Rev. Rul. 81-288

ISSUE

Are taxes imposed on an individual under the New Hampshire Business Profits Tax deductible in determining adjusted gross income under section 62(1) of the Internal Revenue Code?

FACTS

The New Hampshire Business Profits Tax, Chapter 77-A, New Hampshire Revised Statutes Annotated (Supp. 1977), imposes an 8-percent tax on the "taxable business profits" of every business organization, including sole proprietorships.

The statute defines taxable business profits as gross business profits reduced by certain allocations and deductions not relevant here. "Gross business profits" means (1) the amount shown as "net profit" on Schedule C (Form 1040) of a sole proprietor's federal income tax return plus (2) the amount shown on Schedule E (Form 1040) as "net income" from rents and (3) the "net amount" of any gains from the sale of assets held for the use of the business activity or held for rental purposes.

In the case of a sole proprietorship, the New Hampshire statute allows an additional deduction from gross business profits of a fair and reasonable compensation for the proprietor's personal services.

LAW AND ANALYSIS

Section 164(a) of the Code allows the following state, local, and, in some cases, foreign taxes as a deduction for the tax year in which they are paid or accrued: income, war profits, excess profits, real property, personal property, and general sales taxes. Also allowed as a deduction are other state, local, and foreign taxes that are paid or accrued within the tax year in carrying on a trade or business or an activity described in section 212 (relating to expenses for the production of income).

Section 62 of the Code defines "adjusted gross income," in the case of an individual, as gross income minus certain deductions, including the deductions attributable to a trade or business carried on by the taxpayer, if the trade or business does not consist of the taxpayer's performing services as an employee.

Section 1.62-1(d) of the Income Tax Regulations provides that to be deductible in determining adjusted gross income, expenses must be those directly, and not merely remotely, connected with the conduct of a trade or business. For example, taxes are deductible in arriving at adjusted gross income only if they are expenditures directly attributable to a trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer's income is derived from the conduct of a trade or business.

The reference in the regulations to "state taxes on net income" pertains to state income taxes of general application, such as those imposed on salaries, investment income, and other forms of income in addition to business income.

The legislative history of section 62 of the Code states:

. . . Thus taxes and interest are deductible in arriving at adjusted gross income only as they constitute expenditures attributable to a trade or business or to property from which rents or royalties are derived. H. Rep. No. 1365, 78th Cong., 2d Sess. 21 (1944), 1944 C.B. 821, 839.

The intent of Congress was that state income taxes, imposed generally, would not be deductible under section 62 of the Code merely because the net income arose from a business, but that taxes of any kind that are imposed only on business activity, or business property, or business income, would be deductible.

The New Hampshire Business Profits Tax is a tax only on the privilege of entering into a trade or business in that state. The measure of the tax is net profits from the trade or business, reduced by a deduction for a reasonable value for the proprietor's services. It is not a tax of general application. Thus, the New Hampshire tax is not a state tax on net income within the meaning of section 1.62-1(d) of the regulations. Compare Tanner v. Commissioner, 45 T.C. 145 (1965), aff'd per curiam, 363 F.2d 36 (4th Cir. 1966), where the court held that income taxes of general application are nondeductible for purposes of section 62 of the Code.

HOLDING

The New Hampshire Business Profits Tax is deductible by a sole proprietor in determining adjusted gross income under section 62(1) of the Code.