What is an “Ordinary and Necessary” Business Expense?

One of the most important advantages of owning your own business is the ability to deduct legitimate business expenses from the gross income generated by your business. Effectively deducting your valid business expenses can provide you with a lower taxable income for your business, as well as some valuable personal benefits for you as a business owner. For example, you can provide yourself with a company car for transportation or with a retirement plan that is sometimes deductable for tax purposes to the company. The problem is that determining the line between a legitimate business expense and personal expenses that generate a tax audit is a fine one.

The IRS describes deductable business expenses as both “ordinary and necessary” to qualify for deduction.

The IRS defines an “ordinary” expense to mean “one that is common and accepted in your trade or business.” A “necessary” expense is one that is “helpful and appropriate for your trade or business.” Indispensable is not a requirement to be necessary according to the IRS. The IRS deliberately left this language vague and indefinite to accommodate the innovative nature of business. Allowing legitimate deductions to be defined loosely allows business owners to change their methods and innovate to maximize profits. However, the vague nature of the IRS’ definitions sometimes cause confusion over what is considered an “ordinary” and “necessary” expense as business owners try and push the envelope of what the IRS will accept.

The limits of these terms are generally defined in two ways; by a publication of the IRS regulations or through court cases. The real line is between business and personal expenses. The IRS does not mind, and even encourages, business owners to deduct expenses such as a company car or portions of the cost of your home used for business. These deductions must be taken in proportion to the extent these items are used in furthering the business’ operations. Tax professionals frequently refer to a “laugh test” that allows business owners to take a deduction if it can be claimed without the business owner laughing about it’s absurdity.

It is important to distinguish between things that can be deducted and capital expenses. Capital expenses are items like business startup costs, assets, and improvements. Things in this category are considered assets for the business. Instead of deducting these costs all at once in the year they occur, these expenses must be “amortized”–gradually written off. This means that you extend the deduction from these types of business expenses over a longer period of time as your business’ assets lose value.

Help with Business Issues in New Jersey

These tax issues are just one of a string of concerns that all business owners must take into account in their day to day operations. From ensuring proper structuring of business agreements to defending against legal action by disgruntled employees, the best preventative measures always occur well before any incident or dispute arises. Understanding the basics of the legal landscape beforehand can save a mountain of stress, time, and money later.

In our area it is important to work with your local Burlington County business attorney as well as your financial and tax advisors to ensure all of these issues are handled properly and efficiently.