Business owners often are aware that they can deduct costs related to operating their business in calculating their taxable income. The concept is that a business owner should be taxed only on the net profits of their business. However, certain technical rules govern the deduction for ordinary and necessary expenses. A business owner should be familiar with these rules to make sure that they take full advantage of the deduction without facing an investigation by the IRS.
Under Section 162 of the Internal Revenue Code, a business expense must be ordinary and necessary to be deducted. Since this law does not specifically define what makes an expense ordinary and necessary, it can be challenging to decide where to draw the line. Costs related to buying equipment and supplies for a business would be deductible, and certain types of travel expenses have been explicitly classified as deductible under IRS regulations. You can consult these regulations and other guidance provided by the IRS if you have a question about whether a certain expense qualifies as ordinary and necessary.
Court Decisions on Business Expenses
Courts have analyzed whether a certain expense is ordinary and necessary by considering the purpose of the expense. In general, “ordinary” means something that is normal and widespread in the type of business at issue. “Necessary” does not mean absolutely essential, as the word is sometimes interpreted. Instead, it means something that is appropriate and useful to the business. If an expense would be ordinary and necessary for a business in most situations, but it is not actually used to benefit a particular business, it will not qualify for a deduction. To some degree, a business owner should rely on their common sense in deciding whether a deduction likely would apply. If they cannot make a reasonable argument for a deduction, a court probably will not allow them to claim a deduction.
The Internal Revenue Code does not provide a limit on the size of an ordinary and necessary business expense. However, courts have found that this limit is implicit and prevents business owners from deducting inordinately large expenses, considering the nature and scale of their business.
Most often, disputes surrounding this type of deduction arise when the IRS suspects that a business owner is trying to classify a personal expense as a business expense. For example, using your business credit card or a company vehicle on a vacation does not mean that you can deduct the costs of your vacation as an ordinary and necessary business expense. You cannot deduct the costs of commuting to your office, which is specifically prohibited by the Internal Revenue Code. That said, the law does not prevent business owners from gaining any personal benefit from their business expenses. As long as the purpose of the expense involved the business, they can apply a deduction even if they received an indirect personal benefit.
The IRS tends to take a closer look at “ordinary and necessary” business expenses that involve payments to a relative or a business owned by a relative. Sometimes a business owner will transfer some of their profits from their business to family members while claiming the deduction. If it appears that this transfer resulted in a personal benefit and minimal business benefit, a business owner may face some tough questions during an audit.