Deducting "Ordinary and Necessary" Business Expenses

Understand how to reduce your business taxes by deducting your business expenses.

By , Attorney ● University of Florida Levin College of Law
Updated 3/20/2024

How tax-savvy a businessperson you are has a great effect on how much money is in your pocket at the end of the year. You probably know that the tax code allows you to deduct costs of doing business from your gross income. What you are left with is your net business profit. This is the amount that gets taxed.

So, knowing how to maximize your deductible business expenses lowers your taxable profit. To boot, you may enjoy a personal benefit from a business expenditure, such as a nice car to drive, a combination business trip and vacation, and a retirement savings plan.

However, to benefit from the business deductions available to you and avoid trouble with the IRS, you need to understand when an expense is (or isn't) deductible.

Ordinary and Necessary Expenses

The key to determining whether an expense is legitimate is found in Section 162 of the tax code, which states that a business expense must be "ordinary and necessary." Otherwise, it can't be deducted. Unfortunately, the tax code doesn't define either ordinary or necessary. Luckily, in many cases, whether a business expense is ordinary and necessary is obvious. For instance, office equipment and supplies used in the business are clearly deductible.

Here are some other ways to determine if an expense is ordinary and necessary:

IRS Publications and Regulations

In some cases, such as travel expenses, the IRS provides specific instructions for determining whether or not an expense is ordinary and necessary. This is often done through IRS publications and regulations.

Court Decisions

When there is no guidance on whether an expense is ordinary and necessary, it's up to the courts to figure it out. Generally, courts agree that ordinary and necessary refers to the purpose for which an expense is made. For example, renting office space is an ordinary and necessary expense for many businesses. However, the space must actually be used for the business, or the expense won't qualify.

What do "ordinary" and "necessary" mean according to the courts? "Ordinary" has been held by courts to mean "normal, common, and accepted under the circumstances by the business community." "Necessary" has been interpreted to mean "appropriate and helpful." Given these broad guidelines, it's not surprising that people have tried to push the envelope on what qualifies as a business expense, and the IRS has pushed back. Sometimes, a compromise is reached, and sometimes, the issue is thrown into a court's lap.

Example. Mr. Henry, an accountant, deducted his yacht expenses, contending that because the boat flew a pennant with the number "1040," it brought him professional recognition and clients. The matter ended up before the tax court. The court ruled that the yacht wasn't a normal business expense for a tax professional, and so it wasn't ordinary or necessary." In short, the yacht expense was personal and thus nondeductible. (Henry v. CIR, 36 TC 879 (1961)).

The Laugh Test

Tax professionals frequently rely on the so-called "laugh" test: Can you put down an expense for business without laughing about putting one over on the IRS? In the example above, the tax court laughed the accountant and his yacht out of court.

Large Expenses

While the tax code itself contains no "too big" limitation, courts have ruled that it is inherent in Section 162. For example, it might be reasonable for a large apparel company to lease a jet to travel between manufacturing plants but not for a corner deli owner to fly to New York to meet with her pickle supplier.

Personal Expenses

The IRS's number one concern when auditing business deductions is whether purely personal expenditures are being claimed as business expenses. For instance, you can't deduct the cost of commuting to work, because the tax code specifically says this is a personal, not a business, expense. The same goes for with using the business credit card for a vacation or cruising the beach in the company car. Because such shenanigans are common, IRS auditors are ever watchful.

Fortunately, you can often arrange your affairs (legally) in a way that lets you derive considerable personal benefit and enjoyment from business expenditures.

Read More Articles

Find out about IRS audit rates and the odds of being audited in What Are the Triggers of IRS Tax Audits?

Learn how much time most people spend doing business taxes.

Get information about common tax deductions for individuals.

Get More Information

For more information on this and other tax issues for small businesses, get Deduct It! Lower Your Small Business Taxes, by Stephen Fishman (Nolo).

If you need more help, talk to a tax professional, such as a certified public accountant or a tax attorney. A tax professional can prepare tax returns or provide tax information, guidance, or representation before the IRS.

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