Definition
Ordinary and Necessary Business Expenses refer to expenses incurred in the operation of a business that are considered both common (ordinary) and appropriate (necessary). These expenses can be deducted from a business’s income for tax purposes, thereby reducing the taxable income. The Internal Revenue Service (IRS) specifies that for an expense to qualify, it must be an ordinary expense, which means it’s common and accepted in the business trade or industry, and it must be necessary, meaning it is helpful and appropriate for the business. However, it need not be indispensable.
Examples
- Rent for Office Space: Leasing an office space for business operations is both ordinary and necessary, making it deductible.
- Employee Salaries: The salaries paid to employees for services rendered in the business.
- Utilities: Payments for electricity, water, and other utility services for the office.
- Supplies: Office supplies like paper, ink, and stationery.
- Marketing Costs: Expenditures for advertising and promotional activities intended to drive business.
- Travel Expenses: Business trips excluding personal pleasure trips—mileage, airfare, accommodation for business purposes.
Frequently Asked Questions
Q: What expenses are not considered ordinary and necessary?
- A: Any expenses incurred for personal reasons, or deemed extravagant, or unreasonable by the IRS, are not considered ordinary and necessary. This includes personal living expenses and extravagant claims like frequent lavish meals without substantial business justification.
Q: Are capital expenditures deductible as ordinary and necessary business expenses?
- A: No, capital expenditures like purchasing machinery, buildings, or significant equipment are not deductible immediately. They must be capitalized and depreciated over the useful life of the asset.
Q: How does the IRS determine if an expense is necessary?
- A: The IRS considers an expense necessary if it’s helpful and appropriate for the business. It need not be indispensable, but it should not be deemed frivolous or for any personal benefit.
Q: Can a business deduct charitable donations as ordinary and necessary business expenses?
- A: Charitable donations are typically deductible under specific tax rules, but they do not qualify as ordinary and necessary business expenses. They are categorized under charitable contribution deductions.
Q: What documentation is required to support a deduction of ordinary and necessary business expenses?
- A: Receipts, invoices, bank statements, and recorded explanations of the business purpose of the expense are advisable. Proper documentation is essential to substantiate claims on a tax return.
Related Terms
Capital Expenditures:
- Significant investments in assets like machinery, buildings, or equipment that provide long-term value and are capitalized and depreciated over time.
Deductible Expenses:
- Expenses that can be subtracted from gross income to reduce the amount on which taxes are owed.
Internal Revenue Service (IRS):
- The U.S. government agency responsible for tax collection and tax law enforcement.
Tax Deduction:
- An allowable deduction on a taxpayer’s income that reduces the amount of income subject to tax.
Depreciation:
- The process of allocating the cost of a tangible asset over its useful life.
Online Resources
- IRS Publication 535 - Business Expenses
- Internal Revenue Service Official Site
- Small Business Administration (SBA)
- Real Estate Tax Tips by IRS
References
- “Publication 535 (2022), Business Expenses.” Internal Revenue Service. https://www.irs.gov/publications/p535
- “Small Business and Self-Employed Tax Center.” Internal Revenue Service. https://www.irs.gov/businesses/small-businesses-self-employed
Suggested Books
- “J.K. Lasser’s Your Income Tax Professional Edition 2022” by J.K. Lasser Institute
- “Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes” by Tom Wheelwright
- “475 Tax Deductions for Businesses and Self-Employed Individuals” by Bernard B. Kamoroff CPA
- “The Book on Tax Strategies for the Savvy Real Estate Investor” by Amanda Han and Matthew MacFarland
Real Estate Basics: Ordinary and Necessary Business Expenses Fundamentals Quiz
### Which of the following is considered an ordinary and necessary business expense?
- [x] Rent for office space.
- [ ] Purchase of a building.
- [ ] Personal clothing.
- [ ] A vacation trip.
> **Explanation:** Rent for office space is an ordinary and necessary business expense because it is commonly incurred in business operations for providing workspace.
### Are donations to a charity considered ordinary and necessary business expenses?
- [ ] Yes.
- [x] No.
- [ ] Sometimes.
- [ ] Only for specific purposes.
> **Explanation:** Charitable donations are deductible under specific tax rules but do not qualify as ordinary and necessary business expenses.
### What is the primary condition for an expense to be considered 'ordinary' by the IRS?
- [x] It must be common and accepted in the business trade or industry.
- [ ] It must be essential.
- [ ] It must be extravagant.
- [ ] It must be for personal benefit.
> **Explanation:** An expense is considered 'ordinary' if it is common and accepted in the business trade or industry according to the IRS.
### Which expense qualifies for immediate deduction as an ordinary and necessary business expense?
- [x] Office supplies.
- [ ] Purchase of office furniture.
- [ ] New vehicle for business.
- [ ] Office renovation costs.
> **Explanation:** Office supplies qualify for immediate deduction as an ordinary and necessary business expense while capital expenses must be capitalized.
### How should a business treat extravagant meal expenses for tax purposes?
- [ ] Deduct fully as ordinary expenses.
- [ ] Capitalize them.
- [x] These should not be deducted as they are unreasonable.
- [ ] Treat them as a donation.
> **Explanation:** Extravagant meal expenses should not be deducted because they are considered unreasonable by the IRS.
### What is required by the IRS for a business meal to be considered a deductible business expense?
- [x] Proper documentation and a clear business purpose.
- [ ] High expense approval.
- [ ] Personal guest endorsement.
- [ ] Lavish setting.
> **Explanation:** Proper documentation and a clear business purpose are required for a business meal to be considered a deductible business expense.
### Which of these is NOT a characteristic of 'necessary' in IRS terminology for business expenses?
- [ ] Helpful.
- [x] Indispensable.
- [ ] Appropriate.
- [ ] Suitable.
> **Explanation:** The expense need not be indispensable but must be helpful, appropriate, and suitable for the business.
### What type of expense is the purchase of new machinery?
- [ ] Ordinary expense.
- [x] Capital expenditure.
- [ ] Indirect expense.
- [ ] Administrative expense.
> **Explanation:** The purchase of new machinery is considered a capital expenditure, which is not immediately deductible.
### Can personal expenses be claimed as a deduction under ordinary and necessary business expenses?
- [ ] Always.
- [ ] Occasionally.
- [ ] If they relate to business justification.
- [x] No.
> **Explanation:** Personal expenses cannot be claimed as deductions as they do not qualify as ordinary and necessary business expenses.
### Which agency provides the guidelines for determining ordinary and necessary business expenses?
- [ ] Federal Reserve.
- [x] Internal Revenue Service (IRS).
- [ ] Securities and Exchange Commission (SEC).
- [ ] Department of Labor.
> **Explanation:** The Internal Revenue Service (IRS) provides the guidelines for determining ordinary and necessary business expenses.
