Kara Sears
Understanding what constitutes a reasonable business expense is crucial for business owners to make informed decisions and optimize their tax obligations. This topic explores the legal concept of ordinary and necessary expenses, which are costs incurred by business owners in the course of owning and operating their businesses. These expenses are generally tax-deductible, but the determination of reasonableness can be complex and subject to interpretation. Case law provides valuable insights into how courts have addressed this issue, considering factors such as the nature of the business, industry standards, and the specific circumstances of each case. By examining these legal precedents, business owners can gain a clearer understanding of what expenses may qualify as reasonable deductions and navigate the tax system effectively.
| Characteristics | Values |
|---|---|
| Determining factor | Facts, circumstances, and customs of each case |
| Criteria | Ordinary, necessary, and reasonable in amount |
| Ordinary | Common and accepted in a specific trade or business |
| Necessary | Appropriate, helpful, and beneficial for business development |
| Reasonable | Determined on a case-by-case basis, with no fixed formula |
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What You'll Learn
'Ordinary' expenses
Ordinary business expenses refer to costs that are "'common and accepted' in a specific trade or industry. These expenses are typically incurred as a result of owning a business or carrying out a trade. They are outlined in Section 162(a) of the Internal Revenue Code and are generally tax-deductible in the year they are incurred.
Ordinary expenses are those that are typically used by people in a specific trade or industry. For example, rental expenses, taxes, interest on borrowed money for business activities, insurance, and business-related software or equipment. Portions of the home used for business may also qualify as ordinary expenses, but individuals must prove that their dwelling is their principal place of business and calculate the percentage of their home dedicated to business use.
Startup costs associated with setting up a new business may be tax-deductible but are typically spread out over several years. These costs do not qualify as ordinary expenses for IRS purposes but are instead deductible as capital expenses.
Determining whether an expense is ordinary and necessary can sometimes be challenging. In some cases, the IRS provides specific instructions, such as for travel expenses. When there is no clear guidance, it is up to the courts to decide. Generally, courts agree that ordinary and necessary refers to the purpose for which an expense is made.
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'Necessary' expenses
The tax code does not define "necessary expenses", but case law has interpreted the term to mean “appropriate and helpful”. In other words, an expense may be considered necessary if it is helpful for the development of the taxpayer's business. This means that an expense does not need to be essential to be considered necessary.
For example, in Heineman, 82 T.C. 538, 543 (1984), the court found that so long as a business purpose exists, an expense can be necessary even if it is not required. A reasonable expectation that the business will benefit from an expense is enough for it to be considered necessary within the context of Section 162(a).
In another case, 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 IRS pushed back on this, and the issue was thrown to the courts.
Ordinary and necessary expenses are generally considered tax-deductible in the year they are incurred. However, it is important to note that merely incurring an expense is not sufficient to entitle a taxpayer to a deduction. The taxpayer bears the burden of substantiating not only the amount of the deduction but also that the purpose underlying the deduction is ordinary and necessary to operating their trade or business.
Some common examples of necessary expenses include:
- Rental expenses for a property a business owner leases but does not own
- Local, state, federal or foreign taxes paid that are directly attributable to a trade or business
- Interest expenses on money borrowed to cover the costs of business activities
- Insurance acquired for a professional business
- Portions of the home used for business
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Mixed expenses
In the Netherlands, for example, mixed expenses are referred to as "gemengde kosten". A business lunch is a good illustration of this: since everyone needs to eat, the cost of the meal is not a standard deductible expense. However, if the lunch has a business purpose, it acquires a business element, making it partially deductible. Other examples of mixed expenses include representation expenses such as business gifts, receptions, and parties.
The Dutch tax system offers two options for deducting these mixed expenses. The first option is to use a threshold, which was €4,800 in 2022. If your limited deductible costs exceed this threshold, you can deduct the amount above it from your profit. The second option is the 80/20 scheme, where 80% of the mixed expenses are deductible and 20% is for your own account. For most self-employed professionals in the Netherlands, the 80/20 scheme is the more beneficial choice.
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Business travel
The IRS defines "ordinary" expenses as those “common and typically used by people in your trade or industry”, and “necessary” expenses as those that are "helpful and appropriate". Travel expenses must also be “reasonable considering the facts and circumstances”. For example, travel expenses for conventions are deductible if attendance benefits the business. There are special rules for conventions held outside North America.
To be considered "away from home", the travel must be away from the general area or vicinity of the taxpayer's main place of work, and the trip must be long enough or far away enough that the round trip cannot reasonably be completed without obtaining sleep or rest.
When it comes to travel that is both business-related and personal, the primary purpose of the trip must be for business for the travel expenses to be deductible. The primary purpose of a trip is determined by looking at the facts and circumstances of each case, including the amount of time spent on personal activities compared to the amount of time spent on activities directly relating to business.
Examples of deductible expenses include transportation, shipping of baggage, lodging and meals, dry cleaning and laundry, business calls and communication, and tips paid for services related to any of these expenses.
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Home office deductions
The home office deduction is a tax deduction that self-employed individuals can take advantage of if they use a portion of their home for business purposes. This deduction is based on the percentage of the home dedicated to business use, and individuals must calculate the deduction themselves.
To qualify for the home office deduction, one must be self-employed and use part of their home "regularly and exclusively" for business. This means that the home office must be the principal place of business, and no other fixed location is used for substantial administrative or management activities. It is important to note that employees who work remotely for an employer are not eligible for this deduction.
Eligible expenses for the home office deduction include the business portion of real estate taxes, mortgage interest, rent, casualty losses, utilities, insurance, depreciation, maintenance, and repairs. Individuals can deduct 100% of some of these expenses, such as the cost to paint or repair the specific area used for business. Additionally, they can deduct a portion of some overall housing expenses based on the area of the home used for business. For example, if the home office makes up one-tenth of the total square footage, an individual can deduct 10% of the cost of their mortgage interest, rent, utilities, and homeowners insurance.
There are two methods for calculating the home office deduction: the simplified option and the regular method. The simplified option allows taxpayers to use a prescribed rate of $5 per square foot of the portion of the home used for business, up to a maximum of 300 square feet. Under this method, depreciation is treated as zero, and the deduction is claimed directly on Schedule C (Form 1040). The regular method involves dividing expenses between personal and business use, allowing for the deduction of direct business expenses in full and allocating indirect total expenses based on the percentage of home floor space used for business.
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Frequently asked questions
Business expenses are the operating costs of a business. To be considered a reasonable business expense, and therefore tax-deductible, a business expense must be ordinary, necessary, and reasonable in amount.
Ordinary expenses are those that are common and typically used by people in a specific trade or industry. Necessary expenses are those that are helpful and appropriate.
Examples of reasonable business expenses include rental expenses, taxes, interest expenses, and insurance. Portions of the home used for business are sometimes deductible, as well as startup costs associated with setting up a new business.
There is no formula for determining what is a reasonable amount. It is decided on a case-by-case basis, taking into account the facts, circumstances, and customs of each case.
Written records are not explicitly required, but they are considered more credible than oral records. It is important to keep records of the necessary elements as close as possible to the time of expenditure.
