The Internal Revenue Service defines a business expense as ‘ordinary’ and ‘necessary’. Ordinary expenses are those costs typically incurred in your industry. A restaurant would not ordinarily purchase vaccines. And a medical practice would not purchase 50 heads of lettuce. It is important to understand the concept of ordinary.
Necessary expenses are those costs you must incur to fulfill your mission or purpose as a business operation. Often, small business owners try to deduct some personal expenses as business expenses. These include cell phone plans, personal transportation expenses, some medical expenses, and entertainment expenses. In the eyes of the Internal Revenue Service (IRS), these types of expenses are not deductible for business purposes because they fail to meet the mission or purpose of the business.
What is deductible for the small business owner? What are items that the IRS scrutinizes when reviewing business deductions? How does a small business owner substantiate the deductibility of marginal expenses? The sections below explain ordinary and necessary business expenses, provides instructions to substantiate and pass the scrutiny of the IRS rules and regulations.
The primary reference source for this article is Publication 535 from the Internal Revenue Service: IRS Business Expenses.
The IRS classifies costs into four categories. The first are those monies spent on ‘Cost of Goods Sold’. The second category is termed ‘Capital’. The third category is the traditional deductible expense, and the final category is identified as personal. Almost every expenditure for a business falls into one of these four categories. The following describes and illustrates each category and how the IRS addresses this category:
Cost of Goods Sold – if your business resells a physical product produced from raw or process materials then the following types of costs are included in the cost of goods sold:
- Raw or process materials used to manufacture or provide as a product for sale in your business.
- Labor to manufacture or get the item into the hands of the customer
- Delivery and storage costs associated with the item sold
- Production overhead costs – in many situations, these overhead costs are deducted as traditional expenses. As an owner of a small business operation you must understand that you may not deduct this expenditure twice (once in Cost of Goods Sold and then again in regular expenses).
Capital Expenditures – these expenses relate to items not resold to the public but used to manufacture the product, store the product, transport the product, or make the product available for sale. In general, these expenditures are significant in monetary value and the expenditure is spread out over time using depreciation, amortization, or depletion. See Small Business Tax Depreciation – Section 179 for more information. For a general introduction to depreciation, see Depreciation – This is Weird Accounting and The Various Forms of Depreciation.
Traditional Deductible Expenses – The following is a list of the traditional deductible expenses provided that they meet the tests of ordinary and necessary:
o Payroll – must pass the test of reasonable and for services performed. If you pay a family member and that individual does nothing for the company, then the deduction is not allowed.
o Payroll Benefits – in general most benefits are deductible if the benefits are available to all employees. Those benefits accruing to employees with a financial interest in the company are scrutinized to a greater degree. In general, life insurance for owners paid by the company is not deductible as an expense for the company.
o Rent and the associated costs including property insurance, real estate taxes, common area maintenance fees, utilities and maintenance (cleaning, minor repairs, pest control). Improvements are considered a capital issue and should be handled in that manner over the life of the lease.
o Interest paid to service debt and capital.
o Taxes – payroll, revenue, licenses, State income taxes, property and other forms of taxes.
o Insurance – only the insurance related to the business operations, property and employees is deductible. Insurance for the care of vested owners is not deductible e.g. health, life, vision, dental etc. There are strict guidelines on how to handle insurance for owner(s).
o Depreciation, Amortization & Depletion – see the other articles noted above.
Other Types of Expenses:
- Professional Fees (Accounting, Legal, Consulting)
- Banking (Credit Card Discounts, Transaction Fees, Account Fees)
- Transportation – vehicular operations, travel, travel reimbursements
- Lodging – it the lodging is for the benefit of the company and not personal in nature.
- Office Operations – printing, supplies, postage, documentation, shredding, security
- Marketing and Advertising
- Charity – special rules exist for the process of the deduction for S-Corporations and Partnerships; there are limits for all others
- Franchise and royalty fees
- Communications – phone, internet, web access cards, website etc.
- Personal Expenses – these expenses are generally considered non-deductible no differently than on your personal return. The key is that sometimes these expenses are marginally used for the business operation and therefore a reasonable individual would conclude that they should be deductible for the business. The following is list of the most common personal expenses that are often used in business and how they are handled by the IRS:
- Meals – the common taxpayer is not allowed to deduct any of his meals for tax purposes. Therefore, the IRS excludes the portion of the meal in a business meeting for the owner or employee of the company at that meeting. In general, one half of all meals (those allowed meals) are considered deductible. The meal must have a business purpose and be reasonable in nature. Eating steak at Ruth Chris Restaurants when you own a 3 man electrical repair company is unreasonable. Taking a potential customer to a family steakhouse is acceptable though. Alcohol is a tricky situation. One beverage per guest at the meal is considered reasonable; getting the customer drunk is not deductible.
- Personal use of the home – as long as the area is exclusively used for the purpose of business, the prorated share of cost is deductible. The taxpayer needs to exercise caution and be mindful the IRS can and will exclude the entire expense deduction if the taxpayer fails to prove beyond doubt the particular space is exclusively business. As an example, if you use a small bedroom for your desk and office but iron your clothes in that space, then the home expense deduction is not allowed.
- Health insurance premiums are not deductible for the company if paid on behalf of owners of the company. These premiums are passed through to the owners and are used as an adjustment on the front page of Form 1040. In some business situations, the premiums can be included in income of the owners via the W-2 and then are deductible expenses for the business.
- Memberships and Club Dues – not deductible for the business if they provide personal benefit to the owner, examples of dues that are deductible include memberships in chambers of commerce, business marketing clubs, social service clubs (Kiwanis, Rotary), professional organizations and business leagues
- Convention trips that include personal recreation – here the cost associated with the convention is deductible and the personal recreation is not. It is a gray area when dealing with this situation as there are very few discernible lines between the business element and the personal benefit. I strongly encourage clients to go personal if there is any doubt as to the deductible question.
Non-deductible expenses include the following:
- Governmental penalties and fines
- Lobbying Expenses
- Political Contributions
- Life Insurance premiums on behalf of an owner
- Executive Dining
- Certain research and start-up expenses when first planning and investigating your business
- Illegal activities including gambling losses in excess of winnings
In general Congress does not want to subsidize or support businesses that are failing. A taxpayer is allowed to take as a loss those costs considered ordinary and necessary if these expenses generate losses. However, many businesses push the marginal areas because they often benefit the owners in some form or fashion. It is here that the IRS monitors these expenses with a more thorough review. Unlike what most people believe, it isn’t an IRS audit that catches them, it’s the unreasonable nature of the expenses the small business takes that catches the attention of the IRS.
When a tax return is prepared, the taxpayer inserts a 6 digit business activity code on the front page of the return. Taxpayers need to realize the IRS receives thousands of the same business activity code returns; in effect you are not alone in what you do. Human nature tells us that out of 100 people, there is one that is honest to the bone. All the information is loaded into a database and aggregated. A reasonable set of guidelines is established for this particular industry. If your expenses exceed the industry standard beyond what is considered reasonable, your return is flagged for an initial human review. From here it is possible to receive a letter asking you to provide evidence to a particular one or two line items on your return. This is considered a line item audit. The taxpayer must send in copies of every receipt associated with the request and how the taxpayer considers the expenses ‘ordinary and necessary’ given the nature of the business.
If unable to prove ordinary and necessary, the IRS may push for a full audit. In general, penalties and fines can overwhelm a small business. The cost to professionally address the scrutiny of the IRS can often exceed the profit from a single year of operations. It is in your best interest to seek out and get help from a professional for marginal items in advance of filing your tax return.
Overall, the IRS pays attentions to those expenses related to the owner. They should see non-deductible expenses on a tax return. There should be profitability after being in business a few years and the owner should be reporting good income and paying taxes on that income. Items they address in detail include:
- Listed Property – Computers, Video, Communication Devices that could benefit the owner
- Vehicular expenses especially those attached to the owner’s personal vehicle
- Insurance items that directly benefit the owner
- Retirement expenses
- Miscellaneous expenses especially those that are cash based without substantiation
- Unreasonable travel expenses especially to more exotic resorts
In almost all situations dealing with deductible expenses, the criteria required are generally ordinary and necessary. But every now and then an expenditure occurs that the IRS will question. It is your responsibility as the owner to provide substantial evidence as to it necessity and demonstrate how it is actually ordinary in nature.
For the IRS, they are looking at how well you keep your business organized and how you track your expenses. I suggest using the following article for guidance: Create a File Structure for Accounting.
If your system of expense tracking is sound and you play by the rules (file returns timely, pay taxes on time, respond quickly to requests from the IRS) then they will treat you well. Having good staff well trained and respectful helps too. When it does come time for scrutiny by the IRS it is easy to respond and respond with great documentation. In most situations of scrutiny by the IRS for an unreasonable expense is because the business ran into an unusual situation and therefore sought out the best method to mitigate the circumstances. Once explained; the IRS looks at the totality of the situation and will endorse the expense. The following is an example:
Summary – Definition of Expense
For the small business owner, you need to realize that most expenses are legitimate and are deductible. Those expenses benefiting owners follow a different set of rules and guidelines. Any expense that is not ordinary and necessary is not deductible for the business. Another way to state this is: Why are you spending money on something that is not ordinary and necessary for the business? Adhere to good record keeping and remember the goal here, make a profit! Use the above information as a general guideline, get help for those items you do not understand fully and retain your documents for any inquiries. Act on Knowledge.