Commissioner of Internal Revenue v. Sullivan et al.
356 U.S. 27 (1958)
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Rule of Law:
Expenses that are 'ordinary and necessary' for the operation of a business, such as rent and wages, are deductible for federal income tax purposes even if the business itself is illegal under state law, unless the allowance of the deduction would frustrate a sharply defined national or state policy.
Facts:
- The taxpayers operated bookmaking establishments in Chicago, Illinois.
- These enterprises were illegal under Illinois state law.
- The taxpayers paid rent for the premises used to conduct their illegal bookmaking operations.
- The taxpayers also paid wages to employees whose work constituted violations of Illinois's anti-gambling laws.
Procedural Posture:
- The Commissioner of Internal Revenue disallowed deductions for rent and wages that the taxpayers claimed on their federal income tax returns.
- The taxpayers challenged the Commissioner's determination in the Tax Court of the United States.
- The Tax Court ruled in favor of the Commissioner, holding that the expenses were not deductible because they were incurred in connection with illegal acts.
- The taxpayers, as appellants, appealed to the U.S. Court of Appeals, which reversed the Tax Court's decision.
- The Commissioner of Internal Revenue, as petitioner, was granted a writ of certiorari by the U.S. Supreme Court.
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Issue:
Does the Internal Revenue Code permit the deduction of wages and rent as 'ordinary and necessary' business expenses when those expenses are paid in the course of operating an illegal gambling enterprise?
Opinions:
Majority - Justice Douglas
Yes. The Internal Revenue Code permits the deduction of such expenses because they are 'ordinary and necessary' in the accepted meaning of the words. The Court reasoned that while deductions are a 'matter of grace,' Congress has not explicitly disallowed these specific expenses for illegal businesses. Furthermore, Treasury Regulations permit the deduction of the federal excise tax on wagers, which implicitly recognizes a gambling enterprise as a business for federal tax purposes. To deny the deduction of normal operating costs like rent and wages would effectively tax an illegal business on its gross receipts rather than its net income, a policy choice the Court stated should be made by Congress, not the courts. The deduction should only be disallowed if it is clear that its allowance would frustrate a sharply defined public policy, which is not the case with basic operating expenses like rent and wages.
Analysis:
This decision established the principle that, for federal tax purposes, the legality of a business under state law does not determine the deductibility of its ordinary and necessary expenses. It created a distinction between expenses that are an inherent cost of producing income (even illegal income) and those that directly contravene public policy, such as fines or bribes. This ruling prevents the IRS from using tax law to impose an extra penalty on illegal activities by taxing gross receipts, affirming that the federal income tax is a tax on net profit unless Congress explicitly provides otherwise. It requires courts to analyze whether a specific deduction would 'frustrate' public policy, rather than applying a blanket rule against all expenses related to illegal acts.
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