lOWbincome allowance to provide a floor, currently $1,300, so that
this amount can be deducted when it exceeds a taxpayer's itemized
deductions and percentage standard deduction. Its purpose was to
ensure that persons below the poverty level would not be subject to

Federal income tax.48

Summagy

It can be reasonably concluded that income—producing expenses
are deductible for federal income tax purposes wherever and to what-
ever degree is specified by current 1aw. This law specifies that
these expenses be treated in a dichotomous manner. The reasons for
this structure are varied and conflicting. Lawmakers have justified
making only some income-producing expenses deductions for adjusted
gross income because they either were directly incurred in a trade or
business, reimbursed, substantial when incurred, substantial relative
to income when incurred, or similar to business expenses and likely
to be relatively large when incurred. These explicit justifications

do not appear to exhibit a cohesive differentiation from those other

22

income-producing expenses which an individual can deduct only if he
itemizes deductions, especially in the light of the cited arguments
of tax experts advocating a more unified approach in this area. The
reasons cited also do not appear to justify the effects, which were
cited in the previous chapter, of this two-fold treatment of income—
producing expenses. Thus, a tracing of our law to the present does
not provide a consistent and substantive justification for the
apparent lack of horizontal equity in the treatment of income-

producing expenses of individuals.

10.

11.

12.

13.

14.

15.

16.

17.

23

FOOTNOTES--CHAPTER II

Congressional Globe, 37th Congress, lst Session, p. 315.

 

Ibid., p. 321.

Blakey, Roy G. and Gladys C., The Federal Income Tax (New York:
Longmans, Green, and Co., 1940), p. 5.

 

Lutz, Harvey L., "Some Errors and Fallacies of Taxation as
Exemplified by the Federal Income Tax," Proceedings of the 34th
Annual Conference of the National Tax Association (Washington:
National Tax Association, 1941), p. 355.

 

 

Brushaber 'v. Union Pacific Railroad Company, 240 U.S. 1 (1916).
Coach v. Comm. 21 TC 481 (1954).
Blakey, Roy G. and Gladys C., p. 484.

Seligman, Edwin R. A., The Income Tax (New York: Macmillan Co.,
1914), p. 683.

 

Rice, Leon L., "New Light on the Meaning of Ordinary and
Necessary Expenses," Taxes, Vol. 22, No. 6, June 1944, p. 249.

Haden, Harry B., Fundamentals of Federal Taxation (Charlottes-
ville: Michie Co., 1959), p. 30.

 

Pechman, Joseph A., "The Individual Income Tax Base," Proceedings

 

of the 48th Annual Conference of the National Tax Association
(Sacramento: National Tax Association, 1956), p. 306.

 

Surrey, Stanley 3., p. 138.

Griswold, Erwin N., "An Argument Against the Doctrine That
Deductions Should be Narrowly Construed as a Matter of Legis-
lative Grace," Harvard Law Review, Vol. 56, June 1943, pp. 1142-7.

 

American Institute of Accountants Committee on Federal Taxation,
"Federal Tax Revision Program," Journal of Accountancy, Vol. 68,
No. 5, 1939, p. 312.

 

Kaminsky, Michael, "Are All Deductions a Matter of Privilege?"
Taxes, Vol. 37, No. 2, February 1959, p. 137.

Smith, Harry E., The United States Federal Internal Tax History
from 1861 to 1871 (Boston: Houghton Mifflin, 1914), p. 48.

 

Magill, Roswell, Taxable Income (New York: Ronald Press Co.,
1945), p. 336.

 

18.

19.

20.

21.

22.

23.
24.
25.

26.

27.

28.

29.

30.

31.

32.

24

Bear, Arnold R., Proceedings of the 19th Annual Conference of
the National Tax Association (New York: National Tax Association,

 

1927), p. 222.

Blough, Roy, "The Federal Personal Income Tax Under the Revenue
Act of 1941," Proceedings of the 34th Annual Conference of the
National Tax Association (Washington: National Tax Association,

 

 

1941), p. 344.

Staff of the Joint Committee on Internal Revenue Taxation,
General Explanation of the Tax Reform Act of 1969 (Washington:

 

U.S. Government Printing Office, 1970), p. 216.

House Report No. 1365, Report of the House Ways and Means
Committee of the Individual Income Tax Bill of 1944 (Washington:

 

 

U.S. Government Printing Office, 1944), pp. 18-19. Senate
Report No. 885 used the same wording.

Statement of Representative Doughton," Congressional Record,
78th Congress, 2d Session, Col. 90—Part 3, 1944, p. 3976.

 

I.T. 3728, 1945 Cum. Bull. 78.
I.T. 3752, 1945 Cum. Bull. 81.
Rev. Rul. 190, 1953-2 Cum. Bull. 303.

Kershner v. Commissioner, 14 TC 168 (1950) and Smith v.
Commissioner, 21 TC 991 (1954).

Harris v. Commissioner, 22 TC 1118 (1954).

Koshland v. Commissioner, 19 TC 860 (1953). The taxpayer wanted
to deduct interest on a loan used to purchase rent producing
property as an itemized deduction to raise adjusted gross income
so more charitable contributions could be deducted.

Statement of Clinton B.D. Brown at the Hearings Before the
Committee on Ways and Means on General Revenue Revision, 83rd
Congress, First Session, Part 1 (Washington: U.S. Government
Printing Office, 1953), p. 216.

 

Statement of Carrol G. Josselyn at the Hearingszefore the
Committee on Ways and Means on General Revenue Revision, op.cit.,

 

 

p. 220.

Statement of the American Institute of Accountants at the
Hearings Before the Committee on Ways and Means on General
Revenue Revision, op. cit., p. 223.

House Report No. 1337, Report of the Committee on Ways and Means,
Internal Revenue Code of 1954, 83rd Congress, First Session

 

(Washington: U.S. Government Printing Office, 1954), p. 9.

33.
34.

35.

36.
37.
38.
39.
40.

41.

42.

43.

44.

45.

46.

47.

48.

25
Ibid., p. 10.
Ibid., p. 30, and Senate Report No. 1622, p. 35.

Statement of Julia Thompson, Hearings Before the Committee on
Way§_and Means on General Revenue Revision, op. cit., p. 50.

 

T.D. 6272, 1957-2 Cum. Bull. 18.

Rev. Rul. 60-16, 1960-1 Cum. Bull. 58.

Rev. Rul. 60—97, 1960-1 Cum. Bull. 9.

Miller v. Comm., 26 TC 151 (1957).

Haden, Harry H., o . cit., p. 76.

Pechman, Joseph A., "Erosion of the Individual Income Tax,"
National Tax Journal, Vol. X, No. l, 1957, p. 8. He repeated

this statement in similar words in his recent book, Federal Tax
Policy (New York: W. W. Norton & Co., Inc., 1971), p. 83.

 

 

Statement by Harvey E. Brazer in Panel Discussions Before the
Committee on Ways and Means on Income Tax Revision, 86th Congress,
First Session (Washington: U.S. Government Printing Office,
1959), p. 166.

 

Dobres, Jeanne L., "Employee's Expenses in Earning Salary,"
Proceedings of the New York UniversitngOth Annual Institute

on Federal Taxation (Albany: Matthew Bender & Co., Inc., 1962),
p. 120.

House Report No. 749, Report of the Committee on Ways and Means
on the President's 1963 Tax Message, 88th Congress, Second
Session (Washington: U.S. Government Printing Office, 1964),
p. 184. The same wording is used in Senate Report No. 830.

Ibid.

Bittker, Boris I., "A Comprehensive Tax Base as a Goal of
Income Tax Reform," Harvard Law Review, Vol. 80, 1967, p. 925.

Ibid., p. 932.
Staff of the Joint Committee on Internal Revenue Taxation,

General Explanation of the Tax Reform Act of 1969 (Washington:
U.S. Government Printing Office, 1970), p. 218.

 

CHAPTER III

DEDUCTIONS FOR ADJUSTED GROSS INCOME

A tracing of the history of the dichotomous treatment of income-
producing expenses led to several conflicting reasons which did not
account for the apparent horizontal inequity of our present law. A
possible alternative justification for Section 62 might be derived by
a look at the development of the expenses which make up individual
income-producing expenses. Any consistent differences in the criteria
used by lawmakers in formulating the extent to which these expenses
are deductible or distinctions in their separate histories may
justify the different classification of these groups. This chapter
will review the present group of income-producing expenses which are
deductions for adjusted gross income and determine if they possess
any common characteristics which might distinguish them from the
group of income-producing expenses which must be taken as itemized

deductions which are discussed in Chapter IV.

Self-Employed Expenses

All of the income-producing expenses of self-employed taxpayers,
except child care expenses, have always been deductible for adjusted
gross income. The criteria used to determine the deductibility of
these expenses have been the same as the criteria applied to the

similar expenses of employees and investors. Thus, this portion of

26

27
the research cannot answer the question of why all expenses of self—
employed individuals, but only some expenses of employees and
investors, are deductions for adjusted gross income. However, it can’
shed light on further possible reasons for the present split of the
income-producing expenses of employees and investors. If expenses
in these two groups have consistently different histories or deduc-
tibility criteria, then those distinctions may be able to supplement
previously cited sources in explaining the apparent horizontal

inequity of our present law.

Employee Expenses

 

Currently, the income-producing expenses of employees related to
travel, transportation, moving, activities of outside salesmen, and
other expenses which were reimbursed directly by employers are deducted
for adjusted gross income. Each of these will be researched in depth
in the chronological order of its inclusion in the Code as a deduc-
tion for adjusted gross income in order to supply a further perspec-

tive of the process which brought us to the present.

Travel. The revenue acts of the 19th Century and the first revenue
acts after the Sixteenth Amendment was ratified were very general in
their reference towards the deduction of income-producing expenses.
During periods when income was being taxed, a new revenue act was
passed about every two years, but this legislation retained a general
reference to allowing as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any
trade or business.1 The Commissioner of Internal Revenue was left

with the task of interpreting the application of this part of the law

28

to individual taxpayer facts and circumstances.

Until 1918, his pronouncements tended to be informal and not
widely disseminated. Because the income tax started to have a
direct impact on many more citizens, the Commissioner found it neces-
sary to issue many formal regulations interpreting the law. Regula-
tions 45 was formulated to apply to the Revenue Act of 1918. Article
292 of Regulations 45 applied specifically to travel expenses. It
allowed the deduction of railroad fares on business trips but not the
costs of meals and lodging except to the extent they were in excess
of the taxpayer's expenses while living at home.2

The Revenue Act of 1921 modified Section 214(a) to explicitly
allow the deduction of the entire amount expended for meals and
lodging while away from home in the pursuit of a trade or business.
Despite its logical appeal, the previous regulation had proved so
difficult to administer that the Treasury Department had asked
Congress to grant a deduction for the entire amount of such lodging
and meal expenditures.3 At least one contemporary tax expert feared
that even the new provision would have administrative difficulties
outweighing any gains in equal treatment of taxpayers.4 However,
this treatment has been contained in every Revenue Act or in the
Code since 1921. After losing numerous court cases, the Commissioner
gave up the contention that a salaried person was not entitled to the
deduction of all his food and lodging expenses while in a business
travel status.5

subsequently, much disagreement between taxpayers and the
Internal Revenue Service has resulted from the problem of allocation

of expenses on trips which are not completely business related.

29
Article 292 of Regulations 45 had allowed the deduction of travel
expenses if the trip was on business. Article 101(a) of Regulations
62, interpreting the Revenue Act of 1921, allowed a deduction for
travel expenses only when the trip was solely on business. All subse—
quent regulations have used this basic wording but they have not
interpreted it literally. The deduction for all travel fares was
allowed through 1962, if the trips were primarily, not solely, busi—
ness related.6 However, in 1962 Congress reacted to the problem of
taxpayers taking deductions for business trips which had a substantial
vacation element by adding Section 274(d) to the Internal Revenue Code.
It directed that for all business trips with personal elements, ex—
penses must be allocated between business and personal purposes for
trips exceeding one week in duration or where more than 25 per cent
of the trip was time spent on personal activities. In 1964, Congress
amended Section 274(d), retroactive to 1962, to repeal the allocation
rule for expenses incurred for a combined business and pleasure trip
within the United States. At present the law allows a deduction for
the full amount of transport expenses, such as airplane tickets,
incurred on trips which are primarily for business reasons. On trips
which are primarily personal, only the expenses directly related to
income-producing activities are deductible. The relative generosity
of this allocation criterion is reflected by a noticeable lack of
litigation. To a great extent the problem has been compromised in
the Internal Revenue Service audit process because there was no sub-
stantial business purpose for the trip or there was an inability to
substantiate expenses.

A great deal of taxpayer and Internal Revenue Service disagreement

30
has been due to differing interpretations of when a trip is primarily
for the purpose of producing income. The usual criterion used by the
Internal Revenue Service in such cases is to determine the relative
amounts of time spent on personal and business activities during the
trip and to ascribe as the primary purpose the activity to which the
taxpayer has devoted the greatest length of time. This approach
allows slightly differing facts to significantly change the deductible
amounts on a trip which has business and personal aspects. Many early
Internal Revenue Service decisions narrowly construed the range of a
taxpayer's income—producing activities but they were universally over—
turned by subsequent rulings.7 Court decisions also developed a broad
view of when travel expenses were incurred primarily to produce income
but their concept was not without limits.9 Thus a conclusion about
the primary reason of a taxpayer for his travel can be either subjec-
tive, such as a determination of motivation, or objective, such as a
measure of relative time Spent. The burden of proof in each case rests
with the taxpayer to show that these criteria, when applied to the
facts and circumstances, will indicate a primary income-producing
purpose.

The most frequent problem with the travel expense deduction is
the decision about whether or not a person is away from home. If not
away from home, then at most only transport costs are deductible. The
definition of what comprises the tax home of a taxpayer is inextricably
bound up with the motivation of Congress in allowing the deduction of
travel expenses. The law was meant to compensate for the duplication
of living expenses while away from home and to make allowance for the

excessive cost of food and lodging while traveling.10 The definition

31

of tax home has developed with these objectives in mind to prevent the
tax deduction of expenses incurred due to personal needs and considera-
tions. Home was originally viewed as the residence maintained for the
purpose of carrying on the business in connection with which the deduc-
tion for travel expenses was claimed.11 Thus Congressmen could not
deduct their Washington, D.C., living expenses as travel.12 If tax-
payers could not show that they had a tax home, then they could not
deduct the cost of meals and lodging on business trips.13 Many subse—
quent court cases interpreted home to mean the principal place of
employment.14 The Supreme Court has failed to resolve this contro-
versy,15 although the thrust of its deliberations has been subsequently
relied on.16 However, there is agreement that duplication of living
expenses is important and that the existence of a principal place of
employment or a regular place of abode is necessary for the deduction
of travel expenses.17 Congress somewhat solved this problem for its
members by passing a law which allows them to consider their resi—
dences in their home states as their homes for travel purposes to the
extent of the first $3,000 of Washington, D.C., living expenses.18

In some situations, minimum and maximum time constraints have
been applied to the allowable deduction of business travel expenses.
Originally, a subjective evaluation was applied to the facts and cir-
cumstances of each taxpayer claiming travel expenses to determine that
a sufficient amount of expense duplication had occurred, yet the travel
was not of such a duration to justify the switching of the place desig-
nated as his principal place of business and the moving of his prin-
cipal residence. The Internal Revenue Service had decided that the

minimum time criterion was satisfied if the taxpayer was away from

32

home long enough to necessitate resting before returning.19 This test
developed into the present away overnight test which has been sup-
ported by the courts as being a rather arbitrary distinction avoiding
the inequity of benefitting a person just because he covers more
miles in a business day.20 Recommendations for a broader duty area
test, which would allow the deduction of expenses as travel outside
of a geographical range, have not been implemented.21

The maximum duration criterion for travel expenses was necessary
to distinguish between situations where a change of employment loca-
tion was temporary and those where the taxpayer could reasonably have
been expected to move his residence to the vicinity of his new place
of employment. It is only since 1944 that the concept of traveling
expenses has been applied to temporary employment situations, yet a
large amount of litigation in the last 30 years has concerned this
determination.22 The Internal Revenue Service developed explicit con-
cepts of the difference between temporary and indefinite employment.23
The courts have been more willing to use subjective judgments of tax—
payer intent at the time a position was acquired to ascertain if it
was contemplated to be temporary at the time it was accepted.2

There have been more taxpayer disputes concerning the substantia—
tion of expenses in the area of travel expenses than in any other
income-producing expense area with the possible exception of entertain-
ment expenses. The problem of providing written documentation has
existed since the onset of the income tax.25 Originally, bare esti—
mates were not sufficient evidence to prove the allowable deduction of
travel expenses.26 This requirement was modified in 1930 by a court

decision pertaining to circumstances where the evidence indicates that

33
the taxpayer has incurred a deductible expense but its exact amount
can not be determined. The court concluded that the lower court
could not disallow the deduction entirely but that it must make as
close an approximation as it could, bearing heavily upon the taxpayer
whose inexactitude was of his own making.27 Just an oral statement
of expenditures was still not sufficient, however.28 The courts
still looked skeptically at cases where records were lacking due to
the actions of the taxpayer.29 The Cohan doctrine gave rise to such
extensive expense account abuses that Congress used the Revenue Act
of 1962 to add Section 274 to the Internal Revenue Code.30 This
section expressly rejected Cohan and held taxpayers to more rigid
substantiation requirements for business travel.31 The Commissioner
issued many pronouncements to further develop the requirements of
Section 274.32 Regulation Section 1.274-1 emphasized that the Section
274 substantiation requirements were in addition to those of Sections
162 and 212. Therefore, as of now, the Cohan rule may not be applied
to travel expenses.

The Revenue Act of 1962 also placed a maximum on the amounts
which may be deducted as travel expenses by amending Section 162(a)(2).
Thus, meals and lodging related to business travel are only deductible
to the extent they are not lavish or extravagant under the circum-
stances.33 This limitation does not apply to other income-producing
expenses. However, this research was unable to discover any subse-
quent litigation or Internal Revenue Service indications that this
new wording had led to a different treatment of maximum deductible
travel expenses.

The law does not distinguish for deductibility purposes, whether

34

the travel expense is incurred at the option of the employee or at
the insistence of the employer.34

An employee must also be in a trade or business before he can
deduct travel expenses.35

In conclusion, travel for business purposes has been tax deduc-
tible throughout the history of the U.S. income tax, is not subject
to any minimum or, in practice, maximum amounts, and is seldom subject
to allocation when primarily for business, but limited when primarily
for personal reasons. Both subjective and objective criteria are used
to determine purpose. Minimum and maximum time constraints are
applied. The tax home for travel purposes of a taxpayer is usually
his principal place of business. Substantiation requirements are
especially rigid and explicit. Travel costs may be incurred volun-
tarily or at the insistence of the employer and they must be incurred

by a taxpayer already in a trade or business.

Reimbursed. The receipt by employees of amounts directly from

 

employers to partially or completely offset some of the costs of their
income-producing activities in the name of the employer has often
received special treatment in the application of our income tax laws.
There are four Options in regard to reimbursing the income-producing
expenses of employees. One is to have the employee charge the bill to
the employer so that the employer pays it directly. Another is to
have the employee pay the bill, present the receipt to the employer,
and get direct reimbursement. A third would give the employee a
specified expense allowance to use for income-producing expenses.

Lastly, a larger salary can be used to allow for the income-producing

35
expenses of the employee without any direct reference to the neces-
sity of his incurring certain types of expenses.

Article 292 of Regulations 45 demonstrated in 1918 the preferen-
tial treatment to be accorded to certain methods of reimbursing emr
ployee expenses.36 In 1921, Article 101(a) of Regulation 62 brought
these reimbursement methods somewhat closer together in their tax
treatment in that reimbursement for actual expenses had to be included
in gross income and the actual expenses had to be deducted on the tax
return. Also, expenses in excess of an expense allowance could also
be deducted. This treatment lasted until 1942 when the standard
deduction and 1040A tax return were initiated. The Internal Revenue
Service ruled that employees with gross income of less than $3,000
and using the 1040A must include reimbursements in income, but that
they could not deduct their income-producing expenses since they
deducted a standard deduction instead.37 Howls of protest led to
quick revocation, thus reinstituting the 1918 treatment of directly
reimbursed employee business expenses,38 which excluded both the
reimbursement and the expense deduction.

The Individual Income Tax Act of 1944 changed the law to indi-
cate the appropriate treatment of reimbursed expenses whereas the
previous treatment had only been mentioned in Internal Revenue Ser-
vice interpretations. However, the rules themselves remained the
same.39 Thus, expenses directly paid by the employer or directly
reimbursed if the employee paid them, never entered into the tax
return of the employee. When compensation in addition to salary was
paid to the employee as an allowance to offset his income-producing

expenses without regard to their actual amounts, the allowance was

36
included in gross income and the actual expenses were deducted for
adjusted gross income. In 1944, only the travel expenses of employees
could be deducted for adjusted gross income if they were not reim—
bursed. All other unreimbursed income-producing expenses of employees
could be deducted only if the taxpayer itemized deductions.

Some tax experts were concerned that these provisions might
encourage the reimbursement by a business of the personal expenses
of business executives or favored employees since these amounts are
not taxable to the individual and are preferable to an increase in
taxable compensation. It was deemed likely that these expenditures
do not receive the same close scrutiny as other expenses for value
received by the business.40 Congress considered Treasury Department
suggestions to tighten up this area as early as 1952, but it failed
to take any action.41

The Internal Revenue Code of 1954 added transportation and out-
side salesmen expenses to those which could be deducted for adjusted
gross income even if they were not reimbursed. This did not greatly
affect employees with expense allowances since they could and still
can deduct all of their reimbursed income-producing expenses for
adjusted gross income. Neither did it affect directly reimbursed
employees since they can keep the expenses and their offsetting

reimbursements out of their tax computation entirely.

In November, 1957, the Internal Revenue Service tried to enforce
the reporting on individual tax returns of all reimbursed employee
expenses to enable the Service to give attention to apparently dis-
proportionate claims and thus aid in the detection of abuses that

had arisen in the area.42 There was a large volume of protests

37

because many reimbursed employees did not retain copies of bills
and receipts and because of the additional accounting burden that would
be imposed on employers if detailed records had to be supplied. The
Commissioner decided to postpone application until the 1958 tax year.43
However, Regulation 1.162-17, which became final in August, 1958,
stated that an employee who accounted to his employer for his business
expenses would not need to report them on his tax return, but merely
state that the reimbursement he received from his employer either did
not exceed his ordinary and necessary expenses or any excess had been
included in income.44 It was estimated that this lenient treatment
of reimbursed expenses results in an annual tax loss to the federal
government of one to two billion dollars.45

A limited study conducted by the Internal Revenue Service in 1959
found a large number of employers who did not use acceptable business
practices in requiring an accounting of business expenses by their
employees. Audits of their employees resulted in almost 50 per cent
owing additional taxes as a result of erroneous treatment of amounts
received from their employers as expense account allowances or reim-
bursements.“6 The Service had been forced to further define the
procedures that qualify as accounting to an employer for expenses.47

Although Section 274 added by the Revenue Act of 1962 provided
greater substantiation requirements for some income-producing expenses,
Section 274(e)(4) provides, generally, that when they are incurred by
an employee in the performance of services for his employer and he

directly accounts for them to the employer under a reimbursement

arrangement, he is not subject to the harsher requirements of Section

274(a).

38

In 1964, Congress added the newly available moving expense
deduction to those which are deductible for adjusted gross income
even if they are not reimbursed.

In 1965, the Internal Revenue Service issued rulings indicating
that direct accounting to employers was not necessary for travel and
transportation expenses as long as the reimbursement did not exceed
given per mile or per day allowances. The reimbursement was not
included in gross income nor did the actual expenses appear on the
tax return unless the actual expenses exceeded reimbursements.48
However, when actual expenses exceed reimbursements, all amounts
received must be reported as gross income and then actual expenses
deducted.49 Reimbursed expenses would be deductible for adjusted
gross income but the appropriate place for the deduction of the
excess would depend on the identity of the expenses. To the extent
that reimbursement up to these given amounts exceeds actual expenses,
it constitutes tax-free income to the employee with travel or trans-
portation expenses because the I.R.S. does not enforce reporting of
the excess.

Employees can not assume the income-producing expenses of their
employers by not claiming reimbursement when they are eligible for
it. It is still the expense of the employer so the employee can not
deduct it on his tax return.

Thus, the treatment of reimbursed employee income-producing
expenses appears to have been motivated to a great extent by a
striving for administrative simplicity in the application of our
income tax laws. Study by the Internal Revenue Service has shown

that special treatment of reimbursed expenses appears to allow

39
amounts of employee compensation to go untaxed since nondeductible
expenses are directly reimbursed by employers, thus both the expense
and the reimbursement do not appear on the tax return of the employee.

The Section 62 treatment of reimbursed expenses favors employees
with designated expense allowances or direct reimbursement arrange—
ments over employees with their compensation only designated as
wages or salary. Of the main income-producing expenses which can
only be deducted as itemized deductions unless reimbursed, entertain-
ment appears to be the only one conducive to the use of an expense
allowance. Household and dependent care, job—seeking, and, probably,
education expenses would not be reimbursed through an expense allow-
ance arrangement in the vast majority of employment situations.

Thus, the Section 62 reimbursed expenses statement is generally only
applicable to the entertainment expenses of employees with expense
allowances and to partially reimbursed employee expenses.

It also appears that, as a group, the deductions for adjusted
gross income are more likely to be directly paid or reimbursed by
employers than are those expenses which are itemized deductions.
Travel, moving, and transportation are especially likely to be reim-
bursed while household and dependent care expenses are seldom reim-
bursed. Employment seeking or securing expenses, education, and

entertainment are increasingly likely to be reimbursed, respectively.

Transportation. The allowance of a deduction for transport costs
incurred to produce income has existed as long as our income tax
laws. Its treatment by the law and Internal Revenue Service statements

has been less explicit than that of travel expenses. The problems of

40
this deduction have mainly been differentiating between income-
producing and personal expenses and enforcing a reasonable amount of
substantiation.

Under the first interpretation given our income tax laws, an
individual could deduct the cost of daily transportation between
his residence and his place of business.51 By 1920, however, the
Internal Revenue Service adopted a stricter interpretation of what
constituted an ordinary and necessary business expense and reversed
the earlier ruling so that commuting from home to work was not a
deductible expense.52 The reasoning was that the costs of commuting
are not incurred to produce gain because an employee does not start
to work until he reaches his place of employment.53 In general, sub—
sequent court cases have upheld this interpretation of the law con-
cerning the nondeductibility of commuting expenses.

In 1954, the nondeductibility of commuting expenses was rein-
forced by a statement to that effect in the new Code despite much
testimony in the hearings in 1953 which had advocated deductibility.
Congress explicitly decided that commuting is not a business expense.55
The nondeductibility of commuting was interpreted as applying even
where a large distance existed between the principal place of employ-
ment and the nearest habitable community56 although commuting is
deductible when incurred while in a travel status.57 Even physically
handicapped taxpayers have not been able to deduct their commuting
expenses.58 Attempts to change the law have been unsuccessful.59
Some taxpayers have been able to deduct commuting costs fully or

partially when transporting bulky or heavy tools, musical instruments,

etc., to their places of employment, but with decreasing success.6

41
However, nothing prevents the deduction of expenses in excess of
ordinary commuting expenses which can be shown to have been incurred
in transporting job-required tools and materials to or from the work.
site.61

Many attempts to deduct transportation expenses have been
limited by incomplete substantiation although the Cohan rule has been
applied when approximation is appropriate.62 To alleviate some of
the substantiation problem, the Internal Revenue Service initiated a
mileage allowance which a taxpayer could claim for each income-
producing mile in lieu of allocating actual operating costs incurred.6

The problem of allocating transportation costs between business
and personal purposes is interrelated with the substantiation of these
expenses. The use of the mileage allowance for business miles driven
has simplified this allocation for most taxpayers. For those tax-
payers who deduct actual expenses, the percentage of total miles
driven incurred to produce income is multiplied by each actual expense
to obtain deductible transportation costs.64 No primary purpose
criterion needs to be applied to car usage for the year in this allo-
cation process.

It was established early that employees could not voluntarily
assume the expenses of their employers by incurring transportation
expenses and not claiming reimbursement to which they were entitled.65

Court decisions, especially, established the interpretation that,
once an employee arrived at the place of employment, the employee was
in an income—producing status until leaving for a residence or for

some other personal purpose. Not only does using a car in the ser-

vices of the first employer result in deductible transportation

42

expenses, but so does the act of going from the first to a second
place of employment.66 Attempts by employees with offices in their
homes to use this interpretation to overcome the commuting expense
deduction prohibition have been unsuccessful.67

Thus, transportation expenses, except commuting, have a long
history of deductibility, location constraints and no special sub—
stantiation requirements. They receive preferential substantiation
treatment when reimbursed by means of a mileage allowance and are
always subject to business versus personal allocation. Criteria used
to evaluate motivation may be subjective or objective. Concerning
transportation expenses, an employee is not considered to be incurring

income-producing expenses until he reaches his place of employment.

Outside Salesmen. As of 1954, outside salesmen are a class of

 

employees which receives preferential tax treatment allowing the
deduction of all income-producing expenses for adjusted gross income
like self-employed taxpayers. Outside salesmen are employees engaged
principally in the solicitation of business at places other than the
places of business of the employers.68 Some litigation has involved
employees seeking the benefits of outside salesmen status so they
could deduct all of their income-producing expenses for adjusted gross
income.69 Other employee groups have sought to change the law so that
it would include them as outside salesmen.70 The deductibility
criteria applied to the income-producing expenses of outside salesmen

are the same as those applied to other employees.

43
Moving. Prior to 1964, there was no mention of moving expenses in
the tax laws, so the area developed from administrative rulings and
court decisions. Moving expenses were not deductible under any cir-
cumstances before 1964.71 However, reimbursement of direct moving ex-
penses was not taxed for transferred old employees72 due to an appar-
ent disregard of Section 61 pertaining to gross income.73 Direct
moving costs are those of transporting household goods and personal
effects and of the actual trip to the new place of employment. New
employees74 and indirect moving expenses75 did not receive this bene-
ficial treatment since they could not prove that their respective
expenses were ordinary and necessary business expenses within the
meaning of Section 162.76 The result was a difference in tax treat-
ment based on whether or not the salary of the employee had been
established in contemplation that he would pay his moving costs to
the new job. Employees were not considered to be in a trade or busi-
ness when moving to the location of an initial job or while in the
act of changing employers.

In 1964, Congress added Section 217 to the Internal Revenue
Code.77 Section 217 allowed the deduction of direct moving expenses
for new and transferred employees within certain constraints. The
new place of work had to be at least 20 miles further from his former
residence than was his former principal place of work. The employee
also had to be employed full-time for at least 39 weeks of the year
after the move at the new location in order to claim the deduction.
Reimbursed employees still received preferential treatment because
this subsequent full-time employment test did not apply to the extent

that direct moving expenses were reimbursed.78 Reimbursed expenses,

44

which were otherwise deductible, and their reimbursement were not
included in the tax computation. Also, non-direct reimbursed moving
expenses of transferred employees were allowed to offet reimbursements
and to be excluded from the tax return to the extent that the courts
found them to fulfill the criteria of Section 162.79 Suggestions
for a more explicit interpretation of deductible indirect moving
expenses were not implemented.80

Subsequent court decisions and Internal Revenue Service rulings
clarified the meaning of household goods and personal effects and
developed a line of reasoning pertaining to the treatment of reim—
bursed indirect moving expenses of transferred employees. Household
pets are household goods81 whereas yachts82 and furniture purchased
while enroute83 are not. Reimbursed home selling expenses,84 house—
hunting and temporary living expenses,85 and the loss on the sale of
a home86 were determined not to fit under the criteria of Section 162.

The 1969 Tax Reform Act87 widened deductible moving expenses to
increase labor mobility and to provide for more equitable treatment
of employees whose moving expenses are not reimbursed and of self-
employed taxpayers. Deductible indirect moving expenses were delin—
eated, but they are only deductible up to $2,500. Indirect moving
expenses of househunting and up to 30 days temporary living were
subjected to an additional maximum constraint of $1,000. Certain
costs of buying and selling residences and lease settling expenses
are the other deductible indirect moving expenses. Self-employed
taxpayers became eligible to deduct moving expenses, but their sub-
sequent full-time work test at the new location is twice that of

employees, that is, 78 weeks out of the subsequent 2 years. All

45
reimbursements of moving expenses were required to be included in
gross income in following years, thus equalizing the tax treatment
of the moving expenses of reimbursed and nonreimbursed employees
and of self-employed taxpayers. Also the change of location test
was lengthened from 20 miles to 50 miles.88

In 1971, the Internal Revenue Service decided that a mileage
allowance could be deducted for auto usage during the move although
it was only 50 per cent of the mileage allowance allowed for trans-
portation and travel expenses.

The deductibility of moving expenses is relatively recent.
Indirect moving expenses have maximum dollar limits. Allocation of
income-producing and personal expenses is seldom necessary. The
criteria used to evaluate income-producing motivation are objective
and explicitly stated. A minimum time constraint applies to the
full-time employment motivation criterion while a maximum time con-
straint only applies to the indirect moving expenses of temporary
living at the new location. Substantiation requirements are those
normally applied to income-producing expenses, except that reimburse-
ment does not remove the need to justify these expenses on the tax
return and that a mileage allowance can be claimed for auto usage.
Whether the move is voluntary or employer required is irrelevant to
deductibility. New employees and self-employed individuals changing
locations may deduct moving expenses although they are not currently

in a trade or business.

46
Investor Expenses

Income-producing expenses not incurred in a trade or business
were not mentioned explicitly in revenue acts nor in regulations
until 1942. The only basis for their deduction was the sections of
the successive revenue acts which allowed the deduction of all the
ordinary and necessary expenses incurred in carrying on any trade or
business. Neither the statutes nor the regulations defined carrying
on a trade or business. This failure to explicitly allow for the
deduction of income-producing expenses not incurred in a trade or
business was noted and proposals for modification were submitted in
the early days of the modern income tax.90 However, no changes were
made since the Treasury Department had construed the language of the
old law so broadly as to permit the deduction of expenses of invest-
ments and managing property.91 Subsequent Bureau of Internal Revenue
statements reflected this liberal interpretation.92 Generally, court
decisions used a more narrow understanding of the meaning of a trade
or business.

Purchasing a house for renting, listing it for rent, and showing
it to prospective tenants but failing to rent it were determined to
be deductible trade or business expenses.94 The expenses incurred
while offering a house acquired as a gift for rent although never
rented, were not trade or business expenses.

Apparently, the announced policy of the Bureau of Internal Revenue
was not consistently applied because a conflict appeared among the
Circuit Courts of Appeals concerning whether expenses for the manage—
ment of securities were deductible as trade or business expenses.

A 1941 Supreme Court case settled this controversy.97 This decision

47
held that security investment expenses were not made while carrying
on a trade or business but that the expense of renting buildings was.
The distinction apparently was made based on the source of gain in
the one case being real property, incapable of producing gain without
management, while in the other case the source of gain was invested
capital, capable of producing dividends or interest without manage—
ment, except to look after the gain once it was realized.98 The
Board of Tax Appeals had held that an investor is in a business where
there is an active association with enterprises in which there is a
financial interest or where a large part of time is devoted to handling
investments.99 Now the Supreme Court ruled in the Higgins case that
these were not deductible. Previous court decisions and Bureau inter-
pretations in the favor of taxpayer expense deduction were overruled
and rescinded.100
The Treasury Department101 and tax experts102 subsequently
recommended corrective legislation and Congress enacted their basic
proposals to correct this inequitable situation in the form of Section
23(a)(2) which was effective retroactively for all years in order to
reinstate and ratify the previous interpretations of deductible
income-producing expenses of individuals.103
The effect of Section 23(a)(2) was to provide for a class
of non—business deductions coextensive with the business
deductions allowed by Section 23(a)(1), except for the
fact that, since they were not incurred in connection
with a business, the section made it necessary that they
be incurred for the production of income or in the manage-
ment or conservation of property held for the production
of income.104

There are no implicit limitations in Section 23(a)(2), now Section

212, other than the ordinary and necessary criteria which are also

48
found in Section 23(a)(1)(A), now Section 162.105 The Treasury Regu-
lations were amended by T.D. 5196 to conform to the 1942 Act by the
addition of Section l9.23(a)-15 to Regulations 103.106 The subsequent
emphasis in cases concerning the income-producing expenses of indi—
viduals was on the objective of the expenses rather than on whether
they were incurred in a trade or business.

The Individual Income Tax Act of 1944 added Section 22(n) to the
Internal Revenue Code of 1939. It affected the location of the
deduction of Section 23(a)(2) expenses but it did not change any of
the criteria for the deduction of either group. Expenses directly
incurred in the rental of property or in the production of royalties
were made deductible for adjusted gross income. All other non-trade
or non-business expenses could only be deducted by individuals who
itemized deductions. The special treatment of expenses producing
rental income may have its basis in previous court decisions which
concluded that they were incurred in a trade or business.107

The special treatment of expenses producing royalty income has
a less firm basis for those not in a trade or business since royalty
income may be the proceeds of a sale based upon, for instance, the
amount of minerals produced or number of books sold, where, after
the sale, little management effort is possible by the seller. Per—
haps, the Senate Finance and House Ways and Means Committees were
well represented by Congressmen from oil-producing states at this time.

Subsequent litigation concerning expenses attributable to the pro-
duction of rents or royalties has been sparse. Some cases explored

the deductible extent of expenses of residences used for personal

purposes and to produce rents.108 The main criterion applied was

I

49
to determine if the use of the property was of such a nature that
in good faith the taxpayer genuinely expected or intended to make a
profit. Substantial personal usage during the peak rental periods
indicates that the primary purpose for which the property is held
is not to produce income.109 A ruling indicated that a gross income
tax on the portion of an individual's income from the extraction of

minerals was a deductible royalty-producing expense.

Summary

The historical development of income-producing expenses of individ-
uals deductible for adjusted gross income and factors in their deduct-
ibility have been analyzed in this chapter. Table 3.1 indicates a basic
summary of the main considerations in the deduction of some of these
expenses. Expenses of self-employed individuals and outside salesmen
have the same criteria applied to determine their deductibility as
are applied to the like categories of employee expenses with minor
exceptions. Self-employed taxpayers have a longer full-time employ-
ment test than do employees in the qualification for the deduction of
moving expenses. Self-employed taxpayers also miss the benefits
accruing to employees with actual expenses less than employer reim-
bursements for car usage or per diem allowances where the employees
do not have to report the difference as income. It is difficult to
define factors, other than a required primary income-producing purpose,
which are significant in the test of deductibility of expenses
incurred to produce rents or royalties. Table 3.1 does not indicate
a large degree of consistency in the application of these criteria

to determine the deductibility of each expense as analyzed based on

50
a study of the law, Internal Revenue Service statements, the state-
ments contained within court decisions, and other sources of infor-
mation. A comparison with the criteria applied to the deductibility
of income-producing expenses which are only deductible as itemized
deductions, except when reimbursed, is needed next for a comprehen-

sive evaluation.

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Imoooz ooz mucoEoufiovom amsuoz uaooxm .oaoz
mafia Hon QNH o>Huoonn=m aofiumouoa
vouanuom ponuam mucoswuwovom Hmahow no o>Hooonno mam3H< ImcmuH
momcomxm oumu
geese hoe no wcw>oz
momuamsfimm Mom
oomoxMIlmocmsoHH<
Sofia pom no owmoawz
o>fiooom conz no
omoomxm omooaxm Homoaoam ou oooooo< omcooxm omsomxm
zoom mom Loam mom maoooufin c053 swam zoom mom :omm mom momuopafiom
Amado mmmcoaxm noeuo
cmcoo mo cowumo o>wooomnom oomooaa< use
mmufiddom mosuwm IHHoom ozv momma Ho mmmcoaxm upon
lonesoom Hmfiomom m>wuomnno Imamuo How uoz Hm>mua
mumoosao> cowom>fiuoz COHomooaa<
oaoooH wcwoopoum Hmoomuom
mcfioomoum no defiomaocMomnom IoaoocH .> muowoumu
A moumosaom omaoexm
mmoua< ocfisuouoa wowoomoum
Homoaaam
oo mwuoufiuo IoaoocH

 

 

Asmseauaoov H.m manna

l.

2.

3.

4.

5.

8.

9.

10.

53

FOOTNOTES-CHAPTER III

Section 49, Act of 1861, 12 Stat. 292; Section 91, Act of 1862,
12 Stat. 432, and Act of 1863, 12 Stat. 713; Section 117, Act of
1864, 13 Stat 223, Act of 1865, 13 Stat. 469, and Act of 1867,
14 Stat. 471; Section 9, Act of 1870, 16 Stat. 256; Section 28,
Act of 1894, 28 Stat. 509; Section II(B), Act of 1913, 38 Stat.
114; Section 5(a)(1st), Revenue Act of 1916, 39 Stat. 756; Sec-
tion 214(a)(1), Revenue Act of 1918, 40 Stat. 1057.

Kohler, Eric L., Accounting Principles Underlying Federal Income
Taxes, (Chicago: A. W. Shaw Co., 1925), p. 186.

 

Statement of T. S. Adams representing the U.S. Treasury Depart-
ment, Hearings on H.R. 8245 Before the Senate Committee on
Finance, 67th Congress, First Session, (Washington: U.S. Govern-
ment Printing Office, 1921), pp. 234-5.

 

Satterlee, Hugh, "Some Suggestions for the Simplification of
Federal Taxation," Proceedings of the 13th Annual Conference of
the National Tax Association, (New York: National Tax Association,
1921), p. 145.

 

Dendy, Thomas H., "New Cases on What You Can Deduct from Salary
Income," Proceedings of the New York University 7th Annual Insti-
tute on Federal Taxation, (Albany: Mathew Bender & Co., 1949),
p0 1002-3 0

Rev. RUlo 56-168, 1956‘]. cm. B1111. 930

A 1922 ruling prevented the deduction of travel expenses incurred
to teach during the summer at another school I.T. 1238, I-l Cum.
Bull. 140; revoked in 1932 by I.T. 2640, XI-2 Cum. Bull. 246. A
1922 ruling did not allow the deduction of the travel expenses of

a doctor to attend a medical convention I.T. 1369, I-l Cum. Bull.
369; revoked in 1931 by I.T. 2602, X-2 Cum. Bull. 130. A 1922
ruling disallowed the deduction of the travel expenses of a teacher
to a convention I.T. 1520, 1-2 Cum. Bull. 625; revoked in 1933 by
I.T. 2688, XII-l Cum. Bull. 251.

A lawyer was allowed to deduct the cost of attending ABA meetings
Ellis v. Comm. 15 BTA 1075, aff'd 50 F.2d 343 (CA 1, 1931). Also
see Marlin v. Comm. 54 TC 560 (1970).

Especially Comm. v. Flowers 326 U.S. 465 (1946), Barnhill v.

Comm. 148 F.2d 913 (CA 4, 1945), Reed v. Comm. 35 TC 199 (1960);
and Mazzotta v. Comm. 57 TC 43, aff'd (CA 2, 1972), 72-2 USTC 9709,
which emphasized that the travel is deductible only if the exig-
encies of business rather than the personal conveniences and
necessities of the taxpayer are the motivating factors.

James v. U.S. 308 F.2d 204 (CA 9, 1962).

ll.

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

54
O.D. 1021, 5 Cum. Bull. 1803 (1921).

O.D. 864, 4 Cum. Bull. 1549 (1920) and Lindsay v. Comm. 34 BTA 840
(1936).

O.D. 905, 4 Cum. Bull. 1621 (1920); I.T. 1490, I-2 Cum. Bull. 580
(1922); Martin v. Comm. 44 BTA 185 (1941); Mitnick v. Comm. 13 TC
(1949).

Schurer v. Comm. 3 TC 544 (1944); Albert v. Comm. 13 TC (1949);
Kroll V. Comm. 49 TC 557 (1968).

Comm. v. Stidger 386 U.S. 287 (1967). The court held that the
military man's permanent duty station was his home for tax pur-
poses but it stressed the special status of the military taxpayer
and expressly avoided a comprehensive endorsement of the principal
place of employment rule. Three dissents had concluded that home
for tax purposes means residence.

F.J. Markey, T.C. Memo 1972—154; rev'd 74 AFTR 2d 403, (CA 6,
1974).

Griesemer v. Comm. 10 BTA 386 (1928); Gustafson v. Comm. 3 TC 998
(1944) stated that duplication was not necessary; S. Waggener
63,524 P-H Memo TC; Hicks v. Comm. 47 TC 71 (1961) stated that
must have substantial and duplicitous expenses; Rev. Rul. 71—247,
1971-1 Cum. Bull. 54; Rev. Rul. 73—529, 1973-2 Cum. Bull. 49
stated objective factors for determining whether a taxpayer has

a regular place of abode.

Legislative Branch Appropriation Act, Public Law 471, 82nd Con—
gress, Second Session, (Washington: U.S. Government Printing
Office, 1953) and now a provision of Section 162(a).

I.T. 3395, 1940-2 Cum. Bull. 64 and Rev. Rul. 61-221, 1961-2
Cum. Bull. 34.

United States v. Correll 389 U.S. 299 (1967) and Barry v. Comm.
435 F.2d 1290 (CA 1, 1970).

Recommendations of the American Institute of Certified Public
Accountants and American Bar Association, Public Hearings Before
the Committee on Ways and Means, House of Representatives, 93rd
Congress, First Session, on the Subject of General Tax Reform,
(Washington: 0.8. Government Printing Office, 1973), pp. 1034
and 1173.

Schurer v. Comm. 3 TC 544 (1944); Leach v. Comm. 12 TC 20 (1949);
Peurifoy v. Comm. 27 TC 149 (1956); modified 254 F.2d 483 (1957);
aff'd 358 U.S. 59 (1958); Harvey v. Comm. 32 TC 1368 (1959); rev'd
283 F.2d 491 (1960) and many others.

 

23.

24.
25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

55

Rev. Rul. 60—314, 1960-2 Cum. Bull. 48 stated that test periods
of employment constitute indefinite employment; Rev. Rul. 60—189,
1960-1 Cum. Bull. 60 established the criterion that employment
change of location for longer than one year strongly implied
that the change was for an indefinite period.

Dilley v. Comm. 58 TC 27 (1972).
A.R.R. 719, I-l Cum. Bull. 19 (1922).

Weiss v. Comm. 3 BTA 228 (1925) and Coleman v. Comm. 8 BTA 1126
(1927).

Cohan v. Comm. 11 BTA 743 (1928); rev'd 39 F.2d 540 (CA 2,
1930).

Miller v. Comm. 47 BTA 68 (1942).

Finley v. Comm. 27 TC 413 (1956); aff'd 255 F.2d 128 (CA 10,
1958).

Revenue Act of 1962, Public Law 87-834, pp. 123-126. No deduc-
tion is allowed unless the taxpayer substantiates by adequate
records or sufficient evidence corroborating his own statement
the amount of the expense, time and place of travel, and busi-
ness purpose.

House Report No. 1447, 87th Congress, Second Session, (Washington:
U.S. Government Printing Office, 1962), pp. 427—8. Also Senate
Report No. 1881, pp. 740-742.

Revenue Act of 1962, p. 126.

Whitaker v. Comm. 24 TC 750 (1955); Stricker v. Comm. 54 TC 355
(1970).

Tucker v. Comm. 55 TC 783 (1971).

If an employee received a salary as full compensation for his
services, without reimbursement of traveling expenses, his
expenses were deductible. If the employee received a salary and
and expense allowance, any excess of expenses over the allowance
was not deductible, but any excess of the allowance over the
actual expenses was taxable income. For employees receiving

a salary and repayment of his actual expenses, no part of the
expenses was deductible nor was any of the repayment returnable
as income.

I.T. 3547, 1942-1 Cum. Bull. 138.

38.
39.

40.

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

51.

52.

56
Mim. 5397, 1942-2 Cum. Bull. 152.
House Report No. 1365, p. 19.
Elridge, Douglas H., "Expense Accounts," Proceedings of the

54th Annual Conference of the National Tax Association
(Harrisburg: National Tax Association, 1962), p. 218.

 

U.S. Treasury Department, "Proposals for Strengthening Tax
Administration," Hearings Before a Subcommittee of the Committee
on Ways and Means, House of Representatives, 82nd Congress,
Second Session, (Washington: U.S. Government Printing Office,
1952), pp. 98-100. One provision would have required informa-
tion from businesses concerning payments and perquisites of
more than $200 annually furnished any employee, partner, or
shareholder.

 

Treasury Department, Internal Revenue Service, Release IR-204,
November 11, 1957.

Treasury Department, Internal Revenue Service, Release IR—206,
November 25, 1957.

T.D. 6306, filed August 27, 1958.
Rothschild, V. Henry and Sobernheim, Rudolph, "Expense Accounts

for Executives," Yale Law Journal, Volume 67, Number 8 (July,
1958), p. 163.

 

Treasury Department, Internal Revenue Service, 1960 Audit Report
on Entertainment, TravelLAand Similar Expenses (Washington:
U.S. Government Printing Office, 1961), p. 24.

 

Rev. Rul. 59-410, 1959-2 Cum. Bull. 64, stating that using a car
leased by the employer and charging other expenses to the
employer by the use of credit cards did not constitute accounting
to him for the expenses.

Rev. Rul. 67-29, 1967-1 Cum. Bull. 42; Rev. Rul. 65-212, 1965-2

Cum. Bull. 84, superseded by Rev. Rul. 71-412, 1971-37 Int. Rev.
Bull. 71-412, which provided relaxed substantiation for per diem
up to $36 per day and mileage up to 15¢ per mile.

Rev. Rul. 73-191, 1973-1 Cum. Bull. 17.

I.T. 1706, II-2 Cum. Bull. 960 (1923); Podems v. Comm., 24 TC 21
(1955); Rev. Rul. 57-502, 1957-2 Cum. Bull. 118; Stolk v. Comm.,
40 TC 345; aff'd 326 F.2d 760 (CA 2, 1971); Fountain v. Comm.,
59 TC 69 (1973).

1 Cum. Bull. No. 1, p. 159 (1919).

1 Cum. Bull. No. 3, p. 191 (1920).

 

53.

54.

55.

56.

57.

58.

59.

60.

61.

62.

63.

57
Haden, Harry H., op. cit., pp. 38-39.

Steinhort v. Comm., 335 F.2d 496 (CA 5, 1964), stated that
"Deeply ingrained in the whole tax structure, memorialized
by literally hundreds of tax rulings, Tax and other Court
decisions, is the basic proposition that the cost of going
to and from home and an established place of business is a
nondeductible personal expenditure. At times the pursuit
of this approach brings about illogical and near absurd
conceptual situations. But its predominant redeeming grace
is a sort of rough equality among all the millions of tax-
paying, income-earning Americans who go to and from their
homes and their place of work. A lesser virtue is admin-
istrative uniformity."

House Report No. 1337, Report of the Committee on Ways and
Means, Internal Revenue Code of 1954, 83rd Congress, Second

 

 

Session (Washington: U.S. Government Printing Office, 1954),
p. 9. Senate Report No. 9 used identical language.

U.S. v. Tauferner, 407 F.2d 243 (CA 10, 1969); cert. den. 396
us,824 (1969), indicated that the argument of the taxpayer was
appealing from an equitable and logical standpoint, but that it
could not prevail when considered in the light of the statutes,
regulations, and case law. The court concluded that the nature
of the work engaged in, the distance traveled, the mode of
transportation, and the degree of necessity are unsatisfactory
guides with any degree of consistency and certainty.

Rev. Rul. 63-145, 1963-2 Cum. Bull. 86.

Bruton v. Comm., 9 TC 882 (1947); Rev. Rul. 66-80, 1966-1 Cum.
BUllo 57o

H.R. 424 and S. 1069 introduced in 1969 would have permitted
blind and disabled taxpayers to deduct up to $600 for trans-
portation expenses incurred in going to and from work.

See especially Fausner v. Comm., 472 F.2d 561 (1973); aff'd 93
U.S. 2820 (1973), which concluded that no rational basis exists
for allocation between the nondeductible commuting component
and the deductible business component of the total expense.

The deduction was disallowed so that a common burden not be
negated for a particular taxpayer by the happenstance that he
must carry incidentals of his occupation with him.

Rev. R111. 63-100, 1963’]. Cum. 81111. 340

Waldheim v. Comm., 244 F.2d 1 (CA 7, 1957) and Marcello v.
Comm., 43 TC 168 (1964) among others.

Rev. Proc. 64-10, 1964-1 (Part 1) Cum. Bull. 667; superseded
by Rev. Proc. 66-10, 1966-1 Cum. Bull. 622; superseded by Rev.

64.

65.

66.

67.

68.

69.

70.

71.

72.

73.

74.
75.
76.
77.
78.
79.

80.

58
Proc. 70—25, 1970-1 Cum. Bull. 59.

Leonhart v. Comm., 414 F.2d 749 (CA 4, 1969) and many other
cases.

I.T. 1903, III-1 Cum. Bull. 1298 and Podems v. Comm., 24 TC 21
(1955).

Chandler v. Comm., 226 F.2d 467 (CA 1, 1955), Rev. Rul. 55-109,
1955-l Cum. Bull. 261, and Kistler v. Comm., 40 TC 657 (1963).

Sheldon v. Comm., 50 TC 24 (1968) and Green v. Comm., 59 TC 44
(1973).

House Report No. 1337, 10c. cit., Reg. 1.62—1(h) and Rev. Rul.
62-85, 1962-1 Cum. Bull. 13, provide further refinements of
this definition.

Novak v. Comm., 51 TC 7 (1968).
Statement of John P. Meehan, Hearings Before the Committee on

Ways and Means on Tax Reform, 9lst Congress, First Session
(Washington: U.S. Government Printing Office, 1969), p. 4552.

 

 

O.D. 451, 2 Cum. Bull. 848; Appeal of Leland D. Webb, 1 BTA
759 (1924); Nichols v. Comm., 13 TC 916 (1949); Rev. Rul. 54-
429, 1954—2 Cum. Bull. 53; United States v. Woodall, 255 F.2d
370 (CA 10, 1958); Wilson v. Comm. 412 F.2d 314 (CA 6, 1969),
where the move was involuntary; and others.

Schairer v. Comm., 9 TC 549 (1947); Rev. Rul. 55-140, 1955—1
Cum. Bull. 317; Cavanagh v. Comm., 36 TC 300 (1961); and others.

Mason, John C., "New Deductions for Individuals," Proceedings
of the New York University 23rd Annual Institute on Federal

 

 

Taxation (Albany: Mathew Bender & Co., 1965), p. 68.

Bradley v. Comm., 39 TC 652 (1963).

Ferebee v. Comm., 39 TC 801 (1963).

Comm. v. Mendel, 351 F.2d 580 (CA 4, 1965).

Public Law 88-272, 1964-1 (Part 2) Cum. Bull. 6.

Section 217(d)(1).

House Report No. 749, o . cit., p. 182.

Statement of Syd Herlong, Hearings Before the Committee on Ways
and Means on the President's 1963 Tax Message, 88th Congress,

Second Session (Washington: 0.5. Government Printing Office,
1964), p. 1281.

 

 

81.
82.
83.
84.

85.

86.

87.
88.

89.

90.

91.

92.

93.

59
Rev. Rul. 66-305, 1966-2 Cum. Bull. 102.
Aksomitas v. Comm., 50 TC 79 (1968).
Rev. Rul. 70-625, 1970-2 Cum. Bull. 67.
Pederson v. Comm., 46 TC 155 (1966).

McLellan v. Comm., 51 TC 462 (1968), and Lull v. Comm., 51 TC
841 (1969).

Ritter v. United States, 393 F.2d 823 (Ct. cls., 1968); cert.
denied 393 F.2d U.S. 844.

Section 231, Public Law 91-172, 1969-3 Cum. Bull. 61.
Ibid.

Rev. Proc. 71-2, 1971-1 Cum. Bull. 659, allowed the deduction
of $.06 per mile in lieu of computing actual auto expenses.

Committee on the Federal Income Tax, "Report of the Committee
on the Federal Income Tax," Proceedings of the 9th Annual Con-
ference of the National Tax Association (Ithaca, New York:

 

 

National Tax Association, 1915), p. 296. They concluded that
it would be easy to make this matter clear so that the expenses
of managing property held for investment would be treated like
business expense.

Committee on the Federal Income Tax, "A Statement of the Pro-
visions of the Income Tax Law of September 8, 1916, Conforming
to the Committee's Recommendations and of Other Changes Made
by the Said Act," Proceedings of the 10th Annual Conference of
the National Tax Association (New Haven, Connecticut: National

 

 

Tax Association, 1917), p. 189.

O.D. 877, 4 Cum. Bull. 1576, allowed the deduction of expenses
to produce income from stocks and bonds; O.D. 1134, 5 Cum. Bull.
1972, allowed the deduction of expenses to produce rental

income; I.T. 2103, 111-2 Cum. Bull. 1862, allowed the deduction
of expenses for investment advisory services; I.T. 2579, X-2 Cum.
Bull. 129, allowed the deduction of the rent for safety deposit
boxes used primarily for income-producing securities; I.T. 2751,
XIII-l Cum. Bull. 43, allowed the deduction of expenses incurred
with regard to the management, protection, and conservation of
properties producing taxable income.

Potter v. Comm., 18 BTA 549 (1929) allowed the deduction of
travel expenses to inspect investments which afforded the main
source of income of the taxpayer; Hoover v. Comm., 42 BTA 461
(1940) disallowed investment counsel fees not incurred in a
trade or business; Roebling v. Comm., 37 BTA 82 (1938) also
looked at whether the taxpayer was in a trade or business based

94.
95.

96.

97.
98.

99.

100.

101.

102.

103.
104.

105.

106.
107.

108.

60
on a stricter interpretation.
Jephson v. Comm., 37 BTA 1117 (1938).
Montgomery v. Comm., 37 BTA 232 (1938).
Brodsky, Samuel, and McKibben, David, "Deduction of Non-Trade

or Non-Business Expenses," Tax Law Review, Volume 2 (February,
1946), p. 41.

 

Higgins v. Comm., 312 U.S. 212 (1941).

Haden, Harry H., op. cit., p. 35.

Smith, J. Duke, "An Investor's Deductions from Gross Income,"
Taxes, Vol. 19 (March, 1941), p. 138.

I.T. 3452, 1941-1 Cum. Bull. 205, revoked I.T. 2751, I.T. 2579,
and O.D. 877. See Footnote 92.

Statement of the Department of the Treasury, Hearings Before
the Committee on Ways and Means on Revenue Revision, 77th
Congress, Second Session (Washington: U.S. Government
Printing Office, 1942), p. 88.

 

Paul, Randolph E., "Suggested Income Tax Revisions," Proceedings
of the 34th Annual Conference of the National Tax Association
(Washington: National Tax Association, 1941), p. 387.

 

 

Revenue Act of 1942, Section 121, 56 Stat. 798, 819.
Trust of Bingham v. Comm., 325 U.S. 365 (1945).

Schwanbeck, W.J., "Non-Trade and Non-Business Deductions," Taxes,
Vol. 22 (October, 1944), p. 467, stated that the intention of
Congress was to allow the individual taxpayer such non-trade or
non-business expenses as safety deposit box rent, office rent,
clerical salaries, custodian expenses, etc., but not to allow
the individual non-trade or non-business expenses which would
not be deductible as trade or business expenses to an individual
engaged in business.

Brodsky, Samuel, op. cit., p. 44.
See Footnotes 94, 97, and 98.

Jones v. Comm., 22 TC 407; rev'd 222 F.2d 891 (CA 7, 1955);
allowed the deduction of maintenance expenses of a residence
listed for rent but unoccupied until a subsequent year; Coors
v. Comm., 60 TC 44 (1973), allowed the deduction of expenses
of a condominimum only occupied by the owner for 5 per cent
of the year and held out for rent for the rest of the year.

61

109. Carkhuff v. Comm., 425 F.2d 1400 (CA 6, 1970); Rand V. Comm.,
34 TC 1146 (1960).

110. Rev. Rul. 55-237, 1955—1 Cum. Bull. 317.

CHAPTER IV

DEDUCTIONS FROM ADJUSTED GROSS INCOME

The deductible income-producing expenses of individuals which
were not covered in the previous chapter may only be deducted by
taxpayers who itemize deductions. This group of expenses comprises
household and dependent care services for all taxpayers, other trade
or business expenses of employees which are not reimbursed, and non-
business expenses not attributable to the production of rents or
royalties.

The analysis in this chapter will determine the factors signifi-
cant to the deduction of the expenses in this group and study the
consistency of their application within the group. Then, these
factors will be compared with the factors important to the deduction
of income-producing expenses which are deductible for adjusted gross
income to ascertain whether consistent inter-group differences can

justify the present dichotomous treatment of income—producing expenses.

Household and Dependent Care Expenses

 

Early attempts to deduct the costs of care for children to
allow the parent to work were determined not to fall within the
ordinary and necessary criteria applied to the income-producing
expenses of individuals. Both the courts and the Bureau of Internal

Revenue had concluded that these costs were primarily personal in

62

63

nature.

Testimony at Congressional hearings in 1953 indicated that a
large number of people felt that some of these expenses should be
deductible.

It is my belief that if as many mothers, for instance,

had been working at the time that regulations were

shaping the meaning of ordinary and necessary business

expenses as there are now, the Treasury Department

would have permitted deductions for wages paid house-

keepers, nursemaids, and expenses of nursery care.

Other testimony advocated deduction of these expenses for adjusted
gross income.

Section 22(n) should be amended to provide that this

expense be deductible in computing adjusted gross

income. It is an expense directly related to the

production of income and should be deducted on the

same basis as travel and other similar expenses.3

Subsequently, a number of bills were submitted concerning these
expenses and the new Internal Revenue Code of 1954 contained Section
214 which allowed the limited deduction of what were termed child
care expenses. The law followed the proposals of the Senate Finance
Committee which were more liberal than those of the House Ways and
Means Committee.4 The deduction was allowed to a working woman or
widower for the expenses paid for the care of a dependent who was
mentally or physically incapable of self-care or who was the child
of the taxpayer under twelve years of age. The child care expense
deduction could not exceed $600, nor were payments to dependents
deductible. The allowable deduction was reduced for working wives
by the amount by which the adjusted gross income of the taxpayer and

her spouse exceeded $4,500. Because of the construction of Section

62, these expenses could only be deducted from adjusted gross income.5

 

64

It was subsequently established that this deduction also
applied to self-employed taxpayers6 and that these expenses must
have been incurred to allow the taxpayer to produce income.

The provision for the deduction of these expenses was amended
in 1964 because it was too restrictive.8 The maximum deduction be—
came $900 for two or more dependents and the care expenses of
children under 13 were made deductible. The allowable deduction
was reduced by adjusted gross income in excess of $6,000.9

The law was held not to violate due process even though it did
not allow the deduction to a man who had never been married since
all members of the class of unmarried men were treated equally.10
Nor does it violate the Fifth Amendment although one class, women
with children, are discriminated against depending on their income
while other income-producing expenses are not dependent upon level
of income for a determination of the amount which is deductible.11

In 1971, this area was changed again. Reasons for revision
were to encourage the use of domestic help to allow full-time employ—
ment and to support the care of dependents in the home.12 The level
of the maximum allowable annual deduction was raised to $4,800 be-
cause the previous level was deemed inadequate. Coverage was extended
to the care expenses of children 14 years of age and under.

The allowable deduction decreased $1 for every $2 of adjusted
gross income in excess of $18,000, based on a Conference Committee
change.13 The original Senate amendment had mandated phase-out over
a $12,000 adjusted gross income because it was assumed that $12,000

14

would be the median income for families in the subsequent year.

Median income was chosen as the phase-out point because the spouses

 

65

with earnings below this figure are felt to be working to maintain
minimum living standards.15 The Conference Committee raised this
figure to encourage middle class as well as low income families to
pay for high quality child care and household assistance without
worrying about unduly shrinking their total income.16 The Senate
voted 59 to 24 in favor of this change.17
The Senate also debated whether these expenses should be fl
deductible for adjusted gross income. One argument in favor of this
change was that it was estimated that almost 70 percent of taxpayers

with adjusted gross incomes less than $10,000 would not itemize

deductions.18 However, the Treasury estimated that this change

 

would cost an additional $110 million in tax revenues.19 Thus, the
discussion revolved around the probable loss in tax revenue and the
availability to low-income taxpayers rather than whether these ex-
penses were primarily income-producing or personal in nature. The
Senate vote was 74 to 1 in favor of the change,20 yet the Conference
Committee rejected this amendment without explanation but accepted
the $18,000 phase-out amendment which passed the Senate by a much
smaller margin.21 After 1971, indirect child care costs, such as
for cleaning childrens' rooms and preparing meals for them, became
deductible.22

It has been theorized that much of the force behind the posi-
tion that child care is a real business expense derives from the
view of womens' groups that the expense of child care is generally
offset against the probable earnings of the working wife to see how

much net income she would add to the family by working.23 Conse-

quently:

66

Under these mores, the child care deduction assists

her in obtaining a freedom of decision on a parity

‘with the husband. In this view, it would seem that

if decisions as to who works outside the home were

made regardless of sex, there would be no basis for

the child care deduction. If so, as a matter of

tax structure it is hard to see why the expense is

really a business expense and not a personal expense.

Thus, the opinions of Congress, the Treasury Department, and
tax experts are divided concerning whether the expenses of household
and dependent care services are primarily income-producing expenses
of individuals. These expenses have only been deductible for the
last 20 years. There are no special substantiation requirements.
Deductible amounts have a maximum which is $4,800 for adjusted gross
incomes up to $18,000. Between adjusted gross incomes of $18,000 and
$27,600 this maximum decreases. No child care expenses are deduc-
tible on tax returns with an adjusted gross income of at least
$27,600. The criteria applied to determine motivation are objective
insofar as the expenses must be incurred to allow full-time employ-
ment, which is an explicitly defined time constraint, and a joint
return must be filed. Allocation of these expenses is necessary to
the extent that services are provided without a reasonably direct
relationship to the care of dependents of the taxpayer. Location
is only important to the deduction of these expenses when they are

incurred outside of the home of the taxpayer where the maximum deduc-

tion depends upon the number of dependents being cared for.

Employee Expenses

 

All income-producing expenses of employees other than travel,

transportation, moving, outside salesmen, and reimbursed expenses

 

67
are deductible only by employees who itemize deductions from
adjusted gross income. Except for child care expenses, the deduc-
tibility of these expenses has basically been established by the
interpretation of the Internal Revenue Service and the courts of
the section of the law which allows the deduction of ordinary and
necessary trade or business expenses.25 Although there are many of
these expenses,26 only entertainment, education, office-in-home,
and employment seeking or securing expenses will be investigated
because of their relatively large size when incurred or greater

frequency of occurrence.

Entertainment. Entertainment expenses of individuals to produce
income were not mentioned by the law or the regulations until 1958.
Prior to that time, the only basis for deductibility was Revenue
Service and court interpretation of what constituted an ordinary
and necessary business expense. However, entertainment expense
deductions were allowed in many cases for employees27 and self-
employed taxpayers.28

Substantiation of entertainment expenses has probably caused
more problems than any other area of individual income-producing
expenses. Originally, estimates of expenses were of no help in
establishing deductible amounts.29 However, the Cohan case estab-
lished the principle that estimates could be used to determine
deductible entertainment expenses, although the lack of records
would weigh against the taxpayer in the decision of the court as

30

to what amount was deductible. The Cohan rule was applied in

subsequent court cases.31 It resulted in uncertain enforcement by

68

the Internal Revenue Service.32 Proposals to modify the Cohan rule's
effect on entertainment expenses were frequently made by the executive
branch33 and by tax experts.34 The Internal Revenue Service attempted
to maintain a strict enforcement attitude towards the deduction of
entertainment expenses.35 The Treasury felt that many taxpayers, who
incurred a nominal amount of entertainment expenses, were consistently
taking advantage of the Cohan rule by making generous estimates of
entertainment expenses.

Section 274 was added to the Code in 1962 to curb these abuses
and to relieve some administrative uncertainty.37 It requires the
taxpayer to keep and maintain certain records for entertainment
expenses in excess of $25. A transition period was allowed to imple-
ment this change in the keeping of entertainment expense records.38
Numerous subsequent cases continue to involve the problem of which
records provide adequate substantiation of entertainment expenses.

Determining when entertainment expense has been incurred pri-
marily to produce income has had an elusive solution because of the
highly personal nature of these expenses. To delineate between
deductible and nondeductible entertainment expenses has required
some necessarily arbitrary decisions by the Internal Revenue Service,
the courts, and, more recently, Congress.

The original criterion applied to measure the motivation of the
taxpayer in incurring the entertainment expense was a determination
of whether a direct relationship existed between the expense and the
business of the taxpayer. Failure to prove this direct relationship
resulted in disallowance of the deduction.39 However, the Service

and the courts were liberal in the determination of where this

 

69
connection existed.40 Because of this problem, the President recom-
mended that the deduction of most previously deductible entertainment
expenses be disallowed.41 He proposed that some of the remaining
deductible entertainment expenses be subject to daily maxima.42 Con-
gress did not agree that almost complete disallowance was a proper
4

solution to the problem. 3 In 1962, an explicit test was added to
the Code to limit the abuse and ambiguity in this area.44 Deductible
entertainment expenses must subsequently be directly related to, or,
in the case of an item directly preceding or following a substantial
and bona fide business discussion, associated with, the active con-
duct of the trade or business of the taxpayer.45 Objective standards
were made to apply where there must be apportionment between the ex-
penses which meet this test and those which do not.46 These standards
are not clear47 nor objective.

The critical point to note is that Section 274 was

designed to assist, by objective tests, the adminis—

tration of the tax laws. Yet what could be more sub-

jective than a query whether circumstances and sur-

roundings were conducive to a business discussion,

or whether a substantial business discussion did not

occur because of reasons beyond the taxpayer's con-

trol. The administration of the tax laws has not

been helped by the enactment of Section 274. The

Regulations have liberalized Section 274 but have

not clarified the basic rules either for the tax-

payers or the revenue agents.
The end result for the majority of taxpayers who incur entertainment
expenses was not significantly changed by Section 274 because of
subsequent broad interpretations of its wording and intent.49 Thus,
the criteria used to measure the income-producing motivation of

entertainment expenses are objective according to Congress, but

subjective in their practical application to the circumstances of

70

each taxpayer.

The type and degree of relationship between the taxpayer and
the person being entertained are very important to the ultimate
deductibility of the entertainment. The closer the social relation-
ship and the more remote the business relationship, the harder it is
to incur deductible entertainment expenses.

At one time, employees could only deduct entertainment expenses
when they could prove that their wages had been fixed in an amount
to cover such expenses.51 Some subsequent decisions have indicated
that explicit employee-employer agreement as to entertainment respon-
sibilities is still important,52 while others have decided that it
is not important.53 Another case concluded that, despite an agree-
ment, an employee entertaining extensively to further customer rela-
tions could not deduct the expenses because as a corporate officer
he was just fulfilling civic and social obligations which were per-
sonal.54 It seems reasonable to conclude, however, that, generally,
employer—acknowledged entertainment responsibilities are helpful to
the deduction of the entertainment expenses of employees, although
not sufficient nor necessary for their deductibility.

Another consideration in the determination of deductible enter—
tainment expenses concerns whether or not the expenses of the enter-
tainer are deductible. A number of decisions have concluded that
only the excess of expenses for oneself over what would have been
spent normally for one's meal is deductible.55 This situation
arises only in the case of entertainment expenses because other
income—producing expense areas explicitly allow the deduction of the

full amount of otherwise personal costs, not just abnormal costs.

 

71
Examples are meals and lodging when in a travel status or when
moving and temporary living costs incurred in connection with moving.
Some knowledgeable sources take the court decisions at face value.

The entertainment expense deduction for taking a client

to lunch includes only that portion of the check repre-

senting the client. What the host spent on his own

meal, it was assumed, was personal; he would have had

to eat lunch even if he had been alone.5
However, other sources indicate that the Sutter rule will only be
applied by the Internal Revenue Service where it finds an abuse situ-
ation.57 Apparently, the taxpayer's normal personal expenses, which
are incurred in an entertainment situation where the costs of the
person being entertained are deductible, are not deductible, although
the auditing agent may allow their deduction if he does not find that
the taxpayer is claiming a substantial amount of entertainment expenses
which includes personal living expenses.

Thus, entertainment expenses incurred to produce income have been
deductible for many years, although this deductibility has been based
on interpretation of Section 162 and its predecessors, rather than on
explicit statements in the Code. Section 274 requires special record—
keeping for entertainment expenses and disallows the application of
the Cohan rule to estimate expenses incurred when records are inade-
quate. Allocation must be made for portions of entertainment expenses
for the taxpayer, in general, and for guests without an income-pro-
ducing relationship with the taxpayer. The criteria applied to deter-
mine motive, such as directly related to or associated with, are
basically subjective. Deductibility does not depend on employer

requirement or awareness of the employee's entertaining expenses,

but it does depend upon the taxpayer already being in the position

72

of producing income.

Education. It was not until 1950 that a broader interpretation of
what constituted ordinary and necessary business expenses resulted
in the subsequent deductibility of many education expenses incurred
to produce income. Previously, costs of summer school attendance,
post—graduate medical courses,6O professional books,61 research
assistance for a scholar writing articles,62 and engineering night
school courses for a mechanic63 were not deductible.

In 1950, Hill v. Comm. concluded that summer school expenses
of a teacher were deductible by applying more liberal criteria than
those used in the past.64 Before this time, the criteria used had
been whether the expenses had been required by the employer, whether
they were principally to enable the continuance of a present career,
and whether they would lead directly to profit. The effect of this
case was to eliminate much of the dichotomy between the reasoning in
education and non-education cases so that the costs of obtaining
income-producing knowledge directly in a formal educational setting,
especially, would be as deductible as other means of obtaining
revenue. Hill v. Comm. developed criteria to ascertain the deduc-
tibility of these expenses, such as, whether the expenses were in-
curred to maintain a present position or to attain a new position,
to preserve or to expand and increase, and to carry on or to com—
mence.65 The Internal Revenue Service subsequently promulgated a
statement to the same general effect.66 Education expenses incurred
in connection with advancement within a profession67 or to obtain a

new position68 were not deductible.

73

In 1958, the Service issued formal regulations which applied
a more extended approach for deductible education expenses.69 Subse-
quent deduction depended upon education expenses having had a pri—
mary purpose of maintaining or improving needed skills or of meeting
the express requirements of the employer.70 This primary purpose
test allowed the deduction of costs incurred in obtaining a Ph.D. in
the subject area of the job of the employee,71 but it disallowed the
expense deduction when the original education motivation was not pri-
marily related to retention of the present job held.72 Employer I

requirement of the education enabled the deduction of expenses which

 

otherwise would be considered to be training for a new trade or
business.7

As a result of increased uncertainty and lack of uniformity in
the application of the primary purpose test,74 a new regulation con—
cerning the deduction of education expenses was issued in 1967.75
Subsequently, education costs are not deductible if they are part of
a program which will lead to qualifying the taxpayer in a new trade
or business even though their primary purpose is to maintain or im-
prove present job skills or to meet employment retention conditions
of the employer.76 This requirement has resulted in numerous cases
where education expenses were incurred in programs leading to formal
college degrees, especially law degrees, and their deduction was
disallowed. This more objective test has resulted in many fewer
cases requiring court decisions and being decided in the favor of
the taxpayer.

One problem has been whether a taxpayer is in an income-producing

status and thus is able to deduct education expenses if the present

74

job is left to pursue education on a full—time basis. A teacher
who resigned her position, took graduate courses for one year, and
then took a different teaching position was held to be in the same
. 77
trade or bus1ness continuously. However, studying for four years
with no employment relationship and no attempt to obtain a teaching
78 . . . .
position, and haVing a job in a different profeSSion before
obtaining education related to the old profession and returning a
. 7 . .
to the old profeSSion, 9 were indicative of cea31ng to be in the
same trade or business and, therefore, the education expenses were
not deductible.

Although other types of income-producing investment costs are I
allowed to be amortized over their useful lives, that treatment has
never been allowed for the basic education expenses of individuals
incurred to meet the minimum standards of their subsequent employ—

80 .
ment. Many tax experts have advocated amortization of these

. 81 . . .
human capital costs, but the Regulations have continually main-
tained that they are personal, despite the fact that moving costs
to a first or a new job are deductible income-producing expenses.

Thus, education expenses incurred to produce income are
deductible only after entering a trade or business and they can not
be part of a program leading to qualification in a new trade or
business. Their deductibility has been recently established, but
only through Regulations, rulings and court decisions. There must
always be allocation between personal and income-producing educa-
tion expenses and the criteria for this allocation are mainly subjec-
tive. The incurring of these expenses can be either on a voluntary

basis or as a result of an employer requirement for keeping a job.

75

Education expenses have no special substantiation requirements.

Office-in-Home. References were made to the deductibility of the

 

allocated expenses of a home used to produce income as early as
191882 and similar language has been used by all subsequent regula-
tions to the present time.83 The revenue acts and Codes have never
mentioned this expense explicitly.

Early litigation determined that the taxpayer had to be in a
trade or business to deduct these expenses.84 Also, allocation
had to be made between the income-producing expenses of the office
and the personal expenses of the rest of the residence.85 The
courts seemed to interpret the regulations as preventing the deduc-
tion of office-in—home expenses of an employee.86 Subsequent liti-
gation recognized that employees could be eligible to deduct this
income-producing expense, but only when the home office was required
by the employer.87 Guidelines issued by the I.R.S. in that same year
allowed the deduction of these expenses only when the home office
was required by the employer and when it was regularly used.88

Subsequently, expenses for a home office were deductible where
space limitations existed at the office furnished by the employer,89
but they continued to be deductible only for a taxpayer actively
engaged in a trade or business.90 In 1963, the Service ruled that
expenses of research were deductible even though they might have
only an indirect income-producing effect for teachers.91 As a
result of this ruling, home office costs for research are more
likely to be deductible than office costs for ordinary teaching

activities.92 Revenue Ruling 64-27293 expanded upon Revenue Ruling

76
63-275, but its deductibility criteria were that the expense was
deductible if the college expected faculty research but did not pro—
vide adequate facilities and that the portion of the home be used
regularly. These are, basically, an extension of Revenue Ruling
62-180 criteria.

The courts have recently modified these criteria insofar as
employer requirement is considered a necessity for deduction of
office-in—home expenses. In 1966, the Tax Court held that to be
deductible as an ordinary and necessary business expense it is
sufficient that the expenditure be appropriate and helpful to the
conduct of the business; it need not be required.94 In 1970, the
courts further emphasized that Revenue Ruling 62—180 is not control-
ling but is merely helpful and that each case is to be decided upon
the weight of the facts presented.95

Two Tax Court cases decided in 1973 further applied this test
of appropriate and helpful. In one, the court stated that this
test, rather than employer requirement, should be applied here just
as it is to other business expenses.96 As a condition of employment
was interpreted to mean required to perform properly the duties of
employment, rather than the more limited Service interpretation.
Strong dissents saw an analogy to Fausner97 and would have disallowed
the deduction unless the taxpayer had been able to show that he would
have rented a smaller apartment or bought a smaller house, except for
his need of an office in his home to produce income. The other Tax
Court decision also disagreed with Revenue Ruling 62—180, especially

regarding how much office-in-home expenses were incurred to produce

income.98

77

Thus, office—in-home expenses are subject to normal substantia-
tion requirements and they always must be allocated between personal
and income-producing purposes. To result in deductible expenses,
the office must be used regularly by a person already in a trade or
business. It is reasonable to assume that use of the office need
only be appropriate and helpful to the performance of employment
duties rather than required by the employer as the Internal Revenue 1

Service contends.

Employment Seeking or Securing. The costs of looking for or actually
finding a job have never been explicitly mentioned in our income tax i
laws. However, the Internal Revenue Service generally has interpreted 1
the sections of the law allowing the deduction of ordinary and neces—
sary trade or business expenses to apply to fees incurred to success—
fully find employment.99 Fees paid to seek employment unsuccessfully

were held to be nondeductible.100 Subsequent court decisions relied

on that distinction.101 The Service tried to carry this rationale
even further by reasoning that the obligation to pay employment agency
fees in the event of employment is incurred in seeking employment and,
therefore, not deductible even if employment is secured through the
agency.102 Very strong protests to this ruling caused the I.R.S. to
reconsider and revoke Revenue Ruling 60-158 so that employment agency
fees continued to be deductible if they resulted in a new job.103

A 1970 court case established a two-part test for the deductibil-
ity of employment agency fees.104 To be deductible, the fees must

have led to securing a new job and the new job must have duties similar

to those of the present job of the taxpayer. Another decision in that

78

same year allowed the deduction of employment agency fees where
the agency secured a new job for the employee although he stayed
with the same employer.105 However, the I.R.S. and another court
continued to draw a line between job-seeking and job-securing
expenses,106 although the Service indicated acceptance of the
Primuth decision.107 In 1972, the Tax Court completely eliminated
the distinction between seeking and securing.108 The new tests for
deductibility appear to be that the employment must be sought in
good faith and in a similar occupation,109 although the Service has
not explicitly indicated agreement with Cremona. Such criteria
abandon the clear-cut test of the securing and seeking distinction
for a test in which each case must be decided on its own facts.110
A recent decision disallows a deduction if the origin of the expense
is personal even though incurring it may make a present job more
secure.111 The Service removed job seeking expenses from its list
of tax issues that it will not compromise on.112 This implies its
acceptance of the thrust of these latest court decisions which are
in accord with previous suggestions of some tax experts.113

One criterion which has been applied consistently to job
seeking expenses is that they must be for employment in a new posi-
tion with similar duties.114

It has also been consistently held that a taxpayer may not
deduct employment seeking or securing expenses if he is unemployed115
even though some other types of income-producing expenses have been
held to be deductible by temporarily unemployed taxpayers.116

Thus, employment securing expenses have long been deductible,

while mere employment seeking expenses have only recently become

79
deductible. Normal substantiation requirements apply to these
expenses. These expenses are not deductible when incurred either
by an unemployed taxpayer or to obtain a position in a different
trade or business. Employment seeking or securing expenses are
either fully deductible or not deductible, so no allocation between
deductible and personal portions is necessary. The criteria applied
to determine whether a primary income-producing motive exists are

very subjective.

Investor Expenses

 

A great variety exists in the types of income-producing expenses
which are not incurred in a trade or business nor attributable to the
production of rents or royalties. Expenses incurred to produce in-
come from securities or alimony income are the most frequent subjects
of litigation.

The criteria for deductibility are basically the same as those
applied to expenses incurred to produce rents or royalties which
were covered in pages 46 to 49. They must bear a proximate relation
to the activities carried on. The expenses are not deductible if they
arise from personal activities, notwithstanding the fact that failure
to incur these expenses may result in the attachment, sale, or use of
the income-producing property of the taxpayer in order to settle a

liability.118 The key question is the intention of the taxpayer

in the light of all the facts and circumstances.119 The use of the

property should be of such a nature that the taxpayer in good faith
genuinely expected or intended to make a profit.120

Thus, the main criterion for deductibility of these expenses

80
appears to be that the primary motive of the taxpayer was to pro-

duce income.

SummaEy

This chapter has analyzed the historical development and factors
in the deduction of the income-producing expenses of individuals
which are deducted from adjusted gross income. Table 4.1 indicates
a basic summary of the main considerations impacting on most of these
deductible expenses. The same basic criteria for deductibility of
each type of expense are applied to self-employed taxpayers, employees
and investors. Table 4.1 indicates some internal consistency in the
use of mostly subjective deductibility criteria and the requirement
that all be incurred while in a trade or business, although a tempo-
rarily unemployed person is not considered to be in a trade or busi-
ness for the purpose of deducting job seeking or securing expenses,
whereas he would be for the purpose of deducting some other income-
producing expenses.

The purpose of Chapters 3 and 4 was to determine whether any
consistent differences exist in the criteria promulgated by lawmakers
to indicate the extent to which the two groups of income-producing
expenses are and have been deductible. The presence of consistent
differences may account for the lack of horizontal equity perceived
in Chapter I which was not explained by the Chapter II tracing of
the chronological development of the dichotomous treatment of
income-producing expenses. A scrutiny of the pertinent factors in
the deduction of each expense as summarized in Table 4.2 fails to

find even internal consistency in their application. Both

81

 

 

 

 

 

 

 

 

 

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84
deductions for and from adjusted gross income have expense cate-
gories with a long history of acceptance and others with a short
history of deductibility. Deductions for adjusted gross income
have maximum time and minimum location constraints unlike deduc-
tions from adjusted gross income, but both groups have maximum
amount, maximum location, and minimum time constraints. Neither
group has any minimum amount constraints. The application of
other factors appears to be similarly distributed within each group,
except for the moving expense deduction which is allowed for indi-
viduals before they start producing income or before they enter a
trade or business. This analysis of deductibility criteria does
not, therefore, lead to any consistent substantive distinctions
which would justify the current dichotomous treatment of the

income-producing expenses of individuals.

9.

10.

11.

85

FOOTNOTES--CHAPTER IV

I. T. 1767, II-2 Cum. Bull. 1071; Smith v. Comm., 4O BTA
1038; aff'd 113 F.2d 114 (CA 2, 1940); O'Connor v. Comm.
6 TC 323 (1946).

Statement of Aime J. Forand at the Hearings Before the
Committee on Ways and Means on General Revenue Revision,
83rd Congress, First Session, Part 1 (Washington: U.S.
Government Printing Office, 1953), p. 30.

 

Statement of Julia Thompson, loc. cit.

House Report No. 1337, op. cit., p. 30; Senate Report No. 1622,
op. cit., p. 35; House Report No. 2543, Internal Revenue Code
of 1954, 83rd Congress, Second Session (Washington: U.S. Gov-
ernment Printing Office, 1954), p. 31—32.

 

Section 62 allows the deduction for adjusted gross income of
trade and business expenses allowed by the income tax chapter
concerning normal taxes and surtaxes, Chapter 1, except for
those expenses allowed within Part VII of Subchapter B which
indicates deductible itemized deductions for individuals.
Section 214 is contained within Part VII of Subchapter V so
it is the exception to the rule that the income-producing
expenses of self-employed individuals are deductible for
adjusted gross income. Although moving expenses are made
deductible by Section 217, which also is contained within
Part VII of Subchapter V, their deduction for adjusted gross
income is independently authorized by Paragraph 8 of Section
62.

To Do 6184, 1956—2 Cum. BUll. 157.

Rev. Rul. 56—169, 1956-1 Cum. Bull. 135, and Lustig v. Comm.
30 TC 926 (1958); aff'd 274 F. 2d 448 (CA 9, 1960).

House Report No. 749, 10c. cit., pp. 181-182.
Section 212, Public Law 88—272, 1964-1 (Part 2) Cum. Bull. 6.

Moritz v. Comm., 55 TC 113 (1970), stated that the taxpayer
could only avail himself of the deduction if he fitted within
the terms of the statute. It also concluded that if Congress
sees fit to establish classes of persons who shall or shall
not benefit from a deduction, there is no offense to the Con-
stitution, if all members of one class are treated alike.

Nammack v. Comm., 56 TC 1379 (1971); aff'd 459 F. 2d 1045
(CA 2, 1972); cert. den. 409 U.S. 991 (1972). This decision
concluded that these expenses are business and personal in
nature and that Congress was free to classify such expenses

12.

13.
14.
15.

16.

17.
18.
19.
20.

21.

22.
23.
24.

25.

26.

27.

28.

29.

86

in either category. The fact that it chose to allow the
deduction only in the case of the less affluent family does
not constitute a violation of the rights of the petitioner
under the Fifth Amendment. A different conclusion is not
called for simply because the nondeductibility of certain
child care expenses might impose a particular burden on
working women. The court said that the presumption of
constitutionality of an act of Congress is particularly
strong in the case of a revenue measure.

Senate Rept. No. 437, Report of the Committee on Finance
on the Revenue Act of 1971, 92nd Congress, First Session
(Washington: U.S. Government Printing Office, 1971), p. 60.

 

 

Ibid., p. 61.
Ibid. ’ p. 60.
Ibid., p. 59.

Congressional Record, 92nd Congress, First Session, Vol. 117,
Part 31, p. 41255.

Ipig,, p. 41256.

‘gpgg., p. 40934.

Ibid.

323g,, p. 50935.

Senate Conference Report No. 553, Conference Report on the

Revenue Act of 1971, 92nd Congress, First Session (Washington:
U.S. Government Printing Office, 1971), p. 42.

 

 

Smail v. Comm., 60 TC 76 (1973).
Surrey, Stanley 8., p. 357.
Ibid.

Section 162 of the Internal Revenue Code of 1954 and Section
23(a)(1)(A) of the 1939 Code.

See p. 3.

Lickumovitz v. Comm., 4 BTA 1181 (1926); Pollack v. Comm.,
lO BTA 1297 (1928); Wayburn v. Comm., 32 BTA 813 (1935).

Appeal of Parish—Watson, 3 BTA 840 (1926); King v. Comm.,
9 BTA 502 (1927); May v. Comm., 39 BTA 946 (1939).

Friend v. Comm., 8 BTA 712 (1927).

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

40.

41.

42.

43.

87

Cohan v. Comm., op. cit.

Kahn v. Comm., 38 BTA 1417 (1938); aff'd 108 F. 2d 748
(CA 2, 1940); Boverman v. Comm., 10 TC 476 (1948).

Eldridge, Douglas H., "Expense Accounts," Proceedings of the
54th Annual Conference of the National Tax Association
(Harrisburg, Pennsylvania: National Tax Association, 1962),
p. 216.

 

Department of the Treasury, "Proposals for Strengthening Tax
Administration," Hearings Before a Subcommittee of the Com-
mittee on Ways and Means, 82nd Congress, Second Session
(Washington: U.S. Government Printing Office, 1952), pp. 98-
100; "The President's Recommendations Contained in his Message
on Taxation," Hearings Before the Committee on Ways and Means,
87th Congress, First Session (Washington: U.S. Government
Printing Office, 1961), pp. 39-40.

 

Smith, Henry Cassorte, "General Business Expense (But with
Particular Reference to Entertainment, Gift and Travel
Expenses)," Tax Revision Compendium of the Committee on Ways
and Means, 86th Congress, First Session (Washington: U.S.
Government Printing Office, 1959), p. 1085.

 

Rev. Rul. 54-195, 1954-1 Cum. Bull. 47, directed internal
revenue officers to closely scrutinize the deduction of
business expenses.

Internal Revenue Service, Department of the Treasury, 1960
Audit Report on Entertainment, Travel and Similar Expenses
(Washington: U.S. Government Printing Office, 1961), p. 23.

 

Revenue Act of 1962, 10c. cit.

Rev. Proc. 63-3, 1963-1 Cum. Bull. 258; Rev. Proc. 63-18,

G.C.M. 5533, VIII-1 Cum. Bull. 4062; Denny v. Comm., 33 BTA
738 (1935); Schulz v. Comm., 16 TC 401 (1951).

Senate Report No. 1881, op. cit., p. 731.

"The President's Recommendations Contained in his Message on
Taxation," op. cit., p. 39.

Ibid., p. 40.

House Report No. 1447, op. cit., p. 423; Senate Report No.
1881, loc. cit. The Senate report indicated that entertain-
ment expenses should remain deductible to some degree because
they increase business income which in turn produces addi-
tional tax revenues for the Treasury.

44.
45.

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

88
Revenue Act of 1962, loc. cit.
Ibid.

House Report No. 1447, op. cit., p. 425; Senate Report No.
1881, op. cit., p. 735.

Bittker, Boris I., Panel Discussions Before the Committee on
Eggs agd Means, 93rd Congress, Second Session, Part 1
(Washington: U.S. Government Printing Office, 1973), p. 126.
He felt that Section 274 overloads both taxpayer capacity to
comply and I.R.S. capacity to enforce because of its many
fine distinctions.

Rich, Dixon R., "A Wife's Tax Value: Tax Aspects of a Wife's
Attending Conventions, Sales Meetings, Etc.," Proceedings of

the New York Univesity 22nd Annual Institute on Federal Taxa-
tion (Albany: Matthew Bender & Co., 1964), pp. 918-919.

 

 

Laforge v. Comm., 53 TC 41 (1969), allowed a doctor to deduct
allotted country club dues because the club was used primarily
to further his medical practice at quiet business meals;
Bussabarger v. Comm., 52 TC 819 (1969), allowed the deduction

of party expenses for employees of hospital where practiced
medicine.

Mill v. Comm., 5 TC 691 (1945), where drinks and cigars for
lodge members was not shown to be beneficial to the taxpayer's
business; Chapman v. Comm., 48 TC 358 (1967), where court
decided that primary motivation for garden party for students
and fellow faculty members was social; Ryman v. Comm., 51 TC
799 (1969), where law professor had faculty over after passing
bar exam was held to be personal due to inviting wives, serving
alcohol and dinner, holding on a Saturday night, and having
small expectation of business benefit.

Appeal of MaGill, 4 BTA 272 (1926).

Jergens v. Comm., 17 TC 806 (1951); Rev. Rul. 55-201, 1955-1
Cum. Bull. 269.

Abraham v. Comm., 9 TC 222 (1947).

Noland v. Comm., 269 F. 2d 108 (CA, 4); cert. den. 361 U.S. 885
(1959).

Sutter v. Comm., 21 TC 170 (1953); Smith v. Comm., 33 TC 861
(1960); Teeling v. Comm., 42 TC 671 (1964).

Holzman, Robert 8., Federal Income Taxation (New York: The
Ronald Press Co., 1960), p. 9.25.

 

Rev. Rul. 63-144, 1963-2 Cum. Bull. 129.

58.

59.
60.
61.
62.
63.

64.

65.

66.

67.

68.

69.

70.
71.
72.

73.

74.

75.
76.

77.

78.

89

J. K. Lasser Tax Institute, J. K. Lasser's Your Income Tax,
Bernard Greisman ed. (New York: Simon and Schuster, 1970),
p. 270

 

0. D. 892, 4 Cum. Bull. 1595 (1920).
o. D. 984, 5 Cum. Bull. 1755 (1921).
King v. Comm., 9 BTA 502 (1927).
Osborn v. Comm., 3 TC 603 (1944).
Larson v. Comm., 15 TC 956 (1950).

Hill v. Comm., 13 TC 291 (1949); rev'd 181 F. 2d 906 (CA 4,
1950).

Ibid.

I. T. 4044, 1951-1 Cum. Bull. 16 (1951), which also modified
O.D. 892 (See footnote 59).

Namrow v. Comm., 33 TC 419 (1959); aff'd 288 F. 2d 648 (CA 4,
1961); cert. den. 368 U.S. 914 (1962).

Booth v. Comm., 35 TC 1144 (1961).

T. D. 6291, 1958-1 Cum. Bull. 63, and later Rev. Rul. 60-97,
1960-1 Cum. Bull. 69.

Ibid.

Carlucci v. Comm., 37 TC 695 (1962).

Lamb v. Comm., 46 TC 539 (1966).

Lund v. Comm., 46 TC 321 (1966), where the employer required
his flight engineers to obtain pilots' licenses to retain
their status as flight crew members.

Greenberg v. Comm., 45 TC 480 (1966), is a good example
because there were many dissents who found it difficult to
reconcile the ordinary and necessary criteria of Section 162
with the primary purpose test of the 1958 Regulations.

T. D. 6918, 1967-1 Cum. Bull. 36.

Ibid.

Furner v. Comm., 47 TC 165 (1966); rev'd 393 F. 2d 292 (CA 7,
1968).

Corbett v. Comm., 55 TC 884 (1971).

 

79.

80.

81.

82.

83.

84.

85.

86.

87.
88.
89.

90.

90

Wyatt v. Comm., 56 TC 517 (1971).

Denman v. Comm., 48 TC 439 (1967), tried to amortize the
costs of an engineering degree over the years to age 65.

Statement of Elizabeth L. Brady at the Hearings Before the
Committee on Ways and Means on General Revenue Revision,
op. cit., p. 188; Kahn, Harry C., "The Scope for Tax Reform

 

’In Personal Deductions and Exemptions," Proceedings of the

 

55th Annual Conference of the National Tax Association
(Harrisburg, Pennsylvania: National Tax Association, 1963),
p. 69; Goode, Richard, The Individual Income Tax (Washington:
The Brookings Institution, 1964), p. 92, where he stated that
he knew of no evidence that the consumption component is
greater than the cost element, therefore, good social policy
would be to resolve the doubts about deductibility in favor
of the taxpayer; Goode, Richard, Proceedings of the 58th
Annual Conference of the National Tax Association (Harrisburg,
Pennsylvania: National Tax Association, 1966), p. 659, where
he stated that the problem of distinguishing between income-
producing educational expenses and cultural expenditures
would not be basically different from that already being
drawn in connection with travel and entertainment and many
expenses of self-employed persons that may involve personal
as well as business elements.

 

 

Article 291, Regulations 45, stated that if a professional
man used part of his house for his office, such portion of
the rent as was properly attributable to such office was
deductible. '

Regulation Section 1.162-6 states that a professional man
may deduct the cost of rent paid for office rooms and the
cost of the fuel, light, water, telephone, etc., used in
such offices.

Walker v. Comm., 20 BTA 937 (1930); aff'd 63 F. 2d 351 (CA 3,
1933); cert. den. 289 U.S. 746 (1933).

I. To 3929, 1948”2 Cum. BUllo 290

Hand v. Comm., 16 TC 1410 (1951), where a teacher could not
deduct the costs of using a home office for teaching acti-
vities primarily because he was not an independent contractor
engaged in business.

Davis v. Comm., 38 TC 175 (1962).

Rev. Rul. 62-180, 1962-2 Cum. Bull. 52.

Peiss v. Comm., 40 TC 78 (1963).

Knowles v. Comm., 40 TC 578 (1963).

 

 

91.

92.

93.
94.
95.
96.
97.

98.

99.
100.

101.

102.

103.

104.
105.

106.

107.

108.

109.

91

Lewis, Charles D., "IRS and courts adopting more liberal views
toward professors' home office expenses," The Journal of

 

Taxation, Volume 24, Number 10 (April, 1966), p. 232.

Rev. Rul. 64—272, 1964-2 Cum. Bull. 55.

Bischoff v. Comm., T. C. Memo 1966-25, 66 AFTR 102.

Newi v. Comm., 432 F. 2d 998, 70-2 USTC 9669 (CA 2, 1970).
Bodzin v. Comm., 60 TC 86 (1973).

See Footnote 60, Chapter 3.

Gino v. Comm., 60 TC 304 (1973), which stated that allocations
of this type are necessarily imprecise, but they are required
if justice is to be served.

O.D. 579, 3 Cum. Bull. 1055 (1919).

I.T. 1397, I-2 Cum. Bull. 428 (1921).

McDonald v. Comm., 323 U.S. 57 (1944), disallowed a judge's
campaign expenses; Frank v. Comm., 20 TC 511 (1953).

Rev. Rul. 60—158, 1960-1 Cum. Bull. 140, revoked O.D. 579.

Rev. Rul. 60-223, 1960-1 Cum. Bull. 57, revoked Rev. Rul.
60-158 and reinstated O.D. 579.

Primuth v. Comm., 54 TC 374 (1970).
Kenfield v. Comm., 54 TC 1197 (1970).

Rev. Rul. 70-396, 1970-2 Cum. Bull. 68, disallowed the deduc-
tion of amounts expended in traveling to find employment and
superseded I.T. 1397; Morris v. Comm., 423 F. 2d 611 (CA 9,
1970).

Rev. Rul. 71-308, 1971—2 Cum. Bull. 167, to the effect that
fees paid to an executive placement service were deductible
even though payable regardless of whether the service found
the taxpayer a job.

Cremona v. Comm. 58 TC 20 (1972), where a fee to assist
obtaining a better job was held deductible even though no
employment offers resulted and the taxpayer kept his old job.

Malloy, John M., "Employment Agency Fees: An Area of Continued
Litigation?," Taxes, Volume 52, Number 2 (February, 1974),
p. 104.

110.

111.

112.

113.

114.

115.

116.

117.

118.
119.
120.

121.

92

Ibid.

Walker v. Comm., T. C. Memo 1973-144, 32 TCM 690, where the
taxpayer indirectly paid his creditors to escape bankruptcy
which would have led to being discharged from his job.

"Job-Seeking Costs Removed from 'Prime Issue' List," The
Practical Accountant, Volume 7, Number 1 (January/February,
1974), p. 34.

 

Bittker, Boris I., "The Individual as Wage Earner," Proceedings
of the New York University 11th Annual Institute on Federal
Taxation (Albany: Matthew Bender & Co., 1953), p. 1167.
Recommendation of the American Institute of Certified Public
Accountants, Hearings Before the Committee on Ways and Means

on Tax Reform, 93rd Congress, First Session (Washington:

U.S. Government Printing Office, 1969), p. 4391.

 

 

 

 

Carter v. Comm., 51 TC 932 (1969); Black v. Comm., 60 TC 13
(1973); and previously cited cases where the primary issue
had been whether employment seeking expenses were deductible. i

 

Morris v. Comm., 423 F. 2d 611 (CA 9, 1970); Miller v. Comm.,
73-2 USTC 9681 (DC Tenn.).

Haft v. Comm., 40 TC 2 (1963), where the court concluded that
the entertainment expenses of the unemployed salesman were
incurred during a period of transition while seeking a job in
which he could serve his old customers; Furner v. Comm., 393
F. 2d 292 (CA 7, 1968), where a teacher could deduct education
expenses for attending one year of college while temporarily
unemployed because the employer did not grant leaves.

Bingham's Trust v. Comm., 325 U.S. 365 (1945); Rev. Rul.
64-236, 1964-2 Cum. Bull. 64.

Franklin v. Comm., 39 TC 192 (1962).
Newcombe v. Comm., 54 TC 1298 (1970).
Coors v. Comm., 60 TC 44 (1973).

See Footnote 116, Chapter 4.

CHAPTER V

ANALYSIS OF CONSIDERATIONS IN COURT DECISIONS
INVOLVING INCOME-PRODUCING EXPENSES
A tracing of the history of the dichotomous treatment of the
income-producing expenses of individuals and an analysis of the

explicit deductibility criteria used for each main expense led to

 

no consistent substantive justification for the apparent lack of L
vertical and horizontal equity in this area.

The purpose of this chapter is to analyze the most recent
court cases in this area to identify any basic distinctions between
objectively determinable considerations in cases in which the
income-producing expense was allowed, and those where it was denied.
The purpose of this procedure is to determine if there are consis-
tently different factors operating in the two deductibility classi-
fications. The frequencies of occurrence of factors within each
classification will then be aggregated and compared for possible
distinctions.

This analysis will be accomplished in three steps. The first
will identify objectively determinable considerations present in
court cases where the deduction of an income-producing expense of
an individual has been substantially disallowed. These cases will
be grouped based on whether the expense category of concern is

deductible for or from adjusted gross income. The considerations

93

94
present in the cases in these two groups will then be compared to
determine whether different characteristics are present in each
group which might justify their present separate treatment. The
second step will apply a similar methodology to cases where the
income—producing expense was substantially allowed. A third step
will compare total frequencies of considerations in each deduction
classification. E:
There are a number of important considerations involved in
this analysis. The first concerns the existence of previous research

utilizing this technique. A number of previous studies have applied

 

this methodology to varying degrees in widely diverse tax areas. L9
One study analyzed the eighteen Federal tax cases concerned with

the valuing of fractional interests in property where the allowance
of a discount was an issue.1 The objective of this analysis was to
arrive at some basic distinctions between the cases in which the
discount was allowed and those where it was denied.2 Although some
factors favorable to each side were identified and compared, the
conclusion was that it was impossible to arrive at any formula which
establishes exactly the circumstances which will, or will not, give
rise to a discount because the facts can vary so greatly between

any two cases.3 Another research effort has identified the criteria
involved and the final outcome of cases concerning unreasonable com-
pensation.4 This study attempted to highlight the relative fre-
quency with which the various criteria were applied in resolving
disputes over the reasonableness of compensation.5 A third source
has identified the factors important in court decisions concerning

the accumulation of earnings.6 The last two sources attempted only

95
a descriptive matrix summarization of factors important in court
decisions without any analysis of, for instance, cases where a
deduction was allowed compared with those where it was denied.
However, all of these studies concluded that factors identified
in court cases in a given area can provide a useful pattern of
information, although different combinations and different
weightings prevent reliable predictability for a specific set of
facts and circumstances.

A second concern is the number of cases selected for examina-
tion. Cases will be chosen concerning expenses deductible for
adjusted gross income and those which would have been itemized
deductions. The actual number chosen will depend on the length of
the period chosen. The cases chosen will cover the same period,
but cases where deductions were substantially allowed will be
smaller in number than those denied because the I.R.S. wins the
bulk of court decisions.

The period of selection of cases is a third important consider-
ation. Selection will commence using the topical indexes of the
Prentice-Hall and Commerce Clearing House federal tax case publi-
cations7 covering November, 1969, to July, 1974. This period was
chosen because explicit deductibility criteria have gone through
few changes during the period covered by these cases. Also, these
cases detail the most recent considerations applied to determine
the deductibility of these expenses.

Cases chosen, a fourth consideration, will be all of the
decisions during the period chosen of the District Courts, the Tax

Court, the Circuit Courts of Appeals, the Court of Claims and the

96
Supreme Court pertaining to the Federal income tax deduction of
the income-producing expenses of individuals which were studied in
Chapters III and IV. District Court cases are included although
the available information about their decisions tends to be confined
to instructions to the jury. These instructions usually supply most
of the facts and relevant considerations available in texts of the
decisions of other courts. Tax Court Memorandum decisions are not
covered because they consist largely of the establishment of fact
situations within previously settled legal principles and, there-
fore, have little precedential value.

A fifth important concern is the determination of which con-
siderations to look for in each case. Previous research indicates
that these considerations only become apparent, to a great extent,
after a reading of some of the cases. The considerations must be
objectively determined from the text of each case. This constraint
is necessary so that replication by another researcher would provide
similar results. One portion of objectively determinable considera-
tions will involve quantifiable facts which are generally provided
in the texts of court decisions. An example would be the annual
income of the taxpayer during the year in dispute, if that infor-
mation is usually provided. Only the frequency of occurrence of
other objectively determinable considerations can be observed,
such as, whether or not the decision included a determination of
the "reasonableness" of the expense. Since the analysis of con-
sistency will depend on average amounts or relative frequencies
there is no need to determine the relationship of these considera-

tions to the court's decision. Such a determination would be

97

highly subjective. An additional criterion used to determine rele-
vant considerations is mentioning in more than just a couple of
cases. Also, a consideration must have some possible impact on the
decision concerning deductibility. For example, the number of
commas within the decision would not be a relevant consideration.
Occurrence is recognized for each consideration when the court's
terminology mentions the factor, thus indicating that it had an
impact on the deductibility decision.

A last consideration concerns the analysis and conclusions.
The choice of the most recent cases from all main courts deciding
on federal tax matters and the subsequent analysis of objectively
determinable considerations in each case provides a relevant pattern
of information. Consistency and frequency of occurrence of these
factors are compared between the two deduction classifications of
income-producing expenses of individuals. Lack of consistency in
the frequency and degree of application of these considerations
between deductions for adjusted gross income and deductions from
adjusted gross income would provide a rationale for the present

dichotomy.

Deduction Substantially Disallowed

 

This step will identify objectively determinable considerations
present in court cases where the deduction of income-producing ex-
penses of individuals was substantially disallowed. These factors
are organized in a matrix format in Tables 5.1 and 5.2 and compared
based on respective deduction classifications.

The identification of important considerations resulted from an

98

 

 

 

 

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101

extensive and detailed reading of these cases. Quantifiable facts
generally observed were (1) annual amounts in dispute and (2) num-
bers of lawyers. Other factors were (3) the particular court,

(4) the analyzing of the appropriateness of the deduction based on
the criteria of Sec. 262, which pertains to the nondeductibility of
personal expenses, (5) the meanings of "ordinary and necessary,"
(6) the determination of what constitutes a "trade or business,"
(7) the meaning of a "reasonable" expense and (8) the presence of
inadequate substantiation. Another possible consideration, tax-
payer income, was not included because it was available in few
cases and, where available, it was stated in many differing forms.
Infrequency of mention or unlikelihood of impact on the deductibility ‘
decision excluded other possible considerations from this analysis.

During this period, 64 decisions disallowed the deduction of
income-producing expenses which would have been deductible for
adjusted gross income and 37 disallowed the itemized deduction of
income-producing expenses. The mean amounts in dispute and the
mean number of lawyers categories appear to have different treat-
ments. These differences will be explained in the third step where
deductions allowed and disallowed are aggregated within the two
groups of deductions because they appear in the aggregate figures
also.

Two areas which have very different frequencies of occurrence
are the analysis of the meaning of a trade or business and the
existence of poor substantiation. Cases concerning deductions for
adjusted gross income mention these items 6 and 17 times, respec-

tively, whereas cases concerning expenses which should be itemized

102

mention them 20 and 4 times, respectively. Only 9 per cent of

cases concerning deductions for adjusted gross income analyze the
meaning of a trade or business while it is done by 54 per cent of
cases concerning itemized deductions. This divergence is largely
explained by the heavy emphasis placed on this consideration in
cases involving the deduction of education expenses. Deleting

them from the pOpulation of itemized deduction cases results in

only 3 cases analyzing the meaning of a trade or business. This

is 18 per cent of the remaining cases. Poor substantiation is
mentioned in 11 per cent of cases involving itemized deductions

and in 27 per cent of other cases where the deduction of the
income-producing expense was substantially disallowed. This dif-
ference is largely due to the presence of 8 cases concerning the
deduction of entertainment expenses for adjusted gross income by
self-employed persons while only 2 itemized deduction cases con-
cerned entertainment expenses. All disallowed entertainment expense
cases had poor records. Deletion of entertainment expense cases
leaves 16 per cent of cases concerning deductions for adjusted gross
income mentioning poor substantiation, while it is a concern in 6
per cent of cases involving itemized deductions. Thus, for the
period studied, income—producing expense cases resulting in sub-
stantial disallowance reflect a slightly greater frequency of
mention of the meaning of a trade or business for itemized deduc-
tions, but a less frequent occurrence of inadequate substantiation.
These consistent differences in emphasis could provide a weak par-
tial justification for the present treatment of the income-producing

expenses of individuals. They provide a reason for the different

103

treatments based on inherent distinctions between the expenses in

each group.

Deduction Substantially Allowed

 

Tables 5.3 and 5.4 identify considerations present in court
cases where the deduction of income-producing expenses of individuals
was substantially allowed. During this period, 12 decisions allowed
the deduction of income-producing expenses for adjusted gross income
and 13 allowed the itemized deduction of income-producing expenses.
There are no consistent differences in considerations present in
these cases nor in the frequency of their occurrence other than for
the mean amount of expense in dispute which will be covered for all

groups of cases in the third step.

Aggregate Analysis of Case Factors

This step combines the considerations enumerated in Table 5.1
with those in Table 5.3 and those in Table 5.2 with those in Table
5.4. This aggregation leads to the construction of Table 5.5 which
displays these considerations and their frequencies clustered by
deduction location. Reasonableness and proportion of taxpayers
without lawyers are mentioned here also, although their occurrence
was not significant enough to mention in the tables previously pre-
sented.

Analysis reveals that a much larger proportion of cases in-
volving itemized income-producing expenses are decided in the Tax
Court. The average amount of tax in dispute in cases involving
deductions for adjusted gross income appears to be much higher

than the mean tax for itemized deductions. However, deleting 2 of

104

 

 

 

 

 

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105

 

 

 

 

 

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106

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107

the 76 cases, Brown and Carkhuff, results in an average tax in dis—
pute in cases involving deductions for adjusted gross income of $697
which is very close to the $630 for itemized deduction cases. The
average amount of expense in dispute in itemized deduction cases
appears to be relatively higher, but deleting l of the 50 cases,
Brooks, results in an average expense in dispute for itemized income—
producing expenses of $1,849 which is slightly below the $2,378 aver- T“
age for deductions for adjusted gross income.

The overall mean numbers of lawyers appear to be lower in cases

involving itemized deductions but this is a result of the case mix

 

for each area. If the mean number of lawyers for the government and b'
the taxpayer in cases concerned with deductions for adjusted gross

income are multiplied in each court separately times the number of

itemized deduction cases decided in that court, the overall means

become 2.1 and .6, respectively. So this apparent difference

reflects the fact that a greater proportion of itemized deduction

cases were decided in the Tax Court which has the lowest average

number of lawyers for either side. Other considerations observed,

other than trade or business definition and poor records which were

covered in the first step, do not display different frequencies of

occurrence between the two deduction classifications.

Summary

This chapter involved the analysis of the most recent court
cases concerning the deduction of income-producing expenses by indi-
viduals in order to identify any basic distinctions in considerations

or in their frequency of occurrence within decisions concerning

108
deductions for adjusted gross income and decisions concerning
itemized deductions. Although no observably different factors
occurred in these groups of cases, some differences in their fre-
quency of occurrence were observed. However, these distinctions
were basically due to different case mixes, to one or two cases
with extremely high amounts of tax or expense in dispute, or to
the basic nature of one of the expense categories, such as education,
within a deduction group. Deductions for adjusted gross income had
a larger proportion of cases decided in Courts of Appeals and a
smaller proportion of cases decided in the Tax Court than did cases
concerning itemized income-producing expenses. This distinction
does not appear to be a reasonable explanation for the present
dichotomous treatment because tax law distinctions should not be
based on differing frequencies of courts resolving disputes in the
area. Slight differences in the frequency of occurrence of 2 con-
siderations and the slight tendency for amounts in dispute for
deductions for adjusted gross income to be higher provide weak
partial justification for the present dichotomous treatment of the
income-producing expenses of individuals. It is possible that the
present dichotomy is justified because the meaning of a trade or
business is a more frequent consideration, inadequate substantiation
is a less frequent consideration and larger amounts are in dispute
for deductions for adjusted gross income. However, these differ-
ences are so small that they provide a minor justification for the

inequities of the present law.

5.

6.

109

FOOTNOTES--CHAPTER V

Fowler, Anna C., Analysis of Valuation of Undivided Interests

in Property for Federal Tax Purposes, M.B.A. Thesis, The Univer-
sity of Texas at Austin, Graduate School of Business, 1970.

The factors identified and compared were evidence of comparable
sales, subsequent sales, expert witness presented, actual
appraisals conducted, nature of the property, income status

of the property, situs of the property, owners of the other
interests, presence of diverse parties, size of the interest,
court, and date of decision.

 

fill

Ibid., p. 62.
Ibid., PP. 106-7o

Halsey, Crawford C. and Peloubet, Maurice E., Federal Taxation
and Unreasonable Compensation (New York: The Ronald Press
Company, 1964), p. 20. This study identified 21 different
factors.

 

 

 

Ibid.

Prentice-Hall Federal Taxes - 1974, Vol. 3 (Englewood Cliffs,
New Jersey: Prentice-Hall, Inc., 1974), pp. 21,326-21,356-D.
Identification of 12 items and their effects was accomplished.

Tax Court Reported Decisions, Volumes 53 thru 62, (Englewood
Cliffs, New Jersey: Prentice-Hall, Inc.), and U.S. Tax Cases,
Volumes 70-1 thru 74-2 (New York: Commerce Clearing House,
Inc.)

 

CHAPTER VI

THE IMPACT AND ALTERNATIVES OF THE
DICHOTOMOUS TREATMENT PROBLEM
The preceding chapters have developed a conflicting basis for
the present dichotomous treatment of the income-producing expenses
of individuals. The purpose of this chapter is to determine the
impact of the present law, to examine or consider possible alterna—
tives based on the results of Chapters II through V, and to ascer-

tain the probable effects of these alternatives.

The Impacts of the Present Dichotomous Treatment

 

Pages 5 through 8 of Chapter I detailed many of the ramifica-
tions of the present dichotomous treatment concerning the numbers
of people not itemizing deductions. The amount of standard deduc-
tion or low-income allowance which they can deduct is the same for
identical adjusted gross incomes even though they have different
amounts of income-producing expenses which can not be deducted for
adjusted gross income. The consequences of this treatment for non-
federal income taxes, for other parts of the tax computation process,
and for various types of tax-payers were also detailed.

This portion of the present chapter will analyze the effects of
the present law on taxpayers with various types and levels of income.
The basic source of data for this analysis is Statistics of Income-

Individual Income Tax Returns,1 which is published annually by the

 

110

 

111

Internal Revenue Service about three years after a given tax year.
It summarizes the statistics of returns filed for that given year.
Table 6.1 shows the proportion of individual taxpayers in
recent years who itemized deductions each year. They are divided

into adjusted gross income classes.

Table 6.1

Percentage of Individuals Itemizing Deductions

 

 

 

 

 

AGI (S) 1966 1967 1969 1970 1971 Q
< 5,000 17 17 18 16 10 :j
5 - 10,000 53 53 53 52 42 a,
10 - 15,000 71 72 74 75 64

15,000+ 87 88 90 91 87

All 41 42 46 48 41

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

The 1969 Tax Reform Act and the Revenue Act of 1971 reversed a
trend towards more people itemizing. In 1971, only 41 per cent of
all taxpayers and only 10 per cent of taxpayers with an adjusted gross
income less than $5,000, itemized deductions. Preliminary figures
indicate that only 35 per cent of taxpayers itemized in 1972.2 To
the extent that itemizers are favored by the present treatment of
income-producing expenses, the law is vertically inequitable because
there is a direct correlation between itemization frequency and level

of income.

A study of the I.R.S. data pertaining to the sources of income

112

of itemizers and non—itemizers provides a further perspective of

the taxpayer groups who are unable to deduct some of their income-

producing expenses. Not only do itemizers tend to have larger abso—

lute amounts of certain types of revenue, but they also have a dif-

ferent revenue mix and, in some cases, they claim certain types of

revenue more often than do non-itemizers.

These conclusions are

based on a study of the data available for three years which seg-

mented revenue sources for itemizers and non—itemizers.

was derived by dividing the amount claimed as wage and salary

Table 6.2

revenue by the number of taxpayers claiming it in each deduction

classification.

Table 6.2

Average Amounts Claimed as Wage and Salary Revenue

 

 

 

 

 

 

 

AGI ($) Item.1967N-item. Item. N-item. Item. N-item.
< 5,000 $3,262 $2,087 $3,589 $2,131 $3,623 $2,233
5 - 10,000 7,307 6,872 7,530 7,023 7,501 7,014
10 - 15,000 11,532 10,967 11,910 11,258 12,031 11,401
15,000+ 18,880 14,654 16,698 15,851 20,197 16,058
All 9,530 4,253 11,530 4,694 12,881 5,305

 

Source: Statistics of Income-Individual Income Tax Returns,

Internal Revenue Service.

However, these absolute numbers are not realistically comparable

because, even within income brackets, itemizers tend to have higher

average incomes. To facilitate comparison, it is necessary to deter-

mine in Table 6.3 the average gross income for each taxpayer group.

113

Table 6.3

Average Gross Income

 

 

 

 

 

 

AGI ($) Item.1967N-item. Item.197ON-item. Item.1971N-item.
< 5,000 $3,392 $2,136 $3,786 $2,202 $3,833 $2,331
5 - 10,000 7,624 7,171 7,758 7,257 7,875 7,273
10 - 15,000 12,176 11,848 12,452 11,929 12,536 12,071
15,000+ 27,424 20,249 24,698 19,422 24,980 19,265
All 10,953 4,453 12,840 4,863 14,490 5,532

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

Dividing the average amount claimed for a certain type of revenue
by the appropriate average gross income indicates in Table 6.4 the
relative impact of that type of revenue after adjusting for differ-

ences in average gross incomes.

Table 6.4

Percentage of Revenue Derived From Wages and Salaries

 

 

 

 

 

 

AGI (S) Item.1967N-item. Item.1970N—item. Item.1971N-1tem-
< 5,000 96 98 95 97 95 96
5 - 10,000 96 96 95 97 95 96
10 - 15,000 95 93 96 94 96 94
15,000 + 69 72 80 82 81 83
A11 87 96 9O 97 89 96

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

1 1 : Hi." A-r'flLn‘Lrnx —_w.
u F
‘l.'- In
.

 

114

There probably is an overall tendency for non-itemizers having
wages and salaries to have a larger proportion of their revenue in
this form than do itemizers. Unfortunately, the structure of the
basic I.R.S. data prevents testing these figures statistically to
determine if they are significantly different.

A similar technique can be applied to determine the frequency
of the claiming of a type of revenue for itemizers and non—itemizers.
Table 6.5 indicates that overall frequencies of claiming wage and
salary revenue are quite close, but they, apparently, are more fre-

quently claimed in low income groups by non-itemizers.

Table 6.5

Percentage of Returns Claiming Wages and Salaries

 

 

 

 

 

 

AGI ($) Item. 196 7N-item. Item. 19 7ON-item. Item.1971 N-item.
< 5,000 71 89 71 90 66 88
5 - 10,000 90 95 91 95 89 94
10 - 15,000 95 93 96 95 96 95
15,000 + 85 80 91 86 92 88
All 89 91 90 91 90 90

 

Source: Statistics of Income—Individual Income Tax Returns,
Internal Revenue Service.

 

This method of analysis was applied to the other 21 sources of

revenue listed in Statistics of Income-Individual Income Tax Returns

 

for all 3 years. A number of them displayed patterns of consistent
differences which imply differences between itemizers and non-

itemizers.

~ an.- -_ x: diva-1.1L
H
'2'
-.'|

 

1

15

Tables 6.6 and 6.7 indicate that itemizers consistently incur

net gains and net losses from self-employment more frequently than

non-itemizers.

Table 6.6

Percentage of Returns With Self-Employment Net Income

 

 

 

 

 

 

 

 

 

 

 

 

 

1967 1970 1971
A61 ($) Item. N-item. Item. N-item. Item. N-item.
< 5,000 11 4 10 11
5 - 10,000 9 5 9 9
10 - 15,000 8 7 7 7
15,000+ 17 18 12 12 ll 11
All 10 5 9 4 10 5
Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.
Table 6.7
Percentage of Returns With Self-Employment Net Loss
1967 1970 1971
A61 (3) Item. N-item. Item. N-item. Item. N-item.
< 5,000 2 .6 3 .7 4 .8
5 - 10,000 2 .7 3 .8 3 l
10 - 15,000 2 1 2 1 3 1
15,000+ 2 l 3 l 3 1
A11 2 .7 2 .8 3 .9

 

Source: Statistics of Income-Individual Income Tax Returns,

Internal Revenue Service.

 

116

For returns with net income from farm operations, taxpayers
itemizing deductions claim much smaller average amounts for farming
revenue than non-itemizers. They also claim farming revenue rela-
tively less frequently. Tables 6.8 and 6.9 demonstrate these patterns.
Farms with net losses do not display any consistent amount or fre-

quency differences though.

Table 6.8

Percentage of Revenue from Farming Net Income

 

 

 

 

 

 

AGI (3) Item.1967N-item. Item.197ON-item. Item.197lN-item.
< 5,000 49 67 47 49 56 64
5 - 10,000 36 51 38 45 44 51
10 - 15,000 33 51 28 47 30 47
15,000+ 33 62 31 57 32 60
All 31 62 3O 58 32 61

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

Table 6.9

Percentage of Returns Having Farm Net Income

 

 

 

 

 

 

A61 (3) Item.1967N-item. Item.197ON-item. Item.197lN-item-
< 5,000 3 3 3 3 2 2
5 - 10,000 2 3 2 3 2 2
10 - 15,000 1 4 1 4 .9 3
15,000+ 2 7 2 7 1 5
A11 2 3 2 3 1 3

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

 

117
Itemizers have net income from rent more frequently than non-
itemizers, but net rent income tends to comprise a smaller propor—
tion of the total revenues of itemizers. Tables 6.10 and 6.11 show
these tendencies.
Table 6.10

Percentage of Returns Having Rental Net Income

 

 

 

 

 

 

 

AGI ($) Item. 1967N--item. Item.197ON-item. Item. 1971N--item. H
< 5,000 12 3 10 3 12 3
5 - 10,000 7 3 6 7 3
10 - 15,000 7 6 5 4 5 5 j
15,000+ 12 14 9 10 9 8
All 8 4 7 3 7 3

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

Table 6.11

Percentage of Revenue from Rental Net Income

 

 

 

 

 

 

AGI (S) Item.1967N-item. Item.197ON-item. Item.1971N-item.
< 5,000 24 36 27 37 26 37
5 - 10,000 10 12 l4 16 14 13
10 - 15,000 7 9 7 9 8 8
15,000+ 10 ll 10 ll 10 12
A11 11 21 12 21 11 18

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

118

Although the figures for amounts of net rental loss are compar-
able for both deduction classifications, itemizers still tend to claim

it more often as is shown in Table 6.12.

Table 6.12

Percentage of Returns Having Rental Net Loss

 

 

 

 

 

 

AGI ($) Item.1967N-item. Item.197ON-item. Item.197lN-item-
< 5,000 5 .8 5 .8 6 1
5 - 10,000 6 2 5 l 5 l
10 - 15,000 6 3 5 2 6 3
15,000+ 8 5 7 4 7 5
All 6 l 6 l 6 l

 

Source: Statistics of Income—Individual Income Tax Returns,
Internal Revenue Service.

 

Table 6.13 shows that non-itemizers tend to have a greater propor-
tion of their income in the form of pensions and annuities, especially

in the lowest income bracket.

Table 6.13

Percentage of Revenue from Pensions and Annuities

 

 

 

 

 

 

AGI (3) Item.1967N-item. Item.197ON-item. Item.1971N-item.
< 5,000 51 70 52 7O 56 73
5 - 10,000 32 33 36 35 35 40
10 - 15,000 19 21 23 25 26 25
15,000+ 13 14 16 l7 17 20
A11 21 39 21 4O 21 42

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

I
l
.4
9

119
Although dividends reported do not vary much between deduc-
tion classifications as a proportion of gross income, Table 6.14

implies that they are claimed more frequently in all brackets by

 

 

 

 

 

 

itemizers.
Table 6. 14
Percentage of Returns Having Dividend Income
1967 1970 1971
AGI (3) Item. N—item. Item. N—item. Item. N—item.
< 5,000 14 3 15 4 l8 4
5 — 10,000 8 6 10 6 10
10 - 15,000 12 13 11 11 10 10
15,000+ 4O 35 30 26 27 22
A11 15 5 16 5 16 6

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

Concerning proceeds from the sales of capital assets, itemizers
claim net losses and net gains more frequently, especially in the
lowest income bracket. Tables 6.15 and 6.16 provide the basis for

this tentative conclusion.

120
Table 6.15

Percentage of Returns Having Net Gain from Sale of Capital Assets

 

 

 

 

 

 

AGI (5) Item.1967N—item. Item.197ON—item. Item.197lN-item.
< 5,000 12 4 10 3 12

5 - 10,000 9 7 8 4

10 - 15,000 14 15 8 8

15,000+ 38 36 18 18 19 19
All 15 6 11 4 12 5

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

Table 6.16

Percentage of Returns Having Net Loss from Sale of Capital Assets

 

 

 

 

 

 

 

AGI ($) Item.1967N-item. Item.197ON-item. Item.1971N-item.
< 5,000 3 -5 3 ~7 4 '6
5 - 10,000 3 .8 1 3 -3
10 - 15,000 3 2 2 4 2
15,000+ 9 5 12 6 10 5
All 4 .8 6 1 5 1

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

Table 6.17 indicates the inclination of returns not itemizing to

report interest revenue more often than returns itemizing deductions.

121
Table 6.17

Percentage of Returns Having Interest Revenue

 

 

 

 

 

 

1967 1970 1971
AGI ($) Item. N-item. Item. N—item. Item. N-item.
< 5,000 53 23 54 25 57 27
5 - 10,000 46 38 46 34 47 36
10 - 15,000 61 6O 57 54 S7 56
15,000+ 82 81 78 75 78 76 a

All 56 31 58 31 61 35 ,"*a

 

Source: Statistics of Income—Individual Income Tax Returns, ,
Internal Revenue Service. :‘, ”

 

 

This analysis indicates that there are some probable distinctions
in the sources of revenue and the frequency with which they are
claimed between taxpayers who itemize and those who do not, even when
differences in average gross income are adjusted for. Itemizers are
more likely to have relatively larger amounts of dividends, interest,
and gains and losses from the sale of capital assets in their compu-
tation of gross income. Non-itemizers are more likely to have rela—
tively larger amounts of wages and salaries, farm net income, rental
net income, and pensions and annuities in their gross income. Items

of revenue which apparently occur more frequently in the gross income

 

of itemizers are self-employment net income, self—employment net loss,
rental net income, rental net loss, dividends, net gain from the sale
of capital assets, net loss from the sale of capital assets, and
interest. Non-itemizers claim wage and salary revenue more often in
the lowest two adjusted gross income brackets and farm net income

more often at all levels of income.

122

Thus, to the extent the present dichotomous treatment of
income-producing expenses favors itemizers over non-itemizers, the
law is benefitting taxpayers with apparently distinct revenue
patterns. This implicit favoritism of taxpayers with certain
revenue patterns is contrary to the general objective of horizontal
equity. If taxpayers with certain revenue patterns are more likely
to itemize, these revenue patterns predominate at higher income ,
levels, and the present dichotomous treatment favors itemizers, n
then the law is vertically inequitable to a further degree. This
would be beyond the inequity due to the direct relationship of

income level and frequency of itemization. LJ

 

A second consideration of the effects of the present law in-
volves the actual deduction of income-producing expenses which are
deducted for adjusted gross income by all individual taxpayers.

Scrutiny of further Statistics of Income-Individual Income Tax

 

Returns data reveals that itemizers consistently claim some of

these expenses relatively more frequently and in relatively larger
amounts than non-itemizers. Tables 6.18 and 6.19 demonstrate these
patterns for years whose sufficient categorized information allows
the comparison for moving expenses and for employee business expenses
which are defined as travel, transportation, reimbursed and outside
salesmen expenses.

Undoubtedly, some of the intra-bracket differences in frequency
or amount are caused by itemizers having higher average intra-
bracket income. However, at lower income levels especially, the
spreads appear too wide to be explained by this factor alone. The

differences in Tables 6.18 and 6.19 can not be statistically tested,

123

 

 

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124

 

 

 

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one momcomxm moH>oz HmuoH mo owmucoouom osu :uHB :OHuMNHBouH mo hoaosvoum mo comHumeaoo < mH.o MHQMH

125

but the stability of their patterns over time is a strong argument
for their validity. Thus, taxpayers who itemize deductions also
have a greater tendency to deduct some income—producing expenses
which are deductible for adjusted gross income and to deduct them
in larger amounts.

The problem is to determine whether itemizers incur these ex-
penses more frequently and in greater amounts or whether they are
more careful about deducting the expenses they incur. The probable
answer to the first part of the question can be derived by a deter-
mination of the expense factors which lead directly to a taxpayer's
itemizing deductions.

Approximately 74 per cent of 1970 itemizers were homeowners.
The mortgage interest and real property tax that they are able to
include as itemized deductions are the most important factors in
their decision to itemize. Table 6.20 shows for 1970 the number of
itemizers claiming these homeowner expenses, the average amounts
claimed for each, their average totals and the figures which they
could alternatively claim in 1974 if they did not itemize, that is,
$1,300 or 15 per cent of average adjusted gross income with a $2,000
maximum. Thus, home ownership plays a predominant part in the deci-
sion to itemize especially when 1974 interest and tax figures are

compared to the 1974 alternatives.

 

126

 

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127

Itemizers tend to be homeowners and homeowners usually incur
higher average moving costs than non-homeowners, so there is some
positive correlation between the amounts of deductions for adjusted
gross income and the amounts of itemized deductions reported by
taxpayers. However, the relative frequencies and average amounts
claimed are even more disproportionate for the employee business
expenses of itemizers than for their moving expenses. P]

+.

Alternative hypotheses for this relationship concern the 4*:
degree to which expenses incurred are deducted. One possibility

is that taxpayers who itemize tend to be more knowledgeable con- .'*

 

cerning deductible expenses. Another is that itemizers are more . J
likely to keep receipts and other records for their income-producing
expenses because they already are keeping them for the personal ex-
penses which are itemized deductions. A third explanation concerning
the non-claiming of income-producing expenses is that many taxpayers
not itemizing deductions use Form 1040A, which is a short form that
does not allow the deduction of any income-producing expenses.
However, the disproportionate relationships detailed in Tables 6.18
and 6.19 continued to prevail in 1970 and 1971, years in which all
taxpayers had to use Form 1040. It is possible that non-itemizers
had been conditioned by the use in past years of Form 1040A so that
they did not even deduct these expenses on the Form 1040 when they
could have. Form 1040A has been reinstated and millions of taxpayers
will use it in 1974 and subsequent years.

It appears likely that the present dichotomous treatment of
income-producing expenses and the way that the present law is

administered have a negative impact even on the frequency and amounts

128

of income-producing expenses deducted for adjusted gross income by
taxpayers not itemizing deductions. Allowing more income-producing
expenses to be deducted for adjusted gross income would encourage
more non-itemizers to become aware of their deductibility and to
keep better records. To the extent that the present law leads to
unequal tax treatment of individuals in similar economic circum-
stances because one is consequently less likely to deduct income-
producing expenses, the law is horizontally inequitable. Vertical
inequity is apparent to the extent that non-itemizers tend to be
discouraged from deducting income—producing expenses for adjusted
gross income by the structure of Form 1040A because these taxpayers
are predominately in the lowest income groups.

Another element of consideration in this area concerns the
amounts and incidence of income-producing expenses which may not be
deducted by non-itemizers. Pertinent data is sketchy concerning
these expenses because the I.R.S. only analyzes itemized deductions
every even numbered year and, even then, it usually groups these
expenses with others in varying general categories such as
"Miscellaneous Deductions" or "Type not Specified."

The most complete information is available for household and
dependent care expenses which are sometimes separately totalled.
Table 6.21 indicates the number of itemized returns claiming this

expense and the average amounts they claimed.

 

 

129
Table 6.21

Household and Dependent Care Expenses

 

 

Percentage of

 

 

 

 

 

Itemizers

AGI ($) Number of Average Amount Claiming These

Returns Deducted Expenses

1966 1970 1966 1970 1966 1970
< 5,000 99,451 136,886 $484 $360 2 3
5 - 10,000 135,767 281,604 535 455 1 2
10 - 15,000 14,453 91,625 516 357 .2 .9
15,000+ 4,752 54,628 567 199 .1 .6
All 254,423 564,743 515 391 .9 2

 

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

The only other specifically identified and separately aggregated

expense was education in 1966. Table 6.22 shows the impact of its

 

 

 

deduction.
Table 6.22
Education Expenses Deducted in 1966
Percentage of
AGI ($) Number of Itemizers Claiming Average
Returns Education Expenses Deduction

< 5,000 100,966 2 $100

5 - 10,000 291,276 2 189
10 - 15,000 240,887 4 195
15,000+ 125,563 3 195
All 758,692 3 180

 

 

Source: Statistics of Income-Individual Income Tax Returns,
Internal Revenue Service.

 

130

Since it seems reasonable to conclude that to a great extent
similar expenses are incurred by non-itemizers, it appears that
many of them are not able to deduct some income-producing expenses
which average hundreds of dollars. Thus, economically identical
taxpayers pay different tax bills because one has larger amounts of
deductible personal expenses. Non-itemizers with the same adjusted
gross income deduct the identical standard deduction or low-income
allowance although they have varying amounts of income-producing
expenses which can not be deducted. The income-producing expenses
detailed in Tables 6.21 and 6.22 are largest in relation to income
at lowest income levels. Lowest income taxpayers itemize least
often, so they frequently are unable to deduct large amounts of
these expenses. Recent proposals and statements indicate that the
House Ways and Means Committee is seriously considering provisions
which would further limit the deduction of income-producing expenses.
These suggestions would only allow the deduction of itemized income-
producing expenses to the extent they exceed a given amount each
year. If these proposals are accepted, previously observed inequities

would be worsened.

Possible Justification for the Present Dichotomous Treatment

 

There are a number of possible reasons, beyond those developed
in Chapters 11 through V, for retaining the present law despite its
observed inequities. The decision concerning whether they outweigh
the negative aspects of the present law is basically a value judgment.

It can be said that non-itemizers benefit under the present

treatment because they are able to deduct the larger of the lowhincome

 

 

131

allowance or the percentage standard deduction. This deductible
amount is larger than the sum of their income-producing expenses,
which must be itemized, and some specified personal expenses. A
number of conflicts arise, however, even if this justification is
accepted.

The objective of the low-income allowance is to ensure that
persons below the poverty level are not subject to Federal income
tax.3 Since a poverty level income is computed by measuring
minimum physical needs for a given family size, the low-income
allowance figure derived is meant to cover income derived after
subtracting income-producing expenses from gross revenues. Thus,
the loWbincome allowance is only meant to protect from tax income-
available for spending on personal needs.

The percentage standard deduction alternative might have more
merit since its purpose is administrative simplicity.4 Allowing
some taxpayers to deduct a given amount rather than forcing them to
keep records of expenses, fill out more forms, and invite more
arithmetic mistakes and conceptual disagreements, has a lot of
appeal, especially when those expenses are personal. When some of
those expenses are explicitly income-producing, this alternative
loses a great deal of appeal because the basic focus of our income
tax has always been on a measure of net income. This excuse for the
present law becomes even more suspect in regard to horizontal equity
because the identity of the income-producing expense can determine
deductibility. An example would be two taxpayers where both had
the same gross income but one had travel expenses of $100 while the

other had $100 of unreimbursed education expenses. The first

 

 

132
taxpayer would pay a smaller amount of tax even though the two were
in the same economic position.

A practical argument for the present dichotomous structure
concerns the tax revenues which would not be collected if more or
all income-producing expenses were made deductible for adjusted
gross income. Previously mentioned factors, such as the structure
of Form 1040A, historical conditioning and the tendency to keep
fewer records, would inhibit the expanded deduction of these expenses
by non-itemizers but surely some increase in total deductions would
result.

Thus, a number of arguments in addition to those developed in
Chapters II through V support the retention of the present dichotomous

treatment of income-producing expenses.

Alternative Treatments for Income-Producipg_Expenses

Three basic alternatives to the present treatment of the income-
producing expenses of individuals are (1) not allowing their deduc-
tion, (2) allowing different groups of these expenses to be deducted
for or from adjusted gross income or (3) allowing all of them to be
deducted for adjusted gross income. Because the federal income tax
has always sought to tax net income rather than gross income, the
first possibility does not appear very desirable.

Based on the elements identified in Chapters II through V, a
different group of income-producing expenses could be made deductible
for adjusted gross income with the rest deductible only by itemizers.
This option has attraction because it would result in smaller revenue

loss than full deductibility for adjusted gross income and it would

,l.
..
.1.
El

 

 

133
retain relative administrative simplicity.

One possible grouping would make moving expenses and house-
hold and dependent care expenses available only to itemizers on the
grounds that they are primarily personal expenses which have full-
time employment tests only to objectively determine deductibility.

Section 62 would have to be modified to allow the deduction for

 

adjusted gross income of all Section 162 and 212 expenses while Tia
deleting Subsection 8 concerning moving expenses. These expenses 4.]
have been explicitly determined as not being ordinary and necessary

business expenses.5 Their deductibility was established only through 7
special sections of the Code just like personal itemized deductions. HJ

Other income-producing expenses are deductible whether incurred in
connection with part or full-time income-producing activities.
Indirect moving expenses and household and dependent care expenses
are subject to deductible maxima unlike other income-producing
expenses. The thrust of our income tax laws has always been to
allow the complete deduction of expenses directly incurred to pro-
duce income. The treatment of indirect moving expenses and house-
hold and dependent care expenses closely approaches the treatment
of medical expenses and charitable contributions regarding the rela-
tionship of their deductible amounts to income and to maximum
deductible amounts. However, inequities previously detailed would
not be resolved under this alternative treatment to the extent that
these expenses are primarily incurred to produce income.

A third alternative would allow all of these expenses, including
moving and household and dependent care expenses, to be deducted for

adjusted gross income. Section 62 would have to be modified to allow

 

134

the deduction of all Section 162, 212, 214, and 217 expenses for
adjusted gross income. Horizontal and vertical equity would be
more closely achieved between types of taxpayers and different tax-
payer income groups, respectively. Taxpayer compliance might in-
crease due to increased understandability of the tax computation
structure. Administration and compliance would be more efficient
to the extent that resources are presently expended in attempts to
deduct for adjusted gross income expenses which must presently be
itemized. This clear distinction between the treatment of income-
producing and personal expenses would facilitate further discussion
concerning which presently and/or possibly deductible expenses
should be in each group. A stronger excuse would also exist for
the modification of Form 1040A to allow deductions for adjusted
gross income to attain greater horizontal and vertical equity.
Undoubtedly, tax collections would decrease and tax administration
would be more difficult with more taxpayers claiming the deduction
of income-producing expenses. The quantification of these negative
aspects would require information only available at the Department
of the Treasury to the extent pertinent data is available at all.
Table 6.23 compares the comprehensive deduction for adjusted
gross income of all income-producing expenses, the present law, and
the alternative partial treatment where only moving and household
and dependent care expenses would be itemized. Under the partial
treatment alternative, all Section 162 and 212 income-producing
expenses would be deductible for adjusted gross income. Section

214 and 217 expenses could only be deducted by itemizers. The

comprehensive treatment alternative would allow all of these

 

 

135

expenses to be deducted for adjusted gross income.

Table 6.23

Income-Producing Expenses Deductible For Adjusted Gross Income

 

 

 

 

Code Alternatives
Section Present Law Partial Comprehensive
162 Travel All All
Transportation
Reimbursed

Outside Salesmen
Self-employed

212 To Produce Rent All All
or Royalty

214* None None All

217** All None A11

 

*Household and Dependent Care
**Moving

Summagy

The present dichotomous treatment of the income-producing
expenses of individuals has many vertically and horizontally inequit-
able impacts. Non-itemizers, who tend to be in lower income groups,
have different revenue patterns than itemizers. The law presently
tends to favor taxpayers with higher incomes and those with specific
revenue patterns. The present law and its administration appear to
encourage non-itemizers to deduct income-producing expenses for
adjusted gross income relatively less frequently and in relatively
smaller amounts than itemizers. Only itemizers, who also tend to
be homeowners, are able to deduct a large number and quantity of

income-producing expenses, although self-employed taxpayers and

 

 

136
outside salesmen can deduct all but household and dependents care
expenses. However, the present treatment most likely results in the
collection of more tax revenue and certain probably smaller admin-
istrative costs than the two most likely general alternatives
previously developed. These alternatives would reduct inequities
but they probably would result in some increased administrative
costs and some decrease in tax revenues because more taxpayers would

be deducting these expenses.

 

137
FOOTNOTES--CHAPTER V1

Department of the Treasury, Internal Revenue Service,
Statistics of Income-Individual Income Tax Returns, Publication
79 (Washington: U.S. Government Printing Office, annually).

 

Department of the Treasury, Internal Revenue Service, Preliminapy

 

Report, Statistics of Income - 1972, Individual Income Tax
Returns (Washington: U.S. Government Printing Office, 1974).

 

Staff of the Joint Committee on Internal Revenue Taxation,

op. cit., p. 218.
Ibid., p. 216.

See p. 43 and p. 62.

 

CHAPTER VII

SUMMARY, CONCLUSIONS, RECOMMENDATIONS AND SUGGESTIONS
FOR FUTURE RESEARCH

Brief Summapy of Purpose and Methodology

 

The purpose of this research was to determine the appropriate-
ness of the present dichotomous Federal income tax treatment of the
income-producing expenses of individuals. The main criteria applied
were horizontal and vertical equity achievement.

To accomplish this objective, the basis for deductions within
the income tax was sought. The chronological development of the
present law concerning the locations for the deduction of income-
producing expenses was determined. Expense categories were analyzed
to determine the consistency with which deductibility factors were
applied by the present law within and between the two present groups
of income-producing expenses. Court decisions were analyzed to
determine distinctions between considerations significant to the
deductibility and to the nondeductibility of income-producing
expenses deductible for and from adjusted gross income. A final
step sought to delineate the impact of the present law, formulate
possible alternatives, and compare the aspects of the present law

with those of the alternatives.

138

 

 

139
Summary of Findings

Constitutional Federal income tax deductions are basically
whatever Congress deems them to be, although the base for taxation
has always been some concept of net income.

The income-producing expenses of individuals have been subject
to a dichotomous treatment for the past 30 years. Some expenses
are deductible for adjusted gross income while others may only be
deducted from adjusted gross income by taxpayers who itemized
deductions. The explicit reasons advanced for making some expenses
deductible for adjusted gross income have been inconsistent and con-
flicting. Justifications have ranged from "directly incurred in a
trade or business" or "administrative simplicity" to "substantial
relative to income" or "similar to business expenses and likely to
be relatively large."

An analysis of individual expense categories derived a few
distinctions between income-producing expenses deductible for
adjusted gross income and those which must be itemized. Two deduc-
tions for adjusted gross income have maximum time and minimum loca-
tion constraints while itemized income-producing expenses do not.
No other consistent differences existed between these two expense
groups in regard to length of acceptance, amount constraints, mini-
mum time constraints, maximum location limits, personal versus
business allocation, motivation determining criteria, substantiation
requirements, implications of employer requests or income-producing
status.

An analysis of court cases concerning income-producing expen—

ses from 1969 through 1974 identified only one consideration which

 

 

140
differed greatly without explanation between these two deduction
groups. Deductions for adjusted gross income had a larger propor-
tion of cases decided in Courts of Appeals and a smaller proportion
of cases decided in the Tax Court than did cases concerning itemized
income-producing expenses. Differences in frequency of occurrence
between groups of expenses of other considerations were largely
explained by the nature of one expense within a group. There was
only a slight tendency for amounts of expense or tax in dispute to
be higher in cases involving deductions for adjusted gross income.

These groups did not significantly differ in regard to average
numbers of government and taxpayer lawyers and frequency of refer-
ence to Section 262, the meanings of ordinary and necessary, the
meaning of a trade or business, poor substantiation and whether the
expense was reasonable.

The impact of the present dichotomous treatment is contrary to
the principles of horizontal and vertical equity. Taxpayers may
have to pay more tax than others in equal economic circumstances
because of differences in occupations, types of income-producing
expenses incurred, the existence of direct reimbursement, revenue
patterns or incidence of home ownership. Vertical inequity is
present to the extent that lower income taxpayers itemize less often
because they, consequently, are less often able to deduct many
income-producing expenses. The impact is also vertically inequit-
able because low-income taxpayers are discouraged from deducting
income-producing expenses for adjusted gross income by the structure
of Form 1040A. Non-itemizers deduct income—producing expenses less

frequently and in smaller amounts for adjusted gross income than

 

 

141

do itemizers, who tend to have larger incomes, also probably
because they keep poorer records and are less knowledgeable con-
cerning what is deductible since so few of their expenses are
presently deductible.

Two most probable alternatives would provide more horizontal
and vertical equity for the treatment of income-producing expenses.
Each choice, however, leads to a loss in tax revenues unless tax

rates are changed and to an increase in some administrative costs.

Conclusions and Recommendations

 

The Department of the Treasury and Congress should evaluate
the present dichotomous treatment of the income-producing expenses
of individuals to determine whether the horizontal and vertical
inequities are justified. Based on this dissertation research,
historical development, explicit deductibility characteristics,
factors in court decisions and the revenue impacts of alternatives
do not appear to provide substantive and consistent justification
for the present treatment of income-producing expenses.

Serious consideration should be given to the implementation of
either of two alternative treatments of income-producing expenses
in regard to the location of their deduction in the tax computation
process because they would provide a much greater degree of hori—

zontal and vertical equity.

Suggestions For Future Research

 

This research was based on the presently accepted definition

of a deductible income-producing expense. A comprehensive study

should be made concerning the appropriate criteria for distinguishing

 

142
between income—producing and personal expenses in general. This
study should probably be based on the assumption that income-
producing expenses should be deductible without limit by all payers
of Federal income tax.

A comparison of the criteria used to identify individual
income-producing expenses should be made with those criteria used
to identify the income-producing expenses of other tax entities to
ascertain consistency in treatment.

A renewed effort should be made to determine whether the con-
tinued discrimination against the non-reimbursed expenses of employees
is still justified.

Another fruitful area for investigation would be the identifi-
cation of aspects of tax law implementation, such as Form 1040A,
which may lead to impacts not foreseen nor, possibly, desired by

the formulators of the law.

 

 

 

 

BIBLIOGRAPHY
Articles
American Institute of Accountants Committee on Federal Taxation, 5
"Federal Tax Revision Program," Journal of Accountancy, Vol. 8, ‘{
No. 5’ 19390 .91

Bittker, Boris I., "A Comprehensive Tax Base as a Goal of Income
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Brodsky, Samuel, and McKibben, David., "Deduction of Non-Trade or '3
Non-Business Expenses," Tax Law Review, February, 1946. L1

 

Griswold, Erwin N., "An Argument Against the Doctrine That Deduc-
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"Job-Seeking Costs Removed from 'Prime Issue' List," The Practical
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Kaminsky, Michael, "Are All Deductions a Matter of Privilege?,"
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Lewis, Charles D., "IRS and courts adopting more liberal views
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Malloy, John M., "Employment Agency Fees: An Area of Continued
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Pechman, Joseph A., "Erosion of the Individual Income Tax,"
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Rice, Leon L., "New Light on the Meaning of Ordinary and Necessary
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Rothschild, V. Henry, and Sobernheim, Rudolph, "Expense Accounts
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Smith, J. Duke, "An Investor's Deductions from Gross Income,"
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143

144
Books and Proceedings
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National Tax Association. New York: National Tax Association,
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Bittker, Boris I. "The Individual as Wage Earner," Proceedings
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Blakey, Roy G. and Gladys C. The Federal Income Tax. New York:
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Blough, Roy. "The Federal Personal Income Tax Under the Revenue
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fl.

 

 

 

Committee on the Federal Income Tax. "A Statement of the Provisions
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Committee on the Federal Income Tax. "Report of the Committee on
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Dendy, Thomas H. "New Cases on What You Can Deduct From Salary
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Dobres, Jeanne L. "Employee's Expenses in Earning Salary,"
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on Federal Taxation. Albany: Matthew Bender & Co., 1962.

 

 

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