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- As a tax professional, I know well what the IRS means by "ordinary and necessary" business expenses that can be deducted on your taxes.
- These expenses include anything you need to run your business, such as equipment, fuel, and bookkeeping services.
- You may run afoul of the IRS if you deduct personal expenses cloaked in a business need, such as a family dinner where you briefly discuss your work.
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When I was learning about taxes in graduate school, I remember distinctly the words of my professor when describing deductible business expenses under the Internal Revenue Code Section 162:
"While Congress says all income is taxable unless they say otherwise, deductible business expenses under Section 162 are items of legislative grace, meaning that you are not entitled to such deductions. Congress grants them to you by way of dictating what's deductible per the Code.
When contemplating a deductible expense, there are three hurdles that you have to clear: (1) Is the expense deductible per the Code?, (2) Are the conditions that make the expense deductible met?, and (3) Can you actually take the deduction? (e.g. although you can deduct mortgage interest as an itemized deduction, if your itemized deductions are less than the standard deduction, you won't get a tax benefit from taking the mortgage deduction)."
I know it sounds mundane, but during my career as a tax professional, this lesson has served me well in helping clients understand their ability to deduct expenses and keep them from running afoul of the IRS.
As the saying goes, "Pigs get far, but hogs get slaughtered." Translation: Take the deductions you're entitled to, but be careful about being too aggressive or greedy. You're poking the sleeping bear (i.e. the IRS).
How does the IRS define 'ordinary and necessary' expenses?
Under IRC Section 162, taxpayers who are engaged in "trade or business" activities are entitled to deduct from their gross income certain expenses paid or incurred that are "ordinary and necessary."
To keep things simple, we're talking about all expenses that are customary in your industry that are needed in order for you to run your business. If you run a delivery business, the maintenance, fuel, and tolls associated with your delivery vehicles would be an ordinary and necessary expense. If you run a dog-walking business, dog treats, leashes, harnesses, dog training classes, and travel to and from client homes are all ordinary and necessary expenses.
Administrative expenses, including licenses, insurance, bookkeeping, office supplies to support your business, etc., and services of professionals that support your business, like periodic consultations with CPAs and attorneys, are all included as ordinary and necessary expenses.
What expenses might raise the ire of the IRS?
In general, the IRS is generous with the amount of items that business owners can deduct. However, with such broad latitude with deductions, some taxpayers tend to get greedy and blur the lines between what's deductible and what's not (or not deductible right now).
In my years of working with clients, I've often run into debates over what's deductible. Namely, a taxpayer wants to claim a deduction and I advise them that it would be wise for them to either not take the deduction, or not to take as much of it as they would like to.
This is not to say that a client is looking to commit tax fraud, it is more of a situation where a client is taking liberties with a deductible expense and aggressively applying it to a situation where it may not be applicable to their trade or business. Put simply, they are trying to take a nondeductible personal expense and make it deductible by classifying it as a business expense.
Here are a couple of examples that place taxpayers in the crosshairs of the IRS (based on my personal work experience):
Meals and entertainment
In general, meals with clients, networking coffees or lunches, and events where business is discussed or actively pursued are deductible at a cap of 50%. Staff appreciation events, like an annual holiday party, are 100% deductible. However, dinner out with the family, even if you are discussing your business the whole time, is not deductible.
Many taxpayers make the mistake of not documenting their meals — the date, amount spent, who were the participants, and what business was discussed. This is a critical piece of evidence needed to justify a tax deduction.
Typical deductible expenses include the higher of (a) the total amount of mileage driven in a given tax year times a promulgated rate (for 2020, it's 57.5 cents) or (b) the total of itemized automobile expenses, such as gas, tolls, parking, maintenance, or repairs (based on the amount used for business). Documentation of such mileage or expenses is necessary as well.
Many taxpayers try to deduct the cost of personal car usage and even try to double dip by attempting to deduct personal car note payments or car lease payments (with the rationale that the car is being used for business purposes).
Remember that ordinary and necessary travel is eligible for deduction. If you're a local hairdresser, it will be difficult to justify a travel expense. If your profession does annual conventions, the travel expenses and cost of the convention are, in fact, deductible.
However, if you try to blend in a family vacation or getaway, be sure to properly separate personal from business expenses to avoid scrutiny.
This is a big issue with many of my clients in the real estate business. Expenditures for capital improvements (roof replacements, new appliances, bathroom or kitchen remodel, etc.) are typically subject to depreciation, where the expense is recognized and deducted over time (in some cases, as long as 27.5 to 39 years). Many clients are disappointed to hear this, but it's the law. In contrast, repairs are fully deductible. That's why it's important to consider the "repair versus replace" decision carefully.
I am all for maximizing deductions so that you can pay the minimum amount of taxes possible. However, remember that "hogs get slaughtered," and it's better to not poke the sleeping bear that is the IRS. It gets real when that large white envelope from the IRS shows up in the mail, so keep sound records, document your expenses, and only deduct your fair share.
Sharif Muhammad, MBA, CPA, MST, CFP, is the founder and CEO of Unlimited Financial Services LLC, a certified public accounting firm in New Jersey.
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