The Internal Revenue Service (IRS) does not explain tax-deductible business expenses in easy terms. However, it still is the best place to find comprehensive tax information. After all, the IRS writes tax publications, creates tax forms, and enforces tax laws. But the IRS writes with the assumption that people reading their information already have a basic understanding of tax terms.
In the case of ordinary and necessary business expenses, the IRS definitions are a little murky.
What Are Business Expenses?
Business expenses are costs associated with running an existing business. The costs associated with starting up a business are deducted as “capital expenses.” Many business expenses are tax-deductible if you are operating your business for a profit.
Business expenses do not include capital expenses, personal expenses, or expenses used to calculate the cost of goods sold. These expenses are listed separately on your taxes.
Expenses for business use of your home are shared costs (i.e., insurance, mortgage or rent, and utility bills) because costs benefit both the business and the homeowner. These costs are considered business expenses but are listed separately from other business expenses, on IRS Schedule C (Form 1040): Profit or Loss from Business.
By Definition, Business Expenses Must Be 'Ordinary and Necessary'
To be deductible as a business expense, the expense must be both ordinary and necessary. Ordinary and necessary expenses, as defined below, must also be “reasonable,” or the IRS may disallow the expense:
- Ordinary Expenses: Expenses that are commonly used and accepted by general industry standards. This means expenses that are typical in your trade or business that are needed to run your business. Ordinary expenses must also be necessary in order to deduct them from your business taxes.
- Necessary Expenses: Expenses that are helpful and appropriate in running your trade or business. Necessary expenses are not tax deductible unless they are also ordinary expenses.
An example of a reasonable ordinary and necessary business expense is costs associated with sending out newsletters, holiday cards, or other promotional literature that are distributed to promote customer relations or generate new business.
An example of an unreasonable business expense is paying a large sum for designer curtains for your home office. This expense would not be considered ordinary or necessary.
How to Determine if a Business Expense Is Ordinary and Necessary
If you are not certain if an expense is ordinary and necessary, ask two questions:
- Does the expense directly pertain to running the business? If the expense is for personal benefit simply to make your job easier or more comfortable (i.e., you do a lot of driving, so you purchase a seat cushion for your car), it is not deductible.
- Can the expense be deducted under “cost of goods sold” or “capital expenses?” If so, you cannot deduct the item as an "ordinary and necessary" business expense.
It is important to save receipts for every expense you deduct on your taxes, including mortgage, rent, insurance, utility bills, and mandatory homeowner’s association dues. (Note that optional dues, such as club or pool memberships, are not deductible because they are not mandatory to living and working in the home.)
Audit Alert Note: Home-based businesses that report expenses for business use of a home are more likely to be audited by the IRS than other similar businesses.
Source: Department of the Treasury; Internal Revenue Service. ”Business Expenses.” April 5, 2008