Deductibility of Ordinary and Necessary Business Expenses
If you own a company, the rules for deducting business expenses are not always intuitive. Schedule C reporting is an area that the IRS scrutinizes and frequently audits. This guide provides the basic rules for deducting businesses expenses.
Deductibility of Business ExpensesTaxpayers may deduct all ordinary and necessary business expenses paid or incurred during the taxable year, while personal, living and family expenses are not deductible. I.R.C. Sec. 162 and 262(a). Education expenses satisfy the "ordinary and necessary" requirement of Sec. 162 provided that they improve skills which bear a "proximate and direct relationship to the taxpayer's trade or business." Carroll v. Commissioner, 51 T.C. 213, 218 (1968), aff'd, 418 F.2d 91 (7th Cir. 1969). A taxpayer also must establish that the education expense either "maintains or improves skills required by the individual in his employment or other trade or business," or meets the express requirements of his employer or of applicable law. Treas. Reg. 1.162-5(a). A taxpayer may not, however, deduct education expenses which meet the minimum education requirements for a trade or business or which qualify for a new trade or business. Treas. Reg. 1.162-5(b).
The Rule Under Section 162: Ordinary and NecessarySection 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred in carrying on any trade or business. Whether expenditures are for ordinary and necessary business expenses is a question of fact, and the taxpayer must demonstrate that the purpose of the expenditure was primarily business rather than personal. The business in which the taxpayer is engaged must have benefited or intend to be benefited by the expenditure. Hynes v. Commissioner, 74 T.C. 1266, 1289 (1980); Chapman v. Commissioner, 48 T.C. 358 (1967).
The Meaning of "Ordinary" and "Necessary"An expense is ordinary if it is customary or usual within a particular business or industry. Deputy v. du Pont, 308 U.S. 488, 495-496 (1940). According to the Court in du Pont, "one of the extremely relevant circumstances is the nature and scope of the particular business out of which the expense in question accrued." Id. The Supreme Court has held that the statutory term "necessary" requires only that the expenses be "appropriate and helpful" in developing the taxpayer's business, not that they be indispensable or unavoidable. Welch v. Helvering, 290 US 111, 113 (1933). Moreover, the courts have tended to accept a taxpayer's own judgment of the business value of expenditures, rather than to decide this commercial issue de novo. Musgrave v. CIR, RIA TC Memo. 97,019 (1997). Otherwise the courts would have to assume, or to authorize the IRS to assume, the role of "business efficiency experts reviewing the commercial decisions of the taxpayer." See Welch v. Helvering, 290 US 111, 113.
Substantiation of Expense ItemsEven if a taxpayer incurs and pays for an item that is an ordinary and necessary business expense, if the taxpayer does not maintain good records the IRS could disallow those expenses. You are highly encouraged to keep all invoices and receipts of purchases and proof that the invoices were paid. This will allow you to present to the IRS concrete evidence that these items were incurred and paid. Assuming that the expenditures meet the definition of "ordinary and necessary" and described above, and they are properly documented, a taxpayer would likely prevail if a question ever arose during an audit or examination.