Since personal expenses are not deductible under the tax law, deductibility of an expense requires that the expense be a business or investment expense. Generally, such expenses relate to activities that are engaged in for profit. While business and investment expenses both constitute ordinary losses, the deductibility of investment expenses is somewhat limited.
Therefore, characterization of an expense as a business expense is ordinarily preferable, since business expenses reduce gross income (i.e., ordinary income and capital gains income) dollar-for-dollar. In contrast, investment expenses suffer from the infirmity of being a “miscellaneous itemized deduction,” which deductions are allowable, but only to the extent that they exceed 2% of the taxpayer’s adjusted gross income (AGI).
Generally, a business expense requires “economic activity,” whereas an investment expense does not. For example, subscriptions to investment trade publications made by a tax attorney in order to manage a portfolio of investments might constitute an investment expense. These deductible expenses, relating as they do to the “production of income” or the “maintenance and conservation of income-producing property” would be allowed (i.e., reportable) only to the extent they exceeded 2% of AGI. Conversely, expenses incurred in subscribing to tax journals would constitute an “expense incurred in a trade or business” and would be reported as business expenses.
The Code mandates that business and investment activities be “engaged in for profit,” a phrase amplified by the Regulations, which specify the following factors to be considered in this inquiry: (1) the taxpayer’s expertise, (2) the time and effort expended on the activity, (3) the taxpayer’s success, (4) the demeanor of the taxpayer, (5) the taxpayer’s financial status and (6) the taxpayer’s history of income or losses related to the activity. The Regulations also provide that a rebuttable presumption arises that the activity was engaged in for profit if the activity has shown a profit in any 3 of the preceding 5 years.
Having established a profit motive, the business or investment expenses must also constitute “ordinary” expenses. Again, the Regulations provide guidance by requiring that “ordinary” expenses be both reasonable in amount and bear a proximate relationship to the income-producing activity or property. The Supreme Court has added that the expense must be “customary or usual in the context of [the] business community.”
Finally, an “ordinary” expense must also be “necessary.” Necessary means “appropriate or helpful” and not indispensable. Whether a cost is “ordinary” seems to involve a qualitative assessment; whether a cost is necessary seems to involve a more quantitative assessment.