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 you 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.

Example The cost of holiday gifts and cards sent to customers is deductible as a necessary business expense if the items promote healthy customer relations, although certain rules apply. 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.

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. In one case, for example, a chauffeured luxury car provided 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.

Warning 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.

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:

• common business deductions
• common expenses that are not deductible