Tax Cat: Let's Learn About "Necessary And Ordinary Business Expenses"

If you have your own business, you can write off your expenses. This reduces you income, and lowers your tax bill. Sadly, you can’t just write off whatever you want.

Tax Cat sez: You need to follow the IRS’s guidelines and only write off “necessary and ordinary business expenses.”

Here’s the important part of the tax code:

Internal Revenue Code § 162. Trade or business expenses. (a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…

What does this mean?

Well, there are lots and lots of things you may be able to deduct. Here are a few:

  • Office equipment

  • A Home Office
  • Sales tax on business purchases.
  • Professional fees. (This includes tax professionals who’ll do all this crap for you.)
  • Health Insurance premiums
  • Auto expenses.
  • … and more!

Here’s a helpful list. If you have a business expense that isn’t mentioned on the list, that doesn’t necessarily mean you can deduct it.

The Laugh Test

From NOLO.com:taxcatsez.jpg

“Ordinary” has been held by courts to mean “normal, common, and accepted under the circumstances by the business community.” “Necessary” has been taken to mean “appropriate and helpful.”

Given these broad legal guidelines, it is not surprising that some folks have tried to push the envelope on “ordinary and necessary” business expenses, 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).)

Tax professionals frequently rely on the “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.

Understanding Small Business Tax Deductions [NOLO]
(Photo:Chad Beckerman)

Comments

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  1. Ayo says:

    So, say a person were to buy a vehicle for there company. I understand there’s numerous things involved. Like percentage of vehicle use for the company, the type of vehicle determines how you can write it off (in full or depreciation.) Is there anybody with ALL the information on this subject?

  2. FreemanB says:

    Yes, a CPA. If you have questions like that, it is always best to get answers from a professional. It may cost a little more up front, but it will not only save you the time and frustration of trying to figure it out for yourself, but you’ll be reasonably confident that your return is correct. The problem with trying to find the answer online is that in too many cases, the answer is “It depends.”

  3. What about items for non-paid work? I facilitate a discussion group at my local library and purchase supplementary materials (because I’m not allowed to scribble in the margins of library books) for that purpose. Can I list those as a deduction?

  4. GearheadGeek says:

    @Ayo: Sometimes there are pretty loopholes, like this one put in place by W. Let’s say you’re a lawyer, and in the regular course of your work you might have to transport yourself, your briefcase and the occasional file box of documents. Does it make sense that for a couple of years you could buy an SUV with a GVWR over 6,000 lb and write it all off immediately? That’s laughable, but was allowable until it was fixed.

  5. GearheadGeek says:

    @Maude Buttons: as above, seek professional advice before you complete your return, but I think that would fall under expenses you incur for charity/non-profit organizations. Your time isn’t deductible as a donation in that case, but supplies and mileage are.

  6. The tax code’s complexity and frequent misuse is living proof that regulatory authorities will never be effective in this country.

  7. Ayo says:

    @GearheadGeek: Yeah, I’ve read about that. Wish i would of jumped on the opportunity and bought a Monster truck and took up my dream job of driving Megazilla, the fire breathing, car crushing half machine half beast. But yeah, they fixed that loop hole. You would think they would take into consideration fuel efficiency. I guess there goes my Range Rover…

  8. FreemanB says:

    @Maude Buttons: So long as it is a consumable used while you are doing volunteer work, you should be able to deduct it. You have to be careful about items that you can also use for yourself though. You mention supplementary materials, but don’t say what they actually are. If they are additional books that you keep after the discussion groups, then it wouldn’t be considered an expense.(The books still have value and belong to you) Another option is to simply donate the materials to the library once you are done with them and take the deduction as a charitable contribution.

    Again, if you have questions, it is always best to ask a professional. While I may know more than average about taxes, I’m not a professional. Also, there are usually going to be several questions that need to be answered before a true determination can be made, as my statements above illustrate.(Final answer is “It depends.”)

  9. consumersaur says:

    What about non-reimbursed ordinary business expenses you incur from a non self-owned business? For example: Can I deduct mileage if it’s logged, ordinary and necessary for my employer — but not reimbursed by my employer?

  10. rhombopteryx says:

    There’s absolutely nothing more entertaining (or less reliable) on teh internets than free tax advice!!!

    So I’ll join the fun. We’re talking about ordinary business expenses here, which first requires that you be operating a business. Who cares about the ‘laugh test’ or whether it’s on a list somewhere if you’re (like the majority of the US) not actually operating as a business?
    As expected, the IRS has rules about what constitutes a business and what doesn’t. Rules like it being your livelihood, you having a license for it, actually making a profit from it, etc. Make sure you think about this first step before rushing down the path of business deductions. There’s a reason the majority of IRS audits are over disputed business expenses.

  11. Trai_Dep says:

    I’ve heard one of the main reasons people launch (usually failing) restaurants is that they want the enviable ability to travel the world, gorging on the finest cuisine there is, then write it off at the end of the year.

    SIgh. I tried that for raves, loose women, booze and drugs. But unfortunately, “Life of the Party” isn’t a credible occupation. Curse auditors for their lack of imagination!

  12. Eilonwynn says:

    While I’m in Canada and virtually all of that is in some way different, I can heartily advise getting some professional to do it for you. At the end of the year, I hand a great big box of stuff over to my accountant, and she somehow gets me money back. It’s magic. I know, because I see her tears when I hand her the box, and they must be the source of the magic.

  13. Mr. Gunn says:

    Yeah, that whole “you have to be making a profit from it” thing is such a drag, eh?

  14. bustit22 says:

    The tax cat shtick is pretty annoying….

  15. Techguy1138 says:

    @Mr. Gunn: That can’t be true since it takes a business many years to make a profit.
    So you can not write off any business startup costs because you don’t turn a profit in the first year?

    Yeah there is a lot of bad tax advice on the internet.
    That said if you have a business get a CPA.

  16. Techguy1138 says:

    @bustit22: I love the tax cat.
    I’d hire that cat as my accountant if it was a cpa.

  17. lemur says:

    Every now and then, I hear tall tales about how so and so was able to deduct yacht, big screen TV, pool, monster truck from taxes by writing them off as business expenses although the business has no need for those things. Usually, it is not a direct source but more like the man who saw the man who saw the bear so the details have been enhanced or distorted through retelling. Or the story is half-told. It’s like the close friends who were telling me they had a sure way to beat the stock market and then I found through the grapevine that they suffered a huge net loss in the market. Guess the sure method did not work after all.

    You hear about those trick while they are working well, i.e. before the shit its the fan, but after the shit hits the fan, you only hear about that by accident.

  18. lemur says:

    @Techguy1138: You have to operate the business with the intent of making a profit but you do not actually have to make a profit every year. See:

    [www.irs.gov]

    Especially:

    This chapter covers the general rules for deducting business expenses. Business expenses are the costs of carrying on a trade or business and they are usually deductible if the business is operated to make a profit.

    Lower on that page there’s a section that goes:

    In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:

    * You carry on the activity in a businesslike manner,
    * The time and effort you put into the activity indicate you intend to make it profitable,
    * You depend on the income for your livelihood,
    [… and so on …]

    There’s a series of factors they use to determine whether you are operating to make a profit or not. Basically, if you are not serious about your business, they can decide that you are not operating it to make a profit.

    Every now and then I hear from people saying they’ll just register a company and put living expenses as business expenses and make a killing with tax deductions. It does not work that way. If your business is not a serious business, the IRS won’t allow those deductions. And yes, their decision can be retroactive. So someone may be able to do it for a bit and then gets audited and is hit with back taxes and a fines. As I was saying in my previous post, you hear about that kind of story only as long as the fraud has not been uncovered.

  19. StevieD says:

    Free Advice.

    Psst, want some Free Advice?

    Hey Mister, want some Free Advice?

    Your local state or private university usually offers an outreach program for small business startups. The documents provided and the staff usually come from the university’s business or accounting programs. It isn’t totally free, but it is as close to free as you are going to get for decent information.

  20. FreemanB says:

    No, you don’t have to make a profit to have something be considered a business expense. However, if you consistently lose money over a period of several years, the IRS can decide to classify your business as a hobby instead. There are other factors involved in their determination as well, but I don’t remember them all. This rule was put into place to prevent some people from using their hobby to offset their real income. It is most common to see in “businesses” such as dog breeding, small hobby shops(If you are the primary customer of your own business, then it is a hobby), and other things like that. You can always fight any such classification, but losing money in a business doesn’t automatically disqualify it. If so, GM would have been classified as a hobby years ago.

  21. @consumersaur: The ordinary and necessary stuff above (and associated reduction in income) is about businesses, not about individuals. You can possibly deduct it (consult the software/tax pro of your choice), but not straight off income. At the standard 15% of expenses (and I think there is a standard rate for mileage that factors fuel and cost of ownership). Again, DO NOT GET TAX INFO FROM COMMENT BOARDS ON THE INTERNET. Stakes is too high.

  22. funny thing about ordinary and necessary.
    Say you are an actor or film writer. You can deduct as ordinary and necessary:
    Union Dues
    Movie Tickets (research)
    Your large screen, flat panel TV (research)
    Museum memberships/access fees (research)
    Gym membership (if you’re an actor)
    Teeth Whiting (actor)
    Hair styling (actors)
    computer (writer)
    software (writer)
    electricity (writer)
    and all kinds of weird entertainment stuff. Oh yeah, I forgot.
    TRAVEL (it’s research) and all things associated.

  23. forever_knight says:

    i don’t get the cat picture obsession.

  24. lemur says:

    @PotKettleBlack: You are oversimplifying. Actors and writers who are self-employed can deduct some of the expenses you are listing. Those who are working as employees also can but if and only if their employer is not specifically reimbursing those expenses. All of the expenses deducted by a self-employed actor or writer must be clearly tied to their work. Again, the best source is the IRS:

    [tinyurl.com]

    [Pasting the URL straight in did not work well so I created a tiny URL for it but that point to the IRS.]

    Cable TV, Movies and Theatre tickets

    Internal Revenue Code section 274 places strict limits on deductions for items which are “generally considered to constitute amusement, entertainment, or recreation.” Such items are thus deductible only where there is a clear tie to particular work.

    Appearance and Image

    Taxpayers in the entertainment industry sometimes may incur expenses to maintain an image. These expenses are frequently related to the individual’s appearance in the form of clothing, make-up, and physical fitness. Other expenses in this area include bodyguards and limousines. These are generally found to be personal expenses as the inherently personal nature of the expense and the personal benefit far outweigh any potential business benefit.

    No deduction is allowed for wardrobe, general make-up, or hair styles for auditions, job interviews, or “to maintain an image”.

    So not all movie tickets are deductible. Doing general research is not “particular”. An example of a deductible expense would be a self-employed movie reviewer who has to buy tickets to see the movies he reviews. The reviewer however cannot deduct the tickets for his wife and kids and cannot deduct the snacks. An actor who just wants to see the latest blockbuster cannot deduct any of the expenses.

    And clearly whitening teeth, hair styling and going to the gym are not deductible expenses.

  25. Techguy1138 says:

    @lemur: Is it really clear that teeth whitening and a gym membership would not be allowed for an actor?

    Those are both reasonable expenses for an actor?

    Hair styling seems like a definite if you get a style tied to a particular audition.

  26. Techguy1138 says:

    @Techguy1138: I guess I just don’t guess why the irs allows and doesn’t allowe certain deductions.

  27. CumaeanSibyl says:

    Please don’t listen to the haters. I love Tax Cat.

  28. lemur says:

    @Techguy1138: I quoted straight from the IRS web site. If you don’t believe what I quoted, call the IRS and argue with them.

  29. GearheadGeek says:

    @Techguy1138: His quote would seem to indicate that those are specifically ALLOWABLE for actors.

  30. FinanceGuru says:

    Teeth whitening and hair styling don’t even pass the straight face test for deductibility. That’s a far lower standard than more-likely-than-not under 26 USC §6662.