From the December 2008 issue of Wealth Manager Web • Subscribe!

DEFINING BUSINESS EXPENSES

Many businesses have learned the hard way that just because they incur expenses for business reasons does not mean that those outlays automatically qualify as deductible. Internal Revenue Code Section 162 mandates that these expenditures are allowable only if they pass a two-step test: The first requirement is that they are "ordinary." The second is that they are "necessary."

Both the IRS and the courts have characterized "ordinary" expenses as those that are customary or usual. Understand that they need not be customary or usual for the taxpayer, as long as they are customary or usual for the taxpayer's particular trade, industry or community. The Supreme Court held that even a one-time-only expenditure falls within the definition. Likewise, the Court of Appeals for the Second Circuit, a tribunal one rung below the Supreme Court, defined "necessary" as "appropriate" and "helpful," rather than necessarily essential to a taxpayer's business.

But gray areas abound, which account for the reasons so many ordinary-and-necessary disagreements get kicked around in IRS administrative rulings or resolved by the courts. Most businesses that take their disputes to court opt for the Tax Court. Going that route allows them to have their cases heard without first having to pay the taxes in issue. Of course, if they lose, they then pay the taxes plus interest and any penalties.

The courts repeatedly make subtle distinctions. Consider, for example, a Tax Court decision that disallowed payments made by an author to publish his book with Vantage Press, a "vanity" publisher that produces books at the author's expense--the reverse of the usual publisher-pays-author. No problem, though, for the court to approve "publish or perish" outlays. It sided with a research scientist who paid for publication of a paper on his research; in his field, published papers were considered a prerequisite to job advancement.

Then there was the unusual case of the closely held company that paid a shareholder-director to stay away from the business. Ordinary and necessary? Yes, said the Tax Court. It played out like this:

Jim and John Shea were brothers and co-owners of Fairmont Homes. As Jim saw things, John's participation in the business adversely affected Fairmont and its reputation. Moreover, Jim feared a threatened lawsuit by John would create additional problems.

The IRS saw things very differently. The agency contended that Fairmont's payments to John were nondeductible outlays to acquire a capital asset--that is, Fairmont stock--a contention that was rejected by the court. It noted that payments to ward off the threat of litigation are deductible, as are payments made to induce a partner or employee to take a course of action favorable to the business.

The court had an easier time with J. Michael Springmann, ex-commercial attach? at the U.S. Embassy in New Delhi. It decreed no deductions for payments to the diplomat's servants, regardless of his need to maintain his social standing in caste-conscious India.

A judge's one-liner that "hope springs eternal in the heart of the American taxpayer" might have served as the inspiration for a Los Angeles physician who deducted payments to his children for answering the telephone at home. Predictably, the court saw nothing special in his situation.

However, even those IRS spoilsports are sometimes willing to make distinctions. A remodeling firm's president sought an IRS okay for deducting his payments for transcendental meditation seminars. He contended that the practice of TM made him more creative on the job. Unfortunately for him, the karma was wrong. Although the agency acknowledged that the seminars "may have been of some benefit to the business," that was insufficient reason to authorize approval. But the agency agreed that an executive who leaves his attach? case stuffed with important business documents on the train is entitled to deduct a reward for its return--as well as for a newspaper ad offering the reward.

Add to the complications long-standing IRS regulations that disallow deductions for travel and entertainment expenses that are "lavish" or "extravagant." But what is extravagant for one taxpayer might be an ordinary and necessary expense for another, according to a 1977 decision by the Tax Court. It dismissed the IRS's pinched view of extravagant and permitted Mr. Denison, an investment advisor, to claim the cost of transporting potential customers in chauffeur-driven Cadillacs. What proved persuasive? The nature of the advisor's business, testimony that many of his clients were wealthy Europeans, and the court's awareness of "the generally obnoxious traffic situation in midtown and lower Manhattan."

Of course weddings, funerals and other family events are more personal than business in nature. So is it possible to justify a business-expense deduction for a trip to a funeral? A man flew to Europe to attend his wife's rites, at which he met many business contacts and also visited others during the balance of his stay abroad. The Tax Court's response: "We cannot believe that the funeral was incidental and business was the primary motive for the trip."

The court took a similar tack in 1986 with a Philadelphia rabbi who invited his entire congregation to a reception for his son's bar mitzvah. About 700 people showed up, of whom 100 were friends and relatives. A bar mitzvah, the rabbi urged the court, "may to the lawyer be a personal or social event, [but] to the rabbi serving in a congregation it is an integral part of his professional activities."The court turned down the rabbi's request for a Talmudic-type distinction, holding that he "stands in no better a tax position than anyone else who invites a large number of people to a family celebration" with "the idea that the invitations might enhance either an existing business relationship or a hoped-for business relationship."

A drug-trafficking probe of the Phoenix Fire Department resulted in the conviction on possession charges of firefighter Frank Zielezinski of Scottsdale, Ariz. Personal conduct, not firefighting duties, caused him to shell out for defense fees, which is why the court denied his deduction. The Tax Court refused to go along with a New Yorker whose justification for deducting the cost of defending his wife on shoplifting charges was that she would have lost her job if she were jailed. Nor would the court allow a man to write off what he spent to successfully defend himself against a charge of murdering his sister-in-law. It was indifferent to the argument that the man's business "would have been destroyed" had he been found guilty and sent to prison.

And forget about business-expense deductions for health club memberships. Those expenditures are purely personal expenses. It makes no difference that your employer requires you to stay in excellent physical condition, according to an IRS ruling that denied such deductions for police officers (Rev. Rul. 78-128). Daily restaurant meals and birthday bashes are also nondeductible. For instance, talking about business during lunch fails to transform a normal nosh into a deduction--a legal lesson learned by, of all persons, John Moss, a partner in a law firm that regularly argued cases in the courts.

Moss deducted his share of the partnership's daily lunches on the grounds that the diners discussed such matters as settlements and court hearings. His argument fizzled. The court concluded that the convenience and benefit to the firm made the meals no more deductible than riding to work together each morning to discuss partnership affairs would make commuting costs deductible.

Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books is accessible at www.julianblocktaxexpert.com.

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