Ordinary and necessary expenses are those incurred by individuals in the course of owning a business or engaging in trade activities. These expenses play a crucial role for income tax purposes as they are generally tax-deductible in the year they are incurred.
Outlined in Section 162(a) of the Internal Revenue Code, these expenses must meet criteria for business relevance and necessity. Though the IRS does not publish exhaustive lists of what constitutes ordinary and necessary expenses, it is up to the taxpayer to determine their eligibilities.
Key Insights for Maximizing Tax Purposes
- Ordinary and necessary expenses typically reflect costs related to running a business.
- Common examples include business-related software and rental expenses.
- Parts of your home used for business purposes may be eligible for tax deductions.
Understanding Ordinary and Necessary Expenses (O & NE)
This section of the tax code is pivotal in enabling numerous deductions, especially during career transitions. Typical expenses under this category can include business uniforms or software for a home computer.
Startup costs for new businesses can be deductible, often spread over years, designated as capital expenses rather than ordinary and necessary ones.
What Qualifies as Ordinary and Necessary?
The IRS defines an “ordinary” expense as one that is common and accepted in your trade or business. A “necessary” expense, on the other hand, is viewed as helpful and appropriate, though not necessarily indispensable.
Key Examples Include:
- Employee Compensation: Wages or salaries paid to employees for their services.
- Retirement Plans: Funds allocated to employee-sponsored retirement plans such as 401(k), 403(b), SIMPLE, and SEP plans.
- Rental Expenses: Costs for leased properties, excluding those where the business owner holds equity or title.
- Taxes: Local, state, federal, or foreign taxes directly attributable to a business.
- Interest: Interest expenses on borrowed money for business activities.
- Insurance: Any professional insurance policies acquired for the business.
In essence, “ordinary” expenses must be common within your industry, while “necessary” expenses should be both appropriate and ordinary to qualify for tax deductions.
Leveraging the Business Use of Your Home
Business owners may deduct expenses related to portions of their home used for business, including utilities, mortgage interest, and repairs. To qualify, owners must demonstrate their home as their principal place of business, even if ancillary activities are conducted elsewhere. Deductions are based on the home area dedicated to business use.
Overall, strategically understanding and documenting ordinary and necessary expenses can provide significant tax benefits, aiding in a more streamlined and financial-efficient business operation.
Related Terms: tax deduction, Internal Revenue Code, SIMPLE IRA, SEP IRA.
References
- Internal Revenue Service. “Deducting Business Expenses”.
- U.S. House of Representatives, Office of the Law Revision Counsel. “26 USC 162: Trade or business expenses”.
- Internal Revenue Service. “Publication 535 (2019), Business Expenses”.
- Internal Revenue Service. “Publication 587 (2018), Business Use of Your Home”.
