IRS Ruling Benefits Many Small Businesses

WASHINGTON - In a recent ruling, the Internal Revenue Service said small business owners can deduct a part of their tax return preparation fees as a business expense in determining their adjusted gross income.

Sole proprietors, farmers and other individual taxpayers with royalty or rental income will benefit from this deduction because these expenses are not subject to the two percent floor for miscellaneous itemized deductions. The ruling also allows these taxpayers to deduct expenses related to the examination of the business or income production portion of their tax return.

For example, a sole proprietor pays a tax return preparer $500 to prepare the entire individual tax return. Of the $500, $200 is for the preparation of the business portion of the tax return. The sole proprietor incurred another $800 expense related to the examination of the business portion of the tax return. The sole proprietor can deduct $1000 ($200 + $800) as an ordinary business expense on Schedule C. The $300 incurred to prepare the rest of the individual income tax return is deductible as an itemized deduction and is subject to the two percent floor for miscellaneous itemized deductions.

Rev. Rul. 92-29, which explains how to deduct tax preparation fees, is attached and will appear in Internal Revenue Bulletin No. 1992-16, dated April 20, 1992.

Rev. Rul. 92-29

ISSUE

Are the following expenses deductible as trade or business expenses in determining the taxpayer's adjusted gross income under section 62(a)(1) of the Internal Revenue Code: (1) expenses incurred by an individual taxpayer in preparing that portion of the taxpayer's return that relates to the taxpayer's business as a sole proprietor, and (2) expenses incurred in resolving asserted tax deficiencies relating to the taxpayer's business as a sole proprietor?

FACTS

"A," an individual taxpayer, operates a consulting business as a sole proprietorship. During 1992, "A" pays "P," a tax return preparer, $500 to prepare "A's" federal income tax return. Of the $500, $200 is properly allocable to preparing schedule C (Profit or Loss from Business). The remaining $300 is properly allocable to preparing the remainder of "A's" federal income tax return, including Form 1040, Schedule A (Itemized Deductions), and Schedule B (Interest and Dividend Income). During 1992, "A" also pays "P" $800 for services rendered in resolving asserted tax deficiencies relating to the business income of "A's" sole proprietorship.

LAW AND ANALYSIS

Section 162(a) of the Code allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 62(a) of the Code provides that "adjusted gross income" means, in the case of an individual, gross income minus specified deductions. Under section 62(a)(1), one of the specified deductions is any deduction attributable to a trade or business carried on by the taxpayer, if that trade or business does not consist of the performance of services by the taxpayer as an employee.

Section 1.62-1T(d) of the temporary Income Tax Regulations provides, in part, that to be deductible in determining adjusted gross income, expenses must be those directly, and not those merely remotely, connected with the conduct of a trade or business. As an example of the required relationship, the property used in a trade or business are deductible in determining adjusted gross income, but state taxes on net income derived from the conduct of a trade or business are not deductible in determining adjusted gross income.

The legislative history to the predecessor of section 62 of the Code states:

Fundamentally, the deductions thus permitted to be made from gross income in arriving at adjusted gross income are those which are necessary to make as nearly equivalent as practicable the concept of adjusted gross income, when that concept is applied to different types of taxpayers deriving their income from varying sources. ... For example, in the case of an individual merchant or store proprietor, gross income under the law is gross receipts less the cost of goods sold; it is necessary to reduce this amount by the amount of business expenses before it becomes comparable ... to the salary or wages of an employee in the usual case.

S. Rep. No. 885, 78th Cong., 2d Sess. 24-25 (1944), 1944 C.B. 858, at 877-78.

Based on the purpose of section 62(a)(1) of the Code, the Service will allow the following expenses as deductions in determining the taxpayer's adjusted gross income under section 62(a)(1): (1) expenses incurred by an individual taxpayer in preparing that portion of the taxpayer's return that relates to the taxpayer's business as a sole proprietor; and (2) expenses incurred in resolving asserted tax deficiencies relating to the taxpayer's business as a sole proprietor.

In the present case, "A," in determining adjusted gross income under section 62(a)(1) of the Code, may deduct the $200 expense for preparing Schedule C and the $800 expense for resolving asserted tax deficiencies relating to the business income of "A's" sole proprietorship. "A" may deduct the remaining $300 expense from adjusted gross income as an itemized deduction under section 212(3) in determining taxable income, subject to the 2 percent floor limitation under section 67.

HOLDING

The following expenses are deductible as trade or business expenses in determining the taxpayer's adjusted gross income under section 62(a)(1) of the Code: expenses incurred by an individual taxpayer in preparing that portion of the taxpayer's return that relates to the taxpayer's business as a sole proprietor, and expenses incurred when resolving asserted tax deficiencies relating to the taxpayer's business as a sole proprietor. Expenses incurred in preparing schedules or resolving asserted tax deficiencies relating to profit or loss from business (Schedule C), income or loss from rentals or royalties (Part I of Schedule E, Supplemental Income and Loss), or farm income and expenses (Schedule F), are deductible under section 62(a).

EFFECTS ON OTHER DOCUMENTS

Rev. Rul. 70-40, 1970-1 C.B. 50, is modified to the extent that it holds that no deduction is allowed under section 62(a)(1) of the Code for litigating expenses incurred in determining state and federal income taxes on income derived from a trade or business carried on by the taxpayer.

DRAFTING INFORMATION

The principal author of this revenue ruling is G. Channing Horton of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Horton on (202) 566-3627 (not a toll-free call).

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