In 1922, Thomas H. Welch (Petitioner) was the secretary of the E. L. Welch Company, which was engaged in the grain business. The Welch Company went bankrupt and was discharged from its debts. Subsequently, Petitioner obtained a new job with a company engaged in the grain business. To re-establish relations with customers he had served while working with the Welch Company, and to solidify his good will, Petitioner decided to pay the debts of the Welch Company, to the extent he was able, over five years.
Petitioner deducted the payments he made to the Welch Company creditors, characterizing them as ordinary and necessary business expenses, during the corresponding tax years. The Commissioner of Internal Revenue (Commissioner) ruled that the payments made by Petitioner were not deductive from income as ordinary and necessary expenses, but were rather more akin to capital expenditures. The Board of Tax Appeals sustained the ruling of the Commissioner and the Court of Appeals for the Eighth Circuit affirmed. The Petitioner petitioned for a writ of certiorari.
Whether payments by a taxpayer to the creditors of his now-bankrupt former employer, made in an effort to better his own standing and credit, are allowable deductions under IRC § 162(a) in the computation of his own net income?
No, Petitioner could not deduct payments made to the creditors of his now-bankrupt former employer as ordinary and necessary expenses paid or incurred in carrying on any trade or business. Payments of this sort, the Court concluded, are “a high degree extraordinary.”
Key Points of Law:
- IRC § 162(a) provides that “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” [emphasis added]
- Ordinary, in the context of IRC § 162(a), means something that is usual or customary.
- Contrarily, ordinary, in the context of IRC § 162(a), does not require that something be habitual or regularly occurring; a single occurrence can be ordinary.
- Necessary, in the context of IRC § 162(a), means something is appropriate or helpful.
- In reviewing whether a deduction is proper under IRC § 162(a), the Commissioner’s determination is prima facie correct, and the taxpayer bears the burden of proving otherwise. See Wickwire v. Reinecke, 275 U.S. 101 (1927).
- Money spent to ‘obtain’ goodwill is a capital expenditure and should be amortized accordingly.
This case reiterates that IRC § 162(a) allows a taxpayer to take a deduction for expenses paid or incurred in operating a business, but that those expenses must be both ordinary and necessary. Further, clarification is provided as to what “ordinary” means within the statute: Something is ordinary when it is usual or customary; it may be regularly occurring or a single instance.
The Court also notes that the standard provided by the statute is not a rule of law but rather a way of life, and “life in all its fullness must supply the answer to the riddle.” While its meaning is as clear as muddied waters, the famous line by Justice Cardozo underscores the inherently fact-intensive nature of determinations like the one at issue in the present case. And while the Court will ultimately come to its own conclusions based on a review of the facts, it should defer to the taxpayer’s judgement that an expense was ordinary and necessary.
Lastly, the Court acknowledges that reputation, knowledge, and goodwill are important, and sometimes the sole tools an individual has to forge a path forward. And while money spent to acquire each is money that is well and wisely spent – it is not an ordinary expense paid or incurred in operating a business.
 For the years 1924, 1925, 1926, and 1927, the applicable provision was § 214(a)(1) of the Revenue Acts of 1924 and 1926. For 1928, the applicable provision was § 23(a) of the Revenue Act of 1928. Today, the applicable provision is IRC § 162(a).