What is an "Ordinary" and "Necessary" Business Expense?

A.J. Cataldo, Ph.D., CPA, CMA
Northeastern University - Boston

For a business expense to qualify as deductible it must be

1. connected to the taxpayer’s trade, business or profession,
2. be an “ordinary and necessary” expense of this trade, business or profession, and
3. be paid or incurred during the tax year for which the deduction is claimed.

The first and third items are self-explanatory, but which expenses are “ordinary” and which expenses are “necessary?” Note that some courts have held that business expenses must not just be ordinary and necessary, but must also be “reasonable” in amount and in relation to the purpose or intent.

Ordinary business expenses

An ordinary business expense is one that is customary or usual in the taxpayer’s field of business. But even an unusual expense can be ordinary if reasonably related to the taxpayer’s trade or business.

Necessary business expenses

A necessary business expense is one that is appropriate and helpful toward the development and maintenance of the taxpayer’s business. It need not be essential or indispensable to be necessary. And it need not be wise. Taxpayer judgement is usually acceptable.

The “location” where business expenses are incurred – the home office

Having defined ordinary and necessary expenses that might be incurred in the maintenance of your office, consider the location of this office. What if the office was located in your personal residence? Would these business expenses cease to be ordinary and necessary? Of course they would not cease to be ordinary and necessary. However, the fact pattern or evidential circumstances surrounding the reasonableness of these expenses is relevant and must be considered.

Illustrations and cautionary notes on ordinary and necessary business expenses

It would not be reasonable to deduct the depreciation expense associated with the only refrigerator in your personal residence as an ordinary and necessary business expense. However, it may be appropriate to deduct the depreciation associated with the cost of a second refrigerator, preferably a more modest unit, located in your home office in the basement or attic of your personal residence and used exclusively for business purposes. In fact, a major factor used to determine the business nature of assets possessing the potential for personal use is the duplication of personal living expenses.

Therefore, a second video cassette recorder, a second television, a second refrigerator or microwave, and so on, might very possibly be appropriately expensed, depreciated and/or deducted, if these business assets are (1) located in the home office, and (2) used exclusively for business purposes. And, given the opportunity to deduct the cost of one of two such items, it would be advantageous to convert to or elect for business use the more costly of the two video cassette recorders, televisions, and so on, since no tax benefit and/or savings are associated with the non-business or personal assets.

In considering the depreciation deductions associated with personal property business use assets contained within the home office, it is essential that taxpayers recognize that restrictions imposed on the deductibility of home office expenses (i.e., personal residence depreciation, utilities, home insurance, and so on) do not apply. Deductions associated with the home office, per se (e.g., depreciation, utilities, and so on), and deductions associated with the personal property business assets contained within the home office are a very different topics. Therefore, a taxpayer need not qualify for home office deductions, per se (e.g., depreciation of business use percentage of your personal residence), to legitimately deduct the cost of supplies and personal property contained within. This is an important distinction as these issues are separable!

Summary

When considering the ordinary and necessary nature of your business expenses, consider the practices of large corporations. If they can deduct an office bar and other personal property items more typically associated with the consumer's home (e.g., television, VCR, cable hook-ups, and so on), then you should also be provided with deductions for these business expenses. However, in doing so, consider the establishment and maintenance of “profit motive.” It would, in other words, probably be unreasonable to completely refurbish your home office with creature comforts in the presence of persistent and significant losses from self-employment. For additional guidance on ordinary and necessary business expenses, see Internal Revenue Code Section (IRC§162(a)).

“At risk” limitations have not been addressed, but may be reviewed at IRC§465(a)(1). Generally, at risk rules relate to taxpayers subject to passive activities or passive activity loss limitations and those subject to filing the IRS Form 6198. “At risk” rules were designed to prevent taxpayers from generating tax shelter-type tax losses that really do not reflect the economic reality of a transaction, so “at risk” means just that. You may be restricted or limited to deductions for expenses that you are not, personally, “at risk” for. If you are not involved in partnerships, S corporations, limited liability companies or other entities with Schedule E “pass-through” items or other entities designed to provide tax shelter-type deductions, do not concern yourself with anything beyond a very basic understanding of the “at risk” rules.

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