I teach my students this rule: “always take the reimbursement.” Last week’s case of Daniel Alan Near and Denise Frances Mayhugh v. Commissioner, T.C. Memo. 2020-10 (Jan. 14, 2020) (Judge Kerrigan) reinforces the soundness of that rule. There, the Tax Court held that Mr. Near’s travel expenses were not deductible because he did not take the reimbursement his employer offered for those expenses. Details below the fold.
Today’s lesson is about deductions under §162. Courts (and tax professors) never tire of reminding us that deductions are a matter of legislative grace. Since 1992 the Tax Court has cited INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) almost 500 times for that proposition.
Section 162 is often called the workhorse of business expenses deductions. It is definitely the first place one goes to find authorization to take a deduction. The basic idea of §162 is that it takes money to make money and so the money it takes can be deducted from the taxpayer’s trade or business income. In contrast, money spent for personal reasons is not deductible. §262.
Specifically, §162 permits deductions for “ordinary and necessary expenses paid or incurred in the carrying on of a trade or business.” Almost every word in that quote is a term of art. Today’s lesson involves a gloss on the terms “ordinary and necessary.”
The classic case explaining this phrase is Welch v. Helvering, 290 U.S. 111 (1933). There, the taxpayer’s company went bankrupt and he was legally discharged from its debts. He wanted to continue working in the same line of business. He thought that paying off the discharged debts would help him continue working. So he paid them, even though he had no legal obligation to do so.
As to the word "ordinary," the Welch Court said that the proper measure is the behavior of similarly situated taxpayers. The word did not mean simply “habitual or normal in the sense that the same taxpayer will have to make them often.” The Court gave this example: “A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part.” 290 U.S. at 114.
In short, a court should decide whether an expense was “ordinary” by reference to “norms of conduct that help to stabilize our judgment, and make it certain and objective. The instance is not erratic, but is brought within a known type.” Id. In other words, the common practice of similarly situated taxpayers will give the practical boundaries of what is ordinary.
Applying this operational test to Mr. Welch the Court concluded: “Men do at times pay the debts of others without legal obligation or the lighter obligation imposed by the usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity and opulence. Indeed, if language is to be read in its natural and common meaning we should have to say that payment in such circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in the stimulus evoking it, and none in the response.” Id.
As to the word “necessary,” the Welch Court said only that it means “appropriate and helpful” for the development of a taxpayer’s trade or business. As applied to Mr. Welch, the Court said it would be slow to override a taxpayer’s own judgment of what expenses were appropriate and helpful in furthering their business interests. But here it did not matter. Even though Mr. Welch's payments might have been "necessary" in the statutory sense of being appropriate and helpful, they were not "ordinary" and thus could not be deducted under the authority of §162.
In 2015 Mr. Near was an attorney who was partly self-employed and party employed by the California Transit Agency (Caltrans). His office was in Folsom, California. The Caltrans office he worked in was in Sacramento, which Google Maps puts at about 25 miles Southwest of Folsom. For about eight weeks in late 2015 Mr. Near traveled to and stayed in Solano County to work on a trial for Caltrans. Google shows Solano County as about another 40 miles Southwest from Sacramento, making it about 65 miles Southwest of Folsom.
The relevant California state regulations, as well as the Collective bargaining agreement that governed Mr. Near’s employment by Caltrans, provided for the reimbursement of his travel and lodging costs related to the Solano County litigation. But Mr. Near did not ask for reimbursement. Instead he deducted those expenses on the Schedule C he filed for his law practice. On audit the IRS denied the deductions for lack of substantiation. His records were good, but not good enough.
Mr. Near petitioned the Tax Court and, in the alternative, argued that he could at least deduct the Solano County travel and lodging expenses on Schedule A as unreimbursed employee expenses.
Lesson: Take the Reimbursement!
While Mr. Near ran into substantiation problems, the lesson I see in this case is the one about the unreimbursed expenses. Judge Kerrigan finds that the expenses were not “necessary” because Mr. Near could have been reimbursed, but simply chose not to ask.
In this reasoning Judge Kerrigan follows a line of cases where taxpayers are disallowed deductions for expenses for which they could have been reimbursed. She cites to Orvis v. Commissioner, 788 F. 2d 1406 (9th Cir. 1986). One of the earliest cases I found under the 1954 Code was Podems v. Commissioner, 24 T.C. 21 (1955) where the Tax Court said “Obviously, it was not necessary for [the taxpayer] to remain unreimbursed for the expenses...had he taken the trouble to file a voucher and be reimbursed by his employer. Those amounts were not ordinary and necessary expenses of [his] business.”
While Judge Kerrigan got to the right result, I am not sure the reasoning is true to the Supreme Court's opinion in Welch. That is, I am not sure resting the decision on the word “necessary” is right. Certainly it seems intuitive that such expenses are not “necessary” in the sense that the taxpayer was not required to incur them. The taxpayer could have asked for reimbursement and did not have to bear the expense. But “necessary” does not mean “required” or “have to.” It means appropriate and helpful. That what the Welch Court said. The test is simply whether the expense helped the taxpayer’s business. Just as the Supreme Court said in Welch, courts should be slow to override a taxpayer’s judgment on that. As applied to Mr. Near, the proper question is whether the expenses themselves were helpful. Sure, maybe he did not “have to” stay in Solano County to do the work, but it was for darned sure “appropriate and helpful” to do so when litigating a six or eight week trial. So the expenses themselves were appropriate and helpful to his trade or business of being employed as an attorney.
When I read the lines of cases Judge Kerrigan relies upon, they appear to say that allowing the deduction would be allow the employee to “steal” a deduction from the employer. You this reasoning most clearly in one of the case the Orvis court relies upon: Heidt v. Commissioner, 274 F. 2d 25 (7th Cir. 1959). There Mr. Heidt was a mid-level manager who allowed the employees he supervised to take reimbursements for company travel, but who had an informal practice to not ask for reimbursement for his own expenses. The court there explained how, similar to Mr. Welch, Mr. Heidt may well have thought that he was furthering his own career by being a “good” supervisor, but still the availability of the reimbursement made it unnecessary for Mr. Heidt to incur it. The court said that Mr. Heidt’s “decision not to claim reimbursement for automobile expenses, while perhaps sincerely motivated, cannot convert what would properly be [the employer’s] expense into ordinary and necessary business expenses of his own.” By forgoing the reimbursement “he is thus attempting to convert the employer's right to a deduction into a right of his own. This he cannot do.”
I confess I do not follow that reasoning. One cannot steal what is not there. And the employer has no "right to a deduction" to begin with, and certainly not if the employer has no expense to being with! If the employee incurs the expense, then the employer is making the same amount of money but now with lower costs. And if the employer does reimburse the employee, then both taxpayers have an above-the-line deduction. The regulations even tell the employee to not bother reporting the reimbursement as income to the extent it does not exceed the costs. Treas. Reg. 1.62-17. I welcome any comments that can straighten me out on why this stealing rationale in Orvis, Heidt and other cases Judge Kerrigan invokes makes sense.
The sounder approach in my mind would hew closer to Welch and keep the focus on the term “ordinary.” It would use the Welch test of looking to see what folks in this line of business normally do. As applied here, that is pretty easy: employees normally take the reimbursement when offered! That’s the ordinary behavior. To paraphrase Welch: employees do at times decline to seek available reimbursement, but they do not do so ordinarily, not even though the result might appropriate and helpful for their continued employment. Indeed, if language is to be read in its natural and common meaning we should have to say that Mr. Near’s failure to seek available reimbursement here, instead of being ordinary, is in a high degree extraordinary. There was nothing ordinary in the stimulus evoking it, and none in the response.”
Whether you go with Judge Kerrigan's approach or mine, they both lead to the same bottom line: Take the reimbursement.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law