INCOME TAX CASES, MATERIALS, STATUTES, PROBLEMS, and FORMS Topic Five: Business and Profit Seeking Expenses Comprehensive CD Cover Casebook Cover Internal Revenue Code and Regulations 1. Brian practices law as a solo practitioner. His current office expenses include $4000 per month for a plush office that includes a gym (which he claims helps him relieve stress), $10,000 for new carpeting installed this year, $10,000 for an antique desk, and $2000 per month for salary paid to his teen-aged son who delivers packages for him. Which of these expenses is deductible and pursuant to what authority? The $4000 office rent is clearly deductible per section 162. It is both ordinary and necessary. Even the existence of the gym is likely not a problem. Section 132(f) would also exclude any income Brian might have as a result of the extra plush office (this is relevant only if Brian is an employee; however, the question does not detail the entity structure or employee/owner status). The $10,000 item for carpeting is a capital expenditure, resulting in an increased basis per section 1012 and 1016. Per section 168, this item would be depreciable (deductible) over its useful life. Per section 179, Brian could likely elect current deductibility (depending on the total of section 179 assets purchased during the year). The desk would be treated the same as the carpet. Some small question may arise as to whether this item is truly depreciable because it is an antique which is likely appreciate in value (covered in Topic 6); however, considering its use and cost, it surely is. The salary paid his teen-aged son is likely excessive. Section 162(a)(1) requires that compensation be reasonable. The family relationship raises doubts as to resonableness of the amount. Section 267 also might have some impact on the timing of the deduction. 2. a. Mark is a law student, currently employed part-time as a law clerk. Jane, Mark s wife, is also a law student. Previoulsy Jane worked as a public accountant for three years. She is currently studying for the C.P.A. exam while in law school. She paid $600 for a C.P.A. review course. Mark and Jane each pay $8000 tuition per year plus $1000 for course books used in law courses. Which of these costs may they deduct? When? Nothing is currently deductible; however, the $1000 for course books is a capital expenditure resulting in a section
1012 cost basis in the books of $1000. After each graduate, they can each convert the books from personal to business use. The basis will convert at the lower of the 1012 cost basis or fair market value (almost certainly the fair market value will be lower). The item can then be depreciated per section 168 (or expensed if it is small). To convert them, they merely need to use them for business purposes, which would include putting them on their bookshelves at their offices. The C.P.A. review course is not deductible as Jane does not incur it in the carrying on of a trade or business of being a C.P.A. The same is true of the law school tuition costs. O Donnell v. comm r, 62 T.C. 781(1974), aff d 519 F.2d 1406 (7th Cir. 1975) (law student could not deduct law school even though he was a C.P.A.). In addition, although section 195 permits the amortization of some intangibles, neither the C.P.A. or law school costs will be eligible. b. Suppose Jane would like to attend a Graduate Tax Program to obtain an LL.M. in Taxation. Under what circumstances may she deduct the cost of attending? Which costs would be deductible, if any? Tuition? Books? Supplies? Travel? Food and lodging? Suppose Jane s grandmother gave her $15,000 to attend the Tax Program. Does that affect whether Jane can deduct the costs of attending? To deduct any more than the previously capitalized cost of books, Jane would need to be carrying on a trade or business of being a lawyer prior to entering tax school. Prior court opinion suggests that she would ideally have practiced law for one year, although a shorter period (six months, perhaps) should be sufficient. Summer clerking will not be sufficient. If Jane is able to deduct the cost of her LL.M., the tuition, travel, plus living expenses would be deductible, with the caveat that travel and living expenses require that she be away from home\ per section 162(a)(2). Treas. Reg. section 162-2 deals with travel expenses, as does section 274 (which should not be a problem here). See, e.g., Ruehmann, v. Comm r, 30 T.C.M. 675 (1971) (allowing a deduction for expenses for attending an LL.M. program after fours months of law practice post bar admission). Whether Jane is away from home has two elements: her tax home and whether she is away form it. Being away from one s tax home generally requires an overnight trip, which is not a problem for Jane. U.S. v. Correll, 389 U.S. 299 (1967). The donation from her Grandmother has no legal impact. If her expenses are deductible, the source of the funds does not matter. However, some risk exists of the government asserting a section 265(a)(1) issue regarding expenses allocable to income exempt from tax. Because the gift is excluded per section 102, the expenses are traceable to exempt income. However, with the exception of one case, this argument has not been success-
ful. Christian v. U.S., 201 F. Supp. 155 (E.D. La. 1962). 3. a. Jim graduated from law school in July. He incurred $500 in expenses seeking employment as a lawyer, including travel and printing. May he deduct these costs? No. Per Rev. Rul. 75-120, job hunting expenses for new employment are not deductible. b. Marsha graduated from law school two years ago and has been practicing for a law firm, with which she is disatisfied. She has incurred $500 in job hunting expenses, including travel and printing costs. May she deduct these expenses? Does it matter whether she is successful in finding new employment? Does it matter whether she is seeking a job as a lawyer versus a job as a cook? She may deduct her costs of seeking new employment as a lawyer, whether she is successful or not. Rev. Rul. 75-120. The costs, however, of seeking employment as a cook are not deductible as it involves a new line of business. c. Both Jim and Marsha incur unreimbursed moving expenses: Jim in relation to his first job as a lawyer and Marsha in relation to her new job. May either deduct these costs? Each can deduct the moving expenses, if they fit within the restrictions of section 217. They must move the requisite distance and work the requisite period of time following the move. These are above the line deductions listed in section 62(a)(15). 4. Gary has sought to open a Pizza King franchise. He paid $100,000 for the franchise rights, and incurred $10,000 in training costs for himself and his manager. May he deduct these costs? Eventually, yes, but not immediately. The franchise fee must be capitalized and then amortized ratably over fiteen years per section 297. Thus Gary can deduct $6,667 per year for 15 years. Because the training costs appear incurred prior to his beginning the business, they are not incurred in the carrying on of a trade or business under section 162 and hence are not deductible thereunder. They are, however, amortizable under section 195 over a period of 60 months. Hence, once Gary commences the active conduct of the trade or business, he may deduct $167 per month. You may want to explore the difference, if any, between the trade or business requirement of section 162 and the active trade or business requirement of section 195. 5. Effie has a personal residence in which she has lived for six years. She has moved out of the home, having purchased a new house. Unable to sell her former residence, she has sought to convert it either to rental property or to a Bed and Breakfast, which would involved nightly rentals. Advise her on the tax issues she will face.
This involves many issues beyond this chapter. For now, she should realize that if she rents the property, her costs (upkeep, maintenance, repairs, managment) are likely section 212 deductions. If, instead, she operates a bed and breakfast, her costs are section 162 expenses. 6. Ann practices personal injury and family law. To what extent are her fees likely deductible by her clients? How would her clients determine the portion of her fees, if any, which are deductible? Ann should provide them with an itemized copy of her bill. To the extent her advice considered tax issues, it is deductible by the client per section 212(3). 7. Scott began practicing law this year. He purchased five new suits, costing $2,500, to wear to work. He rarely, if ever, wears a suit otherwise. He also pays $100 per month for parking near his job and drives 10 miles to and from work. May he deduct any of these job related expenses? No. Section 262 will disallow them as personal. The parking costs, however, could be provided by his employer, including through payroll deduction. If so, the amount would be exludable per section 132(f). 8. Steve subscribes to the Wall Street Journal at a cost of $200 per year. He enjoys reading the editorials and news columns. He also reads the finacial information to help him manage his retirment investments. Steve rents a safe deposit box at his bank at a cost of $100 per year. He keeps a coin collection in the box, along with some personal papers and family photographs. Based on a recent column in the Journal, Steve recently purchased some State of Florida bonds, the interest on which is excludable per section 103 of the Internal Revenue Code. He keeps the bond records in the safe deposit box. Both the Wall Street Journal and safe deposit box costs are deductible per section 212, excpet to the extent they are allocable either to personal matters or the section 103 bonds. See section 262 and 265(a)(2). The personal nature appears de minimus. To the extent his portfolio contains section 103 bonds, the expenses should not be allowed. 9. Jeff considers himself a Day Trader of stocks and similar investments. He has a substantial portfolio, much of which he inherited from his grandfather. He logs on-line for approximately ten hours daily and trades continuously throughout the day, using several brokerage accounts to effect the trades. May Jeff deduct the costs connected to his trading? If so, which costs and under what authority? May he deduct any losses from his trading activities? The costs are deductible traditionally per section 212. Arguably, he has entered a trade or business such that they are dedutible per section 162. But see, Higgins v. Commissioner, 312 U.S. 212 (1941).
In a later chapter we will cover allocation of his costs betweenher personal living expenses and section 162 or 212 expenses. These would involve utilities, the computer, the house, repairs, and similar items. See section 280A. The losses are deductible per section 165, a section covered in a later chapter. 10. Lynn practices law. For a graduation present, her mother gave her a leather briefcase which cost $350. Lynn also recently purchased a new computer at a cost of $3500. She plans to use it to work at home on week-ends. Although her employer does not require her to have the laptop, she is required to work on weekends. The computer makes it possible for Lynn to do her work at home on the week-end. May Lynn deduct either the briefcase or computer or both? The briefcase is easily deductible. Her basis is $350 per section 1015. She converts it to business use by using it. She probably would simply deduct the cost as not sufficient to capitalize, or she would elect section 179. The computer is more difficult. It would be a capital expenditure, subject to depreciation per section 168 or 179 (covered in a later chapter). It would, however, be listed property per section 280F, subject to severe limitations on deductibility.