To Be Deductible Expenses Must Be Ordinary AND Necessary to Running the Business
The IRS defines allowable business expenses as those expenses that are the ordinary and necessary expenses for carrying on a trade or business. Business owners and tradespeople can deduct these expenses during the year they incur them.
Types of Expenses
The IRS classifies expenses in four basic types:
1. Personal expenses
2. Cost of goods sold
3. Capital expenses
4. Business expenses (ordinary and necessary)
What is an Ordinary and Necessary Expense?
The agency does not define what it considers ordinary and necessary. Each type of business or trade will have its own unique set of allowable expenses.
For the IRS to allow an expense it reports that the expense must be both ordinary and necessary:
• An ordinary expense is one that businesses in an industry commonly use and the industry accepts as a standard expense.
• A necessary expense is one that is helpful and appropriate in running your business.
The agency further states that an expense does not have to be indispensable for the agency to allow it as necessary.
For more detail on the IRS explanation, please visit this link.
To decide what’s an ordinary and necessary (O & NE) expense for your business or trade, you need to consider common practices in your industry.
Determining if you can classify an expense as ordinary and necessary
One way to decide if an expense fits the O and NE category is to ask two key questions:
First question: Can you relate this expense directly to running your business?
You cannot deduct a personal expense that you incur to make your job easier. For example, if you drive a lot for your work and decide to purchase a high-end seat cushion, that is not a necessary expense. You are using it just to make yourself more comfortable.
Other examples of expenses you cannot deduct as O & NE are: penalties for late tax payments, lobbying fees, country club memberships, political contributions.
Second Question: Can you deduct this expense as a “capital expense” or a “cost of goods sold?”
If your expense is a capital expense or a COGS expense, you cannot deduct it as a business expense. For example, if you purchase a truck for your delivery business, the IRS considers that cost as a capital expense.
If you pay a large expense over more than a year, it is typically a capital expense. You can often deduct an expense as a business expense if you pay for it in one year.
Note: tax laws do allow business owners to write-off some capital expenses in one year. Talk to us if you have questions.
Examples of O & NE
First, use common sense, does it pass the “laugh test”.
In one famous case, an accountant flew a flag with the word “1040” on his yacht. He claimed he got clients as a result and he should be able to deduct the yacht as a business expense.
The IRS and the tax courts disagreed. The court ruling said the yacht was not an ordinary AND necessary expense. You can read more about this case here.
Here are some examples of expenses that could be ordinary and necessary:
- A person running a video blog could expense the cost of on-camera make-up
- A person running a guard service can write-off uniforms for the security guards
- A photographer could expense the cost of tripods for the camera
- An architect could deduct charges for attending courses for maintaining his license
Here are some typical expenses available to most business:
- Office supplies
- Rent for office and/or meeting space
- Lease payments for storage or warehouse space
- Fuel costs for business-related trips
- Office utility payments
- Equipment maintenance
If you need help to properly classify your expenses, please contact us.