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full as eligible for the medical expense deduction in the year paid by the taxpayer.
The provision (increasing the deduction floor) is effective for taxable years beginning after December 31, 1986.
The provision is estimated to increase fiscal year budget receipts by $186 million in 1987, $1,223 million in 1988, $1,141 million in 1989, $1,276 million in 1990, and $1,427 million in 1991.
3. Repeal of deduction for certain adoption expenses (sec. 135 of the Act and sec. 222 of the Code) 29
Prior law (sec. 222) provided an itemized deduction for up to $1,500 of expenses incurred by an individual in the legal adoption of a child with special needs. (This deduction became effective in 1981.) Deductible expenses included reasonable and necessary adoption fees, court costs, and attorney fees.
A child with special needs meant a child with respect to whom adoption assistance payments could be made under section 473 of the Social Security Act. In general, this meant a child who (1) the State had determined cannot or should not be returned to the home of the natural parents, and (2) could not reasonably be expected to be adopted unless adoption assistance was provided, on account of a specific factor or condition (such as ethnic background, age, membership in a minority or sibling group, medical condition, or physical, mental, or emotional handicap).
Reasons for Change
The Congress believed that Federal benefits for families adopting children with special needs more appropriately should be provided through an expenditure program, rather than through an itemized deduction. The deduction provided relatively greater benefits to higher-income taxpayers, who presumably have relatively less need for Federal assistance, and no benefits to nonitemizers or to individuals whose income is so low that they had no tax liability. Also, the Congress believed that the agencies with responsibility and expertise in this area should have direct budgetary control over the assistance provided to families who adopt children with special needs.
Explanation of Provision
The Act repeals the prior-law itemized deduction for certain adoption expenses. Also, section 1711 of the Act amends the adoption assistance program in Title IV-E of the Social Security Act to
29 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 134; H. Rep. 99-426, p. 113; and H. Rep. 99. 841, Vol. II (September 18, 1986), pp. 22-23 (Conference Report).
provide matching funds as an administrative expense for adoption expenses for any child with special needs who has been placed for adoption in accordance with applicable State and local law (see explanation in Part XVII.D.5., below).
The provision repealing the prior-law itemized adoption expense deduction is effective for taxable years beginning on or after January 1, 1987.
The provision is estimated to increase fiscal year budget receipts by $1 million in 1987, $5 million in 1988, and $6 million annually in 1989-91.
4. Deductibility of mortgage interest and taxes allocable to taxfree allowances for ministers and military personnel (sec. 144 of the Act and sec. 265(a) of the Code) 30
Code section 265(a) disallows deductions for expenses allocable to tax-exempt income, such as expenses incurred in earning income on tax-exempt investments. In addition, that provision has been applied in certain cases where the use of tax-exempt income is sufficiently related to the generation of a deduction to warrant disallowance of that deduction.
Section 107 provides that gross income does not include (1) the rental value of a home furnished to a minister as part of compensation, or (2) the rental allowance paid to a minister as part of compensation, to the extent the allowance is used to rent or provide a home. In January 1983, the Internal Revenue Service ruled that prior-law section 265 precluded a minister from taking deductions for mortgage interest and real estate taxes on a residence to the extent that such expenditures are allocable to a tax-free housing allowance received by the minister (Rev. Rul. 83-3, 1983-1 C.B. 72). This ruling revoked a 1962 ruling which had taken a contrary position. In its 1983 ruling, the IRS stated that where a taxpayer incurs expenses for purposes for which tax-exempt income was received, permitting a full deduction for such expenses would lead to a double benefit not allowed under section 265 as interpreted by the courts.
The 1983 ruling generally was made applicable beginning July 1, 1983. However, for a minister who owned and occupied a home before January 3, 1983 (or had a contract to purchase a home before that date), the deduction disallowance rule was delayed by the IRS until January 1, 1985, with respect to such home (IRS Ann. 83-100). This transitional rule effective date was extended through 1985 by section 1052 of the Deficit Reduction Act of 1984 (P.L. 98
30 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 144; H.Rep. 99-426, pp. 135-36; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 144; S.Rep. 99-313, pp. 6061; and H.Rep. 99-841, Vol. II (September 18, 1986), p. 23 (Conference Report).
369) and through 1986 by administrative action of the IRS (Rev. Rul. 85-96, 1985–29 I.R.B. 7).
In July 1985, the IRS announced that it had not "concluded its consideration of the question of whether members of the uniformed services are entitled, under current law, to take deductions on their income tax returns for home mortgage interest and property taxes to the extent they receive tax-free housing allowances from the Federal Government" (IRS Ann. 85-104). The IRS also stated that "any determination on the issue that would adversely affect members of the uniformed services will not be applied to home mortgage interest and property taxes paid before 1987."
For purposes of this rule, the IRS stated, the uniformed services include all branches of the armed forces, the National Oceanic and Atmospheric Administration, and the Public Health Service. Eligible members of such services, the IRS announcement stated, are entitled to receive tax-free housing and subsistence allowances if they do not reside on a Federal base (see Treas. Reg. sec. 1.61-2(b)).
Reasons for Change
The Congress concluded that it was appropriate to continue the long-standing tax treatment with respect to deductions for mortgage interest and real property taxes claimed by ministers and military personnel who receive tax-free housing allowances. In determining the level of regular military compensation, the Federal Government has assumed that such treatment would be continued.
Explanation of Provision
Under the Act, Code section 265 shall not disallow otherwise allowable deductions for interest paid on a mortgage on, or real property taxes paid on, the home of the taxpayer in the case of (1) a minister, on account of a parsonage allowance that is excludable from gross income under section 107, or (2) a member of a military service, on account of a subsistence, quarters, or other military housing allowance under Federal law (Code sec. 265(a)(6)). The term military service means the Army, Navy, Air Force, Marine Corps, Coast Guard, National Oceanic and Atmospheric Administration, and Public Health Service.
The provision applies for taxable years beginning before, on, or after December 31, 1986. The Act does not allow taxpayers to reopen any taxable years closed by the statute of limitations to claim refunds based on the provision.
The provision is estimated to reduce fiscal year budget receipts by less than $5 million annually.
E. Expenses for Business or Investment
1. Limitations on deductions for meals, travel, and entertainment (sec. 142 of the Act and secs. 162, 170, 212, and 274 of the Code)31
In general, deductions are allowable for ordinary and necessary expenditures paid or incurred in carrying on a trade or business or for the production or collection of income (Code secs. 162, 212). Travel expenses incurred while away from home in the pursuit of a trade or business, including amounts expended for meals and lodging (other than amounts that are lavish or extravagant under the circumstances), generally qualify for the deduction (sec. 162(a)(2)),32 The taxpayer bears the burden of proving both the eligibility of an expenditure as a deduction and also the amount of any such eligible expenditure.33 In addition, certain limitations and special substantiation requirements apply to travel and entertainment deductions (sec. 274). Taxpayers are subject to penalties if any part of an underpayment of tax (e.g., because of improperly claimed deductions) is due to negligence or intentional disregard of rules or regulations (sec. 6653(a)) or due to fraud (sec. 6653(b)).
No deduction is allowed for personal, family, or living expenses (sec. 262). For example, the costs of commuting to and from work are nondeductible personal expenses.34 However, a special deduction is allowed for a limited amount of moving expenses (including certain travel and meal expenses) incurred by a taxpayer in connection with changing job locations or starting a new job, if certain requirements are met (sec. 217).
The Code provides that no deduction is allowed for a payment that is illegal under any Federal law or State law (but only if such State law is generally enforced) that subjects the payor to a criminal penalty or the loss of a license or privilege to engage in a trade or business. For example, if paying more than the face value for a ticket ("scalping") is illegal under an enforced State law, this rule disallows any otherwise available deduction of such payments as business entertainment expenses.
31 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 142; H.Rep. 99-426, pp. 115-130; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 142; S.Rep. 99-313, pp. 6285; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 24-32 (Conference Report).
32 See Part E.2., below, for rules relating to the deductibility of business expenses incurred by employees.
33 See, e.g., Interstate Transit Lines v. Comm'r, 319 U.S. 590, 593 (1943); Comm'r v. Heininger, 320 U.S. 467 (19
34 Fausner v. Comm'r, 413 U.S. 838 (1973).
In general, expenditures relating to activities generally considered to constitute entertainment, amusement, or recreation are deductible only if the taxpayer establishes that (1) the item was directly related to the active conduct of the taxpayer's business or (2), in the case of an item directly preceding or following a substantial and bona fide business discussion, the item was associated with the active conduct of the taxpayer's business (sec. 274(a)). The "directly related" and "associated with" requirements are intended to require a more proximate relation between the entertainment expense and the taxpayer's business than would be required under the "ordinary and necessary" requirement applicable to all business expenses (including business entertainment expenses).
These special requirements apply (subject, under prior law, to ten statutory exceptions discussed in greater detail below) to entertainment expenses such as expenses incurred at nightclubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, and sporting events, and on hunting, fishing, or vacation trips or yachts, as well as to expenses of food or beverages, lodging not used for business purposes, or the personal use of employer-provided automobiles. If either statutory requirement is met or an exception applies, entertainment expenses of the taxpayer as well as entertainment expenses of the taxpayer's business guests (such as present or potential customers or clients, legal or business advisors, suppliers, etc.) are deductible, assuming all generally applicable requirements for business deductions are satisfied.
"Directly related" requirement
The Treasury regulations under section 274 provide several alternative tests for satisfying the "directly related" requirement. These tests generally are designed to require the taxpayer to show a clear business purpose for the expenditure and a reasonable expectation of business benefits to be derived from the expenditure. For example, under the "active business discussion" test, the taxpayer must have actively engaged in a business meeting during the entertainment period for the purpose of business benefit and must have had more than a general expectation of deriving some income or other business benefit (other than merely goodwill) at some indefinite future time.
The regulations presume that the "active business discussion" test is not met if the entertainment occurred under circumstances where there was little or no possibility of engaging in business. For example, the test is presumed not to have been met if there were substantial distractions, e.g., because the entertainment took place at a nightclub or a cocktail party, or if the taxpayer met with a group at a vacation resort that included nonbusiness-related individuals.
Even if the "active business discussion" test is not met, entertainment expenses are deemed "directly related" to business and hence satisfy the special section 274 limitation if incurred in a "clear business setting" directly in furtherance of the taxpayer's business. For example, the "clear business setting" test is met for