Rev. Rul. 58-25

Advice has been requested whether the earned income tax, imposed by the City of Cincinnati Ordinance No. 42-1954 with respect to income during the period April 1, 1954, to October 31, 1954, both inclusive, is deductible as a business expense by unincorporated businesses, proprietorships and partnerships when the individual or partner elects to take the standard deduction on their individual Federal income tax returns.

Under section 2 of the City of Cincinnati Earned Income Tax Ordinance No. 42-1954, as far is applicable, a tax is levied at the rate of 1 percent upon the net profits of all unincorporated businesses, etc., as follows:

(3) On the net profits of all unincorporated businesses, professions, or other activities, on sales made, work done, and services performed, or businesses or other activities conducted in the City of Cincinnati, whether or not such unincorporated businesses, professions, or other activities have an office or place of business in the City of Cincinnati.

(4) On a resident's share of the net profits of an unincorporated business, profession, or other activity whether located in or outside the City of Cincinnati, not attributable to Cincinnati, under the formula or separate accounting method provided for herein.

Section 1 of the ordinance defines `net profits' as `the net gain from the operation of a business, profession, or enterprise after provision for all ordinary and necessary expenses paid or incurred in the conduct thereof, except taxes imposed by the Ordinance and the Federal taxes based on income.' Section 1 also defines a `business' as `an enterprise, activity, profession, or undertaking of any nature conducted for profit or ordinarily conducted for profit, whether by an individual, copartnership, association, corporation, or any other entity.'

Section 3 of Article II-C of the Earned Income Tax Regulations provides, `The tax imposed on unincorporated businesses owned by two or more persons is upon the entity rather than the individual members or owners thereof but the tax imposed on an unincorporated business owned by one person is upon the individual owner.'

Section 1 of Article II-D of the Earned Income Tax Regulations provides, `In the case of a resident individual partner or part owner of an unincorporated business, profession or other activity, there is imposed a tax of one percent (1%) on such individual's distributive share of net profits earned during the period April 1, 1954, to October 31, 1954, both inclusive, and not attributable to Cincinnati under the formula or separate accounting method provided for in section 2 of the Ordinance and not taxed against the entity.'

In general, as provided in sections 161 and 164(a) of the Internal Revenue Code of 1954, in computing taxable income under section 63(a) of the Code, there shall be allowed as a deduction taxes paid or accrued within the taxable year.

Section 141 of the Code provides that, in the case of an individual, the standard deduction referred to in section 63(b) of the Code shall be an amount equal to 10 percent of the adjusted gross income, or $1,000, whichever is the lesser, except that in the case of a separate return by a married individual, the standard deduction shall not exceed $500. An individual may elect to take such deduction in lieu of all nonbusiness deductions, that is, deductions other than those allowable under section 62 of the Code, and in lieu of certain other credits allowable had he not so elected. See section 1.141-1(c) of the Income Tax Regulations.

Section 62 of the Code defines adjusted gross income in the case of an individual as gross income minus trade or business expenses, as well as minus certain other specified items.

Section 1.62-1(d) of the Income Tax Regulations, in defining adjusted gross income provides, in part:

* * * To be deductible for the purpose of determining adjusted gross income, expenses must be those directly, and not those 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 constitute 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.

A general income tax has been held not deductible in computing adjusted gross income. See, for example, I.T. 3370, C.B. 1940-1, 32, and I.T. 3722, C.B. 1945, 78, relating to the treatment of the income tax imposed by the City of Philadelphia. See also I.T. 3753, C.B. 1945, 82, relating to the treatment of the New York temporary emergency tax on net incomes of unincorporated businesses.

However, certain State taxes pertaining to income have been held deductible in computing adjusted gross income in the case of an individual taxpayer engaged in a trade or business. See, for example, I.T. 3766, C.B. 1945, 83, as modified by I.T. 3829, C.B. 1946-2, 38, which involve the Indiana gross income tax. It was further stated in these published rulings that such tax paid by a partnership is deductible under section 23(c) of the 1939 Code in computing partnership income. Section 22(n) of the 1939 Code was not applicable since in the case of a partnership, no provision was made for the computation of adjusted gross income.

Similar conclusions were reached with respect to an annual license fee imposed by the City of Louisville, Ky., upon every person, association, corporation, or other entity engaged in an occupation, trade, profession, or other activity for the privilege of engaging in such activity. See Revenue Ruling 54-598, C.B. 1954-2, 121, which holds that any such tax paid by a partnership is deductible from partnership gross income but that such deduction shall not preclude the partners from claiming the standard deduction. It further holds that any such tax imposed upon the profits of a sole proprietorship is deductible in computing the taxpayer's adjusted gross income since it is directly attributable to a trade or business carried on by taxpayer.

The earned income tax in the instant case is distinguishable from the Indiana gross income tax (I.T. 3766 and I.T. 3829, supra ) inasmuch as such tax as respects businesses is imposed upon the net profits thereof rather than gross receipts. Similarly, it is distinguishable from the tax involved in Revenue Ruling 54-598, supra , because in that ruling the tax imposed was a license fee for the privilege of doing business within the city. See J. D. Adams Manufacturing Co. v. Storen et al , 304 U.S. 307; Howard et al. v. Commissioners of the Sinking Fund of the City of Louisville et al. , 344 U.S. 624; Cook et al. v. Commissioners of the Sinking Fund of the City of Louisville et al (Ky.), 226 S.W.(2d) 328, and City of Louisville et al. v. Sebree et al. (Ky.), 214 S.W.(2d) 248.

In view of the above, the instant tax imposed by the City of Cincinnati constitutes an income tax within the meaning of section 1.62-1 of the Income Tax Regulations. Accordingly, it is held (1) that any such tax imposed upon and paid by an individual on the net profits of a business owned by him and conducted in Cincinnati is not deductible by him in computing adjusted gross income, but is deductible in computing taxable income, provided that the taxpayer does not elect to claim the standard deduction; (2) that any tax imposed upon and paid by a partnership on the net profits of its business conducted in Cincinnati is deductible in computing the taxable income of the partnership and the partners are not precluded from claiming the standard deduction; and (3) that the tax imposed upon a resident's share of the net profits of an unincorporated business not attributable to Cincinnati and paid by such resident is allowable as a deduction provided that the taxpayer does not elect to use the standard deduction, but the tax may not be deducted from gross income in determining adjusted gross income.

I.T. 3829, C.B. 1946-2, 38, and Revenue Ruling 54-598, C.B. 1954-2, 121, are distinguished from the instant case.