Handbook / Business deductions

What "ordinary and necessary" business expenses mean

Almost every guide to business deductions starts with the same phrase: the expense must be "ordinary and necessary". It is the basic test the IRS uses for whether business costs are deductible. Understanding it helps you claim what you are entitled to and avoid deductions that would not stand up.

The basic rule

The IRS explains that to be deductible, a business expense must be both ordinary and necessary. Publication 334, the IRS tax guide for small business, uses the same definitions:

• Ordinary: an expense that is common and accepted in your trade or business.
• Necessary: an expense that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

Both parts must be met.

Applying "ordinary"

Ordinary does not mean frequent or small; it means the kind of expense businesses like yours generally have. Design software is ordinary for a graphic designer. Tools are ordinary for a handyman. Grooming supplies are ordinary for a pet groomer. An unusual expense for your field is not automatically disallowed, but you should be able to explain why it is accepted practice.

Applying "necessary"

Necessary is a lower bar than many people think. You do not have to prove you could not operate without it. A course that improves skills you use in your business, a subscription that saves time or a marketing cost that brings in clients can all be helpful and appropriate. Extravagant or unrelated spending is harder to justify.

Personal expenses are not deductible

Personal, living and family expenses are generally not deductible. Many costs are partly business and partly personal, such as a phone, internet, a vehicle or a home office. For these, deduct only the business portion and keep a record of how you worked it out. See phone and internet, vehicle expenses and home office setup.

Deductible now, or capitalised?

An expense can be ordinary and necessary but still not deductible all at once. Costs of items that last beyond the year, such as equipment, generally have to be capitalised and recovered over time through depreciation, unless an election such as the de minimis safe harbor or Section 179 applies. Costs of starting a business have their own rules; see startup costs deduction.

Special rules for some expenses

Some ordinary and necessary expenses have extra limits or record requirements:

• business meals
• travel expenses
• business gifts
• vehicles and mileage; see standard mileage rate

Always check the specific rules as well as the general test.

Questions to ask about any expense

1. Is this common for businesses like mine?
2. Does it help my business earn income or operate?
3. Is any part of it personal?
4. Does it last beyond this year, so it may need to be capitalised?
5. Does a special rule apply?
6. Do I have records showing what it was and why it was for business?

Records

The IRS says supporting documents for expenses should identify the payee, the amount paid, proof of payment, the date incurred and a description showing the amount was for a business expense. A bank statement alone may not show what you bought. Keep receipts and invoices, and add a short note when the business purpose is not obvious. See receipt tracking.

Where expenses go

Sole proprietors and single-member LLC owners report ordinary and necessary business expenses on Schedule C, in the categories the form provides, with other expenses listed separately. Hobby activities are treated differently; see hobby vs business.

Common mistakes

• deducting personal spending through the business
• deducting the full cost of mixed-use items
• deducting equipment at once without a valid election
• missing records for business purpose
• assuming that anything paid from the business account is deductible

When to get help

If an expense is unusual, large or partly personal, or you are unsure whether it should be capitalised, a tax professional can help.

Illustrations in words

A freelance writer pays for a research database used for client articles: common in the field and helpful, so it passes the test. A photographer buys a lens used only for paid shoots: also passes, though it may need to be capitalised. A consultant pays for a family holiday and calls it a business trip: personal, so it fails.

An expense is deductible when it is ordinary, meaning common and accepted in your field, and necessary, meaning helpful and appropriate, not indispensable; exclude personal parts, capitalise long-lived items unless an election applies, follow special rules and keep records.