Four Requirements to Deduct Business Operating Expenses
The four things you need to show for your expense to qualify for this deduction.
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There are so many different kinds of business operating expenses that the tax code couldn’t possibly list them all. Instead, if you want to deduct an item as a business operating expense, you must make sure the expenditure meets certain requirements. If it does, it will qualify as a deductible business operating expense. To qualify, the expense must be:
- ordinary and necessary
- a current expense
- directly related to your business, and
- reasonable in amount.
Ordinary and Necessary
The first requirement is that the expense must be ordinary and necessary. This means that the cost is common and “helpful and appropriate” for your business. The expense doesn’t have to be indispensable to be necessary; it need only help your business in some way—even if it’s minor. A one-time expenditure can be ordinary and necessary. Generally, the IRS won’t second-guess your claim that an expense is ordinary and necessary, unless the item or service clearly has no legitimate business purpose.
Only current expenses are deductible as business operating expenses. Current expenses are costs for items that will benefit your business for less than one year. These are the costs of keeping your business going on a day-to-day basis, including money you spend on items or services that get used up, wear out, or become obsolete in less than one year. A good example of a current expense is your business’s monthly phone bill, which benefits your business for one month. In contrast, buying a telephone for your business would be a capital expense (not a current expense) because the phone will benefit your business for more than one year. Other common current expenses include office supplies, repairs, and monthly rent.
Current expenses are currently deductible—that is, they are fully deductible in the year in which you incur them. Because all business operating expenses are current expenses, they are also all currently deductible. However, the annual deductions for some operating expenses (notably home offices) are limited to the amount of profits you earn from the business in that year. Items you buy for your business that last for more than one year (capital expense items) must be depreciated over several years.
An expense must be directly related to your business to be deductible as a business operating expense. This means that you cannot deduct personal expenses. For example, the cost of a personal computer is a deductible operating expense only if you use the computer for business purposes; it is not deductible if you use it to pay personal bills or play computer games. If you buy something for both personal and business use, you can deduct only the business portion of the expense. For example, if you buy a cellular phone and use it half of the time for business calls and half of the time for personal calls, you can deduct only half of the cost of the phone as a business expense.
A business expense for one person can be a personal expense for another, and vice versa. For example, a professional screenwriter could probably deduct the cost of going to movies—he needs to see movies for his screenwriting business. But a salesperson could not deduct this type of expense.
Many expenses have both a personal and business component, which can make it difficult to tell if an expense is business-related. Because of this, the business-related requirement is usually the most challenging factor in determining whether an expense qualifies as a deductible business operating expense. The IRS has created numerous rules and regulations to help determine whether many types of expenses are deductible. Some of these rules help by laying out guidelines for when an expense is and isn’t deductible. Others impose record-keeping and other requirements to prevent abuses by dishonest taxpayers. Most of the complexity in determining whether an expense is deductible involves understanding and applying these special rules and regulations.
Subject to some important exceptions, there is no limit on how much you can deduct, as long as the amount is reasonable and you don’t deduct more than you spend. As a rule of thumb, an expense is reasonable unless there are more economical and practical ways to achieve the same result. If the IRS finds that your deductions are unreasonably large, it will disallow them or at least disallow the portion it finds unreasonable.
Certain areas are hot buttons for the IRS—especially car, entertainment, travel, and meal expenses. There are strict rules requiring you to fully document these deductions
For more detailed guidance on how to deduct business expenses, refer to Fishman, Deduct It: Lower Your Small Business Taxes (Nolo).