Internal Revenue Service
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 Rev. Rul. 70-40

1970-1 C.B. 50

Section 62 -- Adjusted Gross Income

Section 172 -- Net Operating Loss Deduction

IRS Headnote

State income taxes and interest on State and Federal income taxes on net income from business profits, and litigating expenses in connection with such taxes, are "attributable to a taxpayer's trade or business" in determining net operating loss; Revenue Ruling 58-142 superseded and I.T. 3951 revoked.

Full Text

Rev. Rul. 70-40

The Internal Revenue Service has reconsidered the position stated in Revenue Ruling 58-142, C.B. 1958-1, 147, with respect to whether certain expenditures are "attributable to a taxpayer's trade or business" for purposes of determining the net operating loss deduction under section 172 of the Internal Revenue Code of 1954. The specific items dealt with are State individual income taxes on net income from business profits, interest on State and Federal income taxes related to income derived from a trade or business carried on by the taxpayer as, for example, in the case of interest on deficiencies arising from business income adjustments, and litigating expenses in connection with such taxes.

Revenue Ruling 58-142 holds that such taxes, interest, and expenses are not "attributable to a taxpayer's trade or business" within the meaning of section 172(d)(4) of the Code, even if they are related to income derived from a trade or business carried on by the taxpayer; and, therefore, they are not allowable as deductions in determining the net operating loss except to the extent of the amount of gross income not derived from such trade or business. The Revenue Ruling also holds that such taxes, interest, and expenses are not deductible from gross income in determining adjusted gross income within the meaning of section 62(1) of the Code, which requires expenses to be "attributable to a trade or business carried on by the taxpayer" in order to be deductible thereunder.

Because of the similarity in language between section 62(1) and section 172(d)(4) of the Code, the Service has in the past relied in part upon the legislative history of the former section in interpreting the latter section. Section 62(1) of the Code was originally enacted as section 22(n)(1) of the Internal Revenue Code of 1939 by section 8(a) of the Individual Income Tax Act of 1944, Public Law 315, Seventy-eighth Congress, C.B. 1944, 734, at 738. In explaining the purpose of section 22(n)(1), the Committee on Finance of the Senate stated in part as follows:

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. Such equivalence is necessary for equitable application of a mechanical tax table or a standard deduction which does not depend upon the source of income. * * *

The deductions described in * * * [section 22(n)(1) of the 1939 Code] are limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one. For example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas State income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income. * * * Senate Report No. 885, Seventy-eighth Congress, C.B. 1944, 858, at 877-78; see also House Report No. 1365, Seventy-eighth Congress, C.B. 1944, 821, at 838-39. (Emphasis added.)

The legislative history referred to above is reflected in section 1.62-1(d) of the Income Tax Regulations which provides, in effect, that State taxes on net income from business profits are not deductible under that section inasmuch as they are merely remotely connected with the conduct of a trade or business. Revenue Ruling 58-142 holds that this is also true of interest and expenses in connection with State and Federal individual income taxes, even though related to income derived from an individual taxpayer's trade or business, with the result that they are not deductible in arriving at adjusted gross income under section 62(1) of the 1954 Code.

This position under section 62(1) of the Code has been upheld with respect to State income taxes in Douglas H. Tanner v. Commissioner, 45 T.C. 145 (1965), affirmed per curiam, 363 F. 2d 36 (1966), and Jones E. Lutts et al. v. United States, United States District Court for the Southern District of California, Central Division, entered May 17, 1965. Both decisions cited Commissioner v. Sally L. Bilder, 369 U.S. 499 (1962), Ct. D. 1871, C.B. 1962-1, 38, for the proposition that when Congress, by statements made in its committee reports, makes its purpose clear, such statements are of controlling importance.

However, the Committee Reports relating to section 172(d)(4) of the Code have no language comparable to that quoted above for section 62(1) of the Code. Moreover, several courts have held that expenditures for these items (that is, State individual income taxes on net income from business profits; interest on State and Federal income taxes that are related to income derived from a trade or business carried on by the taxpayer; and litigating expenses in connection with such taxes) may be attributable to the taxpayer's trade or business within the meaning of section 172(d)(4) of the Code. Frank Polk et ux. v. Commissioner, 31 T.C. 412 (1958), nonacquiescence withdrawn and acquiescence substituted therefor, C.B. 1969-2, XXV, affirmed 276 F. 2d 601 (1960); Elmer Reise v. Commissioner, 35 T.C. 571 (1961), acquiescence in result only, C.B. 1969-2, XXV, affirmed 299 F. 2d 380 (1962); Clarence Wood, et ux. v. Commissioner, 37 T.C. 70 (1961), acquiescence, C.B. 1969-2, XXV; Jacob Rubin, et ux. v. United States, United States District Court for the Eastern District of Virginia, entered May 31, 1960; and W. J. Winston, et ux. v. United States, United States District Court for the Southern District of Texas, Corpus Christi Division, entered January 19, 1962. Accordingly, it is held that expenditures for State individual income taxes on net income from business profits, interest on State and Federal income taxes that are related to income derived from a trade or business carried on by the taxpayer, and litigating expenses in connection with such taxes, are "attributable to a taxpayer's trade or business" for purposes of section 172(d)(4) of the Code and, provided they are otherwise deductible, are allowable deductions in determining the net operating loss deduction. Likewise, State taxes on gross income directly attributable to a trade or business carried on by an individual are allowable deductions in determining the net operating loss deduction under section 172(d)(4) of the Code.

The foregoing conclusions are contrary to  Revenue Ruling 58-142, to the extent that it holds expenditures for such taxes, interest, and expenses not to be deductible for purposes of section 172(d)(4) of the Code. However, as a reaffirmation and restatement of other conclusions in that Revenue Ruling it is held (1) that expenditures for such taxes, interest, and expenses are not deductible by an individual in determining adjusted gross income under section 62(1) of the Code and (2) that a State tax on gross income directly attributable to a trade or business carried on by an individual is deductible from gross income for the purpose of determining adjusted gross income as defined in section 62(1) of the Code.

Revenue Ruling 58-142 is hereby superseded, and I.T. 3951, C.B. 1949-1, 84, holding that State income taxes are nonbusiness expenses for purposes of determining a net operating loss, is hereby revoked.