If you read the Internal Revenue Code (and you probably don’t want to!), you may be surprised to find that most small business tax deductions aren’t specifically listed. It doesn’t explicitly state that you can deduct office supplies, the home office tax deduction itself and several other expenses.
Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162. This section states you can write off
“all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance costs for business would be an ordinary expense in the retail industry.
A necessary expense is defined as one that’s helpful or appropriate. For example, let’s say a car dealership purchases an automatic defibrillator. It may not be necessary for the operation of the business, but it might be helpful and appropriate if an employee or customer suffers a heart attack.
It’s possible for an ordinary expense to be unnecessary — but, in order to be deductible, an expense must be ordinary and necessary.
In addition, a deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. Keep in mind that with the Tax Cuts and Jobs Act, there is an update to the accounting rules for meals and entertainment. With this new law, they are eliminating most deductions for entertainment expenses but retaining the 50% deduction for business meals.
Not surprisingly, the IRS and courts don’t always agree with taxpayers about what qualifies as ordinary and necessary expenditures.
In one case, a man engaged in a business with his brother was denied deductions for his private airplane expenses. The U.S. Tax Court noted that the taxpayer had failed to prove the expenses were ordinary and necessary to the business for it to count as a tax deductible travel expense. In addition, only one brother used the plane and the flights were to places that the taxpayer could have driven to or flown to on a commercial airline. And, in any event, the stated expenses including depreciation expenses, weren’t adequately substantiated, the court added. (TC Memo 2018-108)
In another case, the Tax Court ruled that a business owner wasn’t entitled to deduct legal and professional fees he’d incurred in divorce proceedings. In this case he was defending his ex-wife’s claims to his interest in, or portion of, distributions he received from his LLC. The IRS and the court rule that legal fees used in dividing a business in a divorce are nondeductible personal expenses and aren’t ordinary and necessary. (TC Memo 2018-80)
The deductibility of some expenses is clear. But for other expenses, complications can arise. When reviewing business expenses, if one seems like it’s not normal in your industry you should proceed with caution. Same caution should be taken if it can be considered fun, personal or extravagant in nature. And keep records to substantiate the expenses you’re deducting. Consult with our accounting team for guidance on your small business tax considerations.