Welch's business went
bankrupt. As part of the bankruptcy process, the court said that the
business was "discharged from its debts."
That means they were not
legally obligated to pay them.
While trying to get the
business back on its feet, Welch decided to reestablish goodwill and
credit by voluntarily paying back the debts anyway (or at least part of
them).
Welch deducted the cost of
these voluntary payments on his taxes as a business expense. The IRS denied the deduction. Welch
appealed.
The IRS argued that these
were not business expenses at all,
but money spent in order to increase the company's goodwill.
Business expenses are covered in 26 U.S.C. §162.
The Tax Court found for the
IRS. Welch appealed.
The Tax Court found that the
payments were not deductible as a business expense because they were not ordinary and
necessary.
Basically, the payments
were voluntary, not a required part of doing business, so they didn't
count as business expenses.
The Appellate Court affirmed.
Welch appealed.
The US Supreme Court affirmed.
The US Supreme Court found
that in order to be deductible as a business expense, the payments need to be ordinary
and necessary.
The Court suggested that ordinary
and necessary could be determined by
looking at the prevailing practice in the business world.
The Court found that in this
case, the payments were not ordinary or necessary, so they did not
qualify as a business expense.
In this case, it was not
the prevailing practice in the business world to pay off debts you
didn't have to pay off. This was more similar to a capital
expenditure, and those are not
deductible (see 26 U.S.C. §263(a)).
In dictum, the Court defined
the term necessary as "appropriate
and helpful [in] the development of the [taxpayer's] business."
