11-23-07
Defining Our Terms
A sentence appears at the end of each “Money and Taxes” column asking if there are money or tax questions you would like to see discussed. Over the years, I’ve gotten some pretty good column topics from these reader suggestions.
Lately, I’ve had several e-mails asking why I don’t write a column about this or that specific business deduction. The answer is that there is not that much to say. Some types of deductions have restrictions—limits, boundaries, documentation rules—that require explanation. Examples include automobile use, business meals and entertainment, home office and travel.
Most business deductions, though, fall under the seemingly simple heading of ordinary and necessary business expenses.
Deconstructing Language
“Ordinary and necessary” is the actual language of Section 162(a) of the Internal Revenue Code. It seems simple enough. But the closer you look at that phrase, the more curious it becomes and the more mysterious its meaning.
What exactly is “ordinary”? How about “necessary”? And, for that matter, who would like to give me an exact, Artistotelian definition of “expense”?
I don’t see many hands raised. That’s good because I can’t precisely answer any of those questions, either.
Nor did Congress and the Internal Revenue Service really try to write clear definitions. Section 162(a) and the related regulations define by example: “among the items included in business expenses are....” That’s bad form, both in law and logic.
Instead, the clarifications are provided by case law: what various courts have ruled in various cases. This is often not much better than defining by example. Principles still have to be inferred from the results, and unless you have a number of similar (but not identical) cases with similar (but not identical) outcomes, that inference could easily be wrong.
Worse, different courts may see similar cases differently. You may not know which rulings are important precedents, and which ones are just weird or wrong-headed, unless one of the courts is the United States Supreme Court. Then the ruling is always an important precedent, though it might still be weird or wrong-headed.
So in 1933, the Supreme Court instructed us that “...an ordinary expense is one which is customary or usual. This does not mean customary or usual within the taxpayer’s experience, but rather, customary or usual within the experience of a particular trade, industry or community. Therefore, it is possible for an expense to qualify as ordinary even though it is the first and only time that the taxpayer incurs it.”
My, doesn’t that just explain it all?
Well, uh, maybe not. It took until 1983 for the IRS to rule that an expense can be ordinary even if nobody has ever incurred it before; that case involved the clean-up costs of a nuclear reactor “mishap.”*
The accepted explanation of “necessary” comes from a 1934 court case: “a necessary one is one that is appropriate and helpful, rather than necessarily essential to the taxpayer’s business.” That is clear enough that discretionary expenses are deductible, if grammatically and logically suspect in its use of “necessarily” to define “necessary.”
But what about expenses that turn out to have been bad ideas? Are they “appropriate and helpful”? Intuitively, we would say yes, because applying hindsight is unfair. Many years later, a court agreed.
Another Tricky Word
It may seem odd that “expense” could be as elusive a term as ordinary and necessary, but it is. Try to define it. You’ll understand why Supreme Court Justice Potter Stewart famously gave up on defining obscenity and merely ruled, “I know it when I see it.”
Usually, “expense” is defined by what it is not. Paying a dividend to the owners of a business is not an expense. Purchasing inventory for resale is not an expense. Neither is acquiring capital assets, such as real estate or equipment. More subtly, an outlay might bring intangible assets, such as patents or copyrights or goodwill (itself a definitional quagmire); that’s not an expense. A vast collection of court cases addresses the appropriate treatment in specific, often complex situations—many so specific as to have no general applicability.
Remember, too, that Code Section 162(a) uses an adjective: “business.” Business expenses are deductible, but personal ones are not. An equally lengthy list of cases addresses that boundary.
Why We Care
Justice Stewart’s dictum applies to most expenses of people and organizations in the arts. Each tax season, I offer a “Checklist of Potentially Deductible Items...” which lists expense categories from A (accompanists) to U (union dues).** Someone may not have thought about that particular category as a business expense, but he/she will generally find it intuitively correct once I point it out.
The tougher problem for people in the arts is the personal/business boundary, since so many categories could contain both. Take books as an example. There’s a continuous spectrum. A book on Meisner technique is clearly business; the Dr. Seuss you use to pacify your niece on a long car ride is not. But what about a biography of George Bernard Shaw? Would your answer be different if I said Harvey Fierstein? Or Angelina Jolie? The right answer for you, based on all the relevant facts and circumstances (as tax rules often say), may be different from someone else’s.
Obviously, some judgment is required. I always tell people to be honest with themselves. Don’t get greedy, and don’t abandon legitimate deductions for fear of what some Internal Revenue Service worker might think. It’s really no different from what your acting coaches tell you to do.
*The IRS’s word. Most of us say “meltdown” when talking about the Three Mile Island events.
**Five dollar prize to anyone who comes up with a “Z” entry for me.
Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.
Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He has also been known to produce theatre.