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