Disallowing Deductions Paid with Excluded Income

12 Pages Posted: 6 Feb 2013 Last revised: 1 Mar 2013

Joseph M. Dodge

Florida State University - College of Law

Date Written: February 5, 2013


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.

Suggested Citation

Dodge, Joseph M., Disallowing Deductions Paid with Excluded Income (February 5, 2013). 32 Virginia Tax Review, 2013; FSU College of Law, Public Law Research Paper No. 623. Available at SSRN: https://ssrn.com/abstract=2212328 or http://dx.doi.org/10.2139/ssrn.2212328

Joseph M. Dodge (Contact Author)

Florida State University - College of Law ( email )

425 W. Jefferson Street
Tallahassee, FL 32306
United States
850-644-4590 (Phone)

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