Question

The tax law requires that self-employed trade or business expenses be ordinary, necessary and reasonable. Discuss the concepts of ordinary, necessary and reasonable in relation to trade or business expenses.

Assume that you are the accountant for a self-employed tax attorney that generates roughly $150,000 per year in gross income and you are advising him/her on the concept of ordinary, necessary and reasonable business expenses. What two specific examples of ordinary, necessary and reasonable business expenses would you provide to your tax attorney client to drive home this concept? What two specific examples of expenses would you provide to your client that you feel would not be considered ordinary, necessary and reasonable business expenses? Explain your responses.

Answer 1

Ans:

Ordinary and necessary expenses are expenses incurred by individuals as the cost of owning a business or carrying on a trade. "Ordinary and necessary" expenses are categorized as such for income tax purposes, and these expenses are generally considered tax deductible in the year they are incurred.

These expenses are outlined in Section 162(a) of the Internal Revenue Code and must pass basic tests of relevance to business, as well as necessity. However, the IRS does not publish a compendium of what expenses can be considered ordinary and necessary to the pursuit of running a business or carrying on a trade, so it is the responsibility of the taxpayer to make this determination.

KEY TAKEAWAYS

• O&NE are generally the expenses you incur as a cost of owning a business.
• Common ordinary and necessary expenses include business-related software for a computer or rental expenses.
• Portions of the home used for business are sometimes tax-deductible.

  This section of the tax code is the source of a large number of deductions by individuals, especially in years of transition between jobs or careers. Typical expenses that can be included in the "ordinary and necessary" group include a uniform for work or business-related software purchased for a home computer.

  Startup costs associated with setting up a new business may also be tax deductible, but typically must be spread out over several years; these costs do not qualify as ordinary and necessary for IRS purposes but are instead usually deductible as capital expenses.

  The IRS defines an "ordinary" expense as anything that is "common and accepted” to a specific trade or business. The IRS defines a "necessary" expense as anything that is "helpful and appropriate,” but not indispensable. Key examples of “ordinary and necessary” business expenses include:

• Employees Compensation: wages or salaries paid to employees for services rendered.
• Retirement Plans: money allocated to employee-sponsored retirement plans such as 401(k), 403(b), SIMPLE (Savings Incentive Match Plan for Employees), and SEP (Simplified Employee Pension) plans.
• Rental Expenses: money for a property a business owner leases but does not own. The rental expenditures are not deductible if the business owner receives equity in, or holds title to the property.
• Taxes: any local, state, federal or foreign taxes paid that are directly attributable to a trade or business.
• Interest: any interest expenses on money borrowed, to cover the costs of business activities.
• Insurance: any type of insurance acquired for a professional business.

• In general, “ordinary” expenses refers to those that are commonly and typically used by people in your trade or industry. “Necessary” expenses refers to those expenses that are helpful and appropriate; necessary expenses must also be ordinary expenses in order to be tax deductible.

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.

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. 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 is 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 numbers "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 number one concern of the IRS 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. Ditto 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.