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order that his burden may not be inequitably large as compared with his neighbor's. But since most individuals find it easier to recall all the items of their income than of their expenditure, they usually do not avail themselves of all allowable deductions. In other words, the keeping of careful records in this case will work out more to the advantage of the taxpayer than of the government, but it will result in the tax being more equitably spread, which is an advantage from every point of view.
Accounts of partnerships and corporations are, as a rule, better kept than those of individuals. They are, of course, supposed to include all items which can be claimed as allowable deductions. The items disallowed by the law and regulations are discussed in detail in the chapters which follow. If the accrual method is used all items of deductions, minus those specifically forbidden, as taken from the record of expenses or liabilities, should yield the proper result. If the accrual method is not followed, the taxpayer must depend upon his cash account.
DEDUCTIONS FOR EXPENSES
General The chief problems of procedure connected with deductions for expenses are occasioned by the presence of certain restrictions in the law itself. First of all, the statute forbids the deduction of personal living expenses. This is quite necessary and proper, but it involves the difficult task of establishing a sharp line of demarcation between business and living expenses. Gifts, in the next place, are not generally deductible, but in many cases it is not easy to determine whether a payment, nominally a gift, is not more truly an expense. The law does not permit the deduction of capital expenditures except in the form of depreciation allowances, and here once more it is necessary to set up a series of distinctions between this type of expenditures and business expenses proper. Again, care must be taken not to allow any distribution of profits under the guise of business expense. Other difficulties are caused by the prohibition of certain expenditures as contrary to public policy and by the necessity of taking a position on the question of insurance—as to how far expenses are deductible which seek to safeguard the income from risks of various sorts.
In this chapter the first general section is devoted to the establishment of the distinction between business and personal expenses and is consequently applicable to individuals only. The remainder of the chapter deals with various specific types of expenses and, unless otherwise specified, applies alike to individuals, partnerships and corporations. In the case of
*This rule is considerably modified if section 214 (a-6) (allowing for losses arising out of casualties) is interpreted to cover ordinary accidents to personal property, the use of which has always been regarded as private or family expense.
many of these expenses the deductibility of a particular item becomes a complicated question involving several of the distinctions referred to in the preceding paragraph, as, for example, when a salary must be shown to be not a gift, a personal expense, a distribution of profit, a distribution of assets nor a payment for property.?
Expenses which are deductible.
Law. Section 214. [Individuals.] (a) That in computing net income there shall be allowed as deductions:
(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
Section 234. [Corporations.] (a) That in computing the net
?See page 549.
1916 Law. Section 5. [Individuals] (a) ". . . . First. The necessary expenses actually paid in carrying on any business or trade, not including personal, living, or family expenses."
Section 12. [Corporations] (a) ".... First. All the ordinary and necessary expenses paid within the year in the maintenance and operation of its business and properties, including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity; ....".
The phrase "maintenance and operation" appearing in section 12 (a) is explained in the following excerpt from the regulations :
REGULATION. "Expenses of operation and maintenance shall include all expenditures for material, labor, fuel, and other items entering into the cost of the goods sold or inventoried at the end of the year, provided such expenditures have not been considered in determining the cost of goods or materials or purchases thereof during the year, when the income derived from operations is ascertained through inventory, and all other disbursements necessary to the operation of the business, except such as are required by the act to be segregated and stated separately in the return.
"Expenditures which are taken into account in determining the cost of products, finished or unfinished, are not to be again deducted as expenses of operation and maintenance. (Reg. 33, 1918, Art. 129.)
'For comment on last two lines which were added by the 1916 law, see Chapter XXV, “Deductions for Interest."
income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity;
REGULATION. In general the deductions from gross income allowed corporations are the same as allowed individuals, except that corporations may deduct dividends received from other corporations subject to the tax and may not deduct charitable contributions, and that insurance companies are permitted special deductions. .... (Art. 561.)
The principle underlying the deductions for expenses was well expressed in a decision under the 1913 law, as follows:
REGULATION. Only those expenses which are incurred in earning income which is subject to tax under the income tax law constitute allowable deductions in computing net income taxable under the law. (T. D. 2137, January 30, 1915.)
In general, there has been adherence to the foregoing principle. In some cases, however, expenses which have been incurred in earning taxable income have not been allowed.
RESTRICTIONS ON EXPENSE DEDUCTIONS.—The restrictions on deductions for expenses are the following:
Law. Section 215. [Individuals.] That in computing net income no deduction shall in any case be allowed in respect of
(a) Personal, living, or family expenses;
(b) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate;
(c) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;4 or
(d) Premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary under such policy."
*See Chapter XXIX, “Depreciation.”
Section 235. [Corporations] That in computing net income no deduction shall in any case be allowed in respect of any of the items specified in section 215.
Accrued expenses may be deducted.—When the accounts of a taxpayer are kept on the accrual basis all expenses incurred to the end of the taxable year whether paid or not are allowable deductions and should be entered in the books. It is, however, most reprehensible to enter accrued items of expenses unless all items of accrued income are also entered. : The term "expenses . ... incurred" must be taken in its usual commercial sense. It would be improper for a concern to enter as an accrued expense at the end of the taxable year any items of which the business had not received the benefit. An office telephone company sent out notices on December 27, 1918, that the signing of a contract for its service was sufficient to warrant the inclusion of the liability thereby incurred as an allowable expense in the 1918 accounts. The statement was incorrect. In the first place, if the equipment was a capital expenditure it could not be deducted as an expense, and, in the second place, if it was an allowable expense item it should not be allowed until the business received the benefit, which could not occur before the year in which the service was actually installed.
Business Expenses Distinguished from Personal Expenses
Definition of "business or trade.”—The law specifies that an individual must not include "personal, living or family expenses” in his computation of deductible expenses. He may subtract under this head merely "the ordinary and necessary expenses paid or incurred .... in carrying on any trade or business."* "Business” and “trade” are used synonymously and have been defined as follows in an old regulation :
REGULATION. That which occupies and engages the time, attention and labor of anyone for the purpose of livelihood, profit or im
Section 214 (a-1).