Disallowing Deductions Paid with Excluded Income
Joseph M. Dodge
Florida State University - College of Law
February 5, 2013
32 Virginia Tax Review, 2013
FSU College of Law, Public Law Research Paper No. 623
The idea advanced herein, as a thought experiment, is the possibility of expanding (by legislation) – or possibly interpreting (by Treasury regulation) – section 265(a)(1) to disallow deductions deemed to have paid out of tax-exempt (i.e., excluded) income. Although section 265(a)(1) already disallows deductions to obtain tax-exempt income (hereinafter referred to as “forward disallowance”), the Treasury has not seriously attempted to systematically disallow deductions paid with tax-exempt income (hereinafter referred to as “backward disallowance”). The reason for this Treasury inattention is undoubtedly a realization that a tracing rule (that would disallow deductions actually paid with tax-exempt income) would, in most cases, be easily avoidable (because cash is fungible) and only serve to unfairly lay a trap for the unsophisticated. This conundrum could be finessed, however, by disallowing that percentage of otherwise-allowable deductions as excluded income bears to total (included and excluded) income – an approach that respects the fungibility of cash.
Number of Pages in PDF File: 12Accepted Paper Series
Date posted: February 6, 2013 ; Last revised: March 1, 2013
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