The Story of Welch V. Helvering: The Use (and Misuse) of the 'Ordinary and Necessary' Test for the Deductibility of Business Expenses

This paper presents the story of Welch v. Helvering, the leading case on the difference between business and personal expenses, and the difference between ordinary business deductions and capital expenses. For a pronouncement by our highest court on two such important topics in tax law, its influence has been surprisingly slight. And for good reason. Thomas Welch and his father owned a grain brokerage business in Minnesota. Their timing was unfortunate. Many Midwestern farmers went under when they failed to adjust to the reemergence of European agricultural production after World War I. Middlemen fared no better; E.L. Welch and Co. went bankrupt in 1922. Undaunted, Thomas Welch determined to try again. He talked to three Minneapolis bankers. They all told him that, if he ever wanted to be accepted by the business community again, he would have to repay his discharged debts. So, he did. Welch tried to deduct the repayments, but the Commissioner said no. Mr. Justice Cardozo wrote the opinion for the Supreme Court. He said the expenses were too personal, that they were too bizarre to be ordinary, and that they were capital. On the first two points, he was wrong. On the third, he was right, but he didn't say why. As to the first two, consider: Welch did not seek advice from ministers; he went to bankers. Bankers don't give personal advice, and they surely don't give bizarre advice. They tell you about the business morays of the community. The expenses were, however, capital. Clearly, they were intended to influence a stream of earnings which would last far more than one year. However, Cardozo told us none of that. He did not even discuss the controversy which led to the grant of certiorari: the alleged difference between the repayments of debts discharged in bankruptcy (Welch) and those discharged by a composition with creditors (A. Harris & Co. v. Lucas). Instead, he said little other than that the Commissioner thought that they were capital. The result of a bad opinion was, as always, confusion. One line of cases denied deductions, following Welch. Another allowed deductions, following Harris. Still other cases went off on the other strands of Cardozo's opinion, including personal vs. business, bizarre vs. ordinary, capital vs. ordinary, and various combinations of the above. Since the opinion gives us precious little guidance, it is hardly cited at all any more for its substantive issues. Instead, it is cited only for a throwaway line on burden of proof, and for the Justice's whining. It is a pity, for the difference between capital expenses and ordinary expenses is just as vexing an issue today as it ever was. The opinion, however, retains one pernicious effect. Its pronouncements on the nondeductibility of bizarre expenses remain a continuing impediment to innovation in American business. Innovative ideas will likely be considered bizarre by the uncreative dolts in the community, including IRS. Thus, the creative person with a new idea will probably have to try it out with nondeductible dollars. Only when the idea has succeeded, and every clod is doing it, will it be common enough to be deductible. Of course, if we allow deductions for creative business ideas, abusive scams will probably slip in as well. However, the right balance between encouraging the innovators and policing the scams will best be struck if we address the proper issues, which Mr. Justice Cardozo most assuredly did not.