Ordinary and Necessary Expenses
The first, most basic guideline to remember is that a tax deduction for an
expense paid in connection with your business will be allowed only if the
expense is "ordinary and necessary" for the operation of the business.
This doesn't mean that the IRS will attack all sorts of legitimately claimed
business deductions, either on the ground that an expense would occur only
occasionally (is it ordinary?), or that the expense would be helpful, but not
vital to the business (is it necessary?).
In practice, the IRS is rather flexible in this regard. It defines
"ordinary" as common and accepted in a field of business, and defines
"necessary" as helpful and appropriate to your business.
"Ordinary" usually refers to expenses that are frequent and
ongoing, such as amounts spend on gasoline or business meals, but can also apply
to something that you pay only once, such as an installation fee for a business
telephone line. And an expense does not have to be indispensable to be a
necessary expense.
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The cost of holiday gifts and cards sent to customers is
deductible as a necessary business expense if the items promote
healthy customer relations.
However, the cost of a gun purchased for personal protection
by an insurance agent, who is sometimes required to make
business calls to private homes late in the evening, would not
be deductible. While the expense of the handgun might be
"ordinary," it is not "necessary" because it
is not helpful or appropriate to the business of an
insurance agent. It would be considered a nondeductible personal
expense.
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In addition to being "ordinary and necessary," it has been held
that a business expense must also be "reasonable." Whether an expense
is reasonable depends upon the facts and circumstances in the particular
situation. For example, it has been held that providing a chauffeured luxury car
to an employee was not unreasonable given the nature of the employment and the
congested area in which the car was driven. Entertainment and meal expenses are
not deductible to the extent that they are lavish or extravagant, given the
circumstances.
In applying the "ordinary and necessary" deduction test, the IRS
isn't looking to second-guess your business decisions. You can expect that
almost any expense that's fairly common for your type of business will pass
muster without serious question. Rather, IRS agents use this test to make sure
that the expense is actually spent, and: (1) pertains to the business (instead
of personal or family needs), (2) is not also being deducted elsewhere on the
return (such as in the cost
of goods sold computation), and (3) is a current, rather than capital,
expense.
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There are a few types of expenses that might be seen as
promoting the business, but are specifically made nondeductible
by the tax laws. These include items such as lobbying expenses
and political contributions, fines and penalties such as parking
tickets, and illegal payments such as kickbacks.
For instance, a traveling salesman who receives a speeding
ticket must pay it, or risk losing his driver's license and his
ability to earn a living. It's arguable that the cost of the
ticket is an ordinary and necessary business expense.
Nevertheless, the law states that legal fines and penalties are
never deductible, so the ticket must be paid out of the
salesman's own pocket.
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To be deductible, business expenses must be incurred in carrying on an already
existing trade or business. Costs
associated with starting up a business are considered a type of capital
expenditure, and are not fully deductible as current expenses.
To help you decide whether a particular expense is likely to be deductible,
we've provided two lists: