Ordinary & Necessary Expenses Definition

Ordinary & Necessary Expenses Definition
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As businesses prepare their income taxes, they may be puzzled by the term “ordinary and necessary expenses.” Among the criteria for determining whether expenses are business deductions, they must pass the test of being “ordinary and necessary.” The term simply means that the expense is commonly accepted and is helpful and appropriate to the trade in which your business is operating.

Ordinary and Necessary Definition

If you run a business, you can deduct your expenses each year. Your business-related expenses reduce your business’s taxable income, so by capturing as many expenses as possible, you may be able to dramatically reduce your tax burden. But it can be tough to know exactly what qualifies as a deductible business expense under IRS rules.

The top criterion the IRS lists is that the expense must be “ordinary and necessary.” The definition they give of ordinary is that it must be “common and accepted in your trade or business.” Necessary, on the other hand, is an expense that is “helpful and appropriate for your trade or business.”

One area of confusion is with the word “necessary.” The IRS is careful to emphasize that an expense does not have to be indispensable to fall under the header of “necessary.” It is simply something that is widely accepted to be a business expense in your industry.

Ordinary and Necessary Expenses Examples

While you’re gathering your business tax information, it’s important to look at examples that the IRS considers ordinary and necessary. This is not an either/or setup. The expense must be both ordinary and necessary to qualify as a business expense.

Here are some examples of ordinary and necessary examples for a service-based business:

  • Payroll and retirement plans
  • Rent for leased space used solely for your business
  • Office space in your home used solely for business activities
  • Marketing expenses such as printing, postage and online advertising
  • Signage for retail locations
  • The cost to get products to customers

Who Can Claim Business Expenses?

Taxpayers who operate a business to make a profit can claim a deduction. You don’t have to incorporate or register your business, but it is important that you be able to differentiate your business from a hobby. A crafter can’t claim the cost of supplies unless those crafts are being sold, but if that crafter is selling those items, that person could easily fall under the header of being self-employed.

The IRS does not require you to be engaged in your business full-time to be considered self-employed. You don’t have to make a profit every year, but your activities must be considered to have a “profit motive,” according to the IRS. If you make more than $400 a year on your business or self-employment venture, you have to pay self-employment tax and file Schedule SE.

Operating Versus Capital Expenses

There’s another category of business expenses that you can claim, but not as an ordinary and necessary operating expense. These are known as capital expenses. The biggest difference between an operating expense and a capital expense is that an operating expense is something that brings benefits to your business only in the current tax year, while a capital expense brings rewards down the road.

A capital expense, for instance, may be business equipment or upgrades you make to your retail space. These investments will hopefully increase the money your business makes on an annual basis well into the future. Startup costs for a new business also fall under the header of capital expenses. You can choose to take these as one-time deductions or amortize them.

Deducting Cost of Goods Sold

Businesses that sell products deal with an additional complication: deducting the cost of goods sold. Generally speaking, the IRS expects you to value your inventory at the start and end of each tax year. If some of your business tax deductions were put toward selling those goods, you can also factor those in to arrive at your cost of goods sold.

At tax time, you subtract your cost of goods sold from your gross receipts, which gives you your business’s gross profits for the tax year. It’s important to note that any expenses you included in the cost of selling those goods cannot be taken as a tax deduction elsewhere on your tax filing.

Deducting Partly Personal Expenses

In general, anything you purchase solely for personal use isn’t deductible for your business. However, there may be some necessary business expenses that you use both personally and professionally. If you drive your personal car to meetings, for instance, it’s a necessary and ordinary business expense that you also use personally.

To deduct a business expense for something you also use personally, calculate the percentage of its use that is dedicated to your business. You would deduct only the percentage used for business on your taxes. If you work out of your home, you can either use the simplified method or actual expenses method. The simplified method uses a worksheet, while the actual expenses method has you calculate your living costs for that square footage.

Deducting business use of your personal vehicle is a little more complicated. You can choose from two methods: standard mileage rate or actual car expenses. The standard mileage rate has you tracking your business miles and deducting that, while the actual car expenses method has you tallying up the business portion of operating expenses, including fuel, maintenance, repairs, tolls and lease payments.

How to Claim Business Expenses

The first thing you need to do if you’re claiming business expenses is to keep receipts. You can download an app that lets you easily scan them and store them or keep paper receipts in a folder. The app may be a better option if you regularly claim travel expenses since it keeps you from having to manage paperwork while you’re on the road.

When it’s tax time, you input your business expenses on the form that’s appropriate for your business type. Sole proprietors and LLCs use Form 1040 Schedule C, while S Corporations use Form 1120-S. For business use of your home, you need Form 8829, which walks you through the calculations necessary.

Depreciating Larger Assets

If you make a large purchase in a tax year, depreciation may work out better for you. The IRS lets you depreciate certain assets, which means you divide the cost over multiple tax years to reduce your tax burden over time, rather than having it all in the same year. To qualify for depreciation, the asset must have a useful life of more than a year and pass the other requirements to be claimed as a business expense.

To depreciate an asset, you need to determine the useful life of the property, then divide the cost over that timeframe. You can opt to use the following methods for depreciation:

  • Straight-line depreciation: This method splits the cost evenly over the timeframe.
  • Double-declining balance depreciation: With this method, you take the bulk of the expense in the first year, then decline it in value over subsequent years.
  • Modified Accelerated Cost Recovery System depreciation: This method uses the IRS’s MACRS to calculate what you claim each year.

In order to claim a business expense as a deduction on your taxes, you need to first be able to demonstrate that you're working with a profit motive in mind. Each expense also has to pass the ordinary expense and personal expense test. If there are questions about an expense’s qualifications as a business expense, you may face an audit, so it’s important to be able to demonstrate the business purpose of each expense before you claim it.