Ordinary and necessary expenses: Meaning, Criticisms & Real-World Uses

What Are Ordinary and Necessary Expenses?

Ordinary and necessary expenses are costs incurred by individuals or businesses that are common and accepted in their specific trade or business, and are also helpful and appropriate for conducting that business. These expenses fall under the broader financial category of tax deductions, as they are generally deductible from gross income to arrive at taxable income for tax purposes. An expense does not need to be indispensable to be considered necessary; rather, it must be appropriate and helpful. Understanding what qualifies as an ordinary and necessary expense is crucial for accurate financial reporting and minimizing tax liabilities. These expenses are fundamental to calculating a business's true business income.

History and Origin

The concept of ordinary and necessary expenses has deep roots in U.S. tax law, primarily deriving from Section 162(a) of the Internal Revenue Code. This foundational section permits deductions for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."²⁷ While the statute itself does not explicitly define "ordinary" or "necessary," their meanings have been shaped over decades through court decisions and administrative guidance from the Internal Revenue Service (IRS).²⁵, ²⁶

Early interpretations and subsequent legal battles helped solidify the understanding of these terms. For instance, the Supreme Court has clarified that an "ordinary" expense is one that is common and accepted in the particular business community, and a "necessary" expense is one that is appropriate and helpful, even if not absolutely essential. This evolving interpretation has provided a framework for taxpayers to determine legitimate deductions, emphasizing the importance of the expense's purpose and its direct relation to the business.²³, ²⁴

Key Takeaways

Ordinary and necessary expenses are business costs that are common and accepted in an industry, and helpful and appropriate for the business's operation.
These expenses are generally tax-deductible, reducing a business's taxable income.
The criteria for ordinary and necessary are established by Section 162(a) of the Internal Revenue Code and clarified through IRS guidance and court rulings.
Examples include salaries, rent, insurance, office supplies, and professional fees.
Proper documentation of these expenses is critical for substantiation, especially during an audit.

Interpreting Ordinary and Necessary Expenses

Interpreting what constitutes an ordinary and necessary expense requires careful consideration of the specific trade or business. An expense deemed "ordinary" for one industry might not be for another. For example, the cost of specialized equipment for a construction company would be ordinary, but the same equipment would not be ordinary for a law firm. Similarly, a "necessary" expense is one that directly supports the business's ability to generate income. This does not mean the expense must be strictly required, but rather that it contributes to the business's operations or profitability.²¹, ²²

The IRS provides detailed guidance in publications such as IRS Publication 535, Business Expenses, which outlines many common deductible business expenses and the general rules for deducting them.²⁰ Ultimately, the taxpayer bears the responsibility of demonstrating that an expense meets both the ordinary and necessary criteria, often by showing its direct relation to the business operations.

Hypothetical Example

Consider Sarah, a freelance graphic designer operating as a sole proprietors. In a given year, she incurs various costs to run her business.

Office Supplies: Sarah buys new pens, paper, and ink cartridges for her home office. These are common and accepted items for a graphic design business and are helpful for her daily work. This would be an ordinary and necessary expense.
Software Subscription: She pays an annual subscription fee for industry-standard design software. This software is widely used by graphic designers and is essential for her to perform her services. This qualifies as an ordinary and necessary expense.
Client Meeting Travel: Sarah travels to a nearby city to meet a potential new client, incurring mileage and a small parking fee. This travel is appropriate and helpful for securing new business, making it an ordinary and necessary expense.
Personal Spa Day: Sarah also spends money on a spa day to relax. While beneficial for her personal well-being, this expense is not directly related to her graphic design business and would not be considered ordinary and necessary for tax deduction purposes.

For the deductible expenses, Sarah would track these costs, which would then reduce her business's taxable income reported on her Schedule C, a common form for sole proprietors.

Practical Applications

Ordinary and necessary expenses are crucial for all types of businesses, from small businesses and sole proprietorships to large corporations. They appear in several practical applications:

Tax Compliance: Businesses deduct ordinary and necessary expenses to reduce their overall tax liability. This is recorded on a profit and loss statement to calculate net income.
Budgeting and Financial Planning: Understanding these core expenses allows businesses to forecast cash flow more accurately and make informed budgetary decisions.
Investment Analysis: For investors, analyzing a company's ordinary and necessary operating expenses provides insight into its efficiency and profitability.
Legal and Professional Services: Fees paid for accounting, legal advice, or consulting services directly related to the business are considered ordinary and necessary.¹⁹
Advertising and Marketing: Costs associated with promoting the business, such as website development or online ad campaigns, are typically deductible.
Interest Expense: Interest paid on business loans or credit cards used for business activities is generally deductible. Recent legislative changes, such as those introduced by the One Big Beautiful Bill Act (OBBBA), have influenced how businesses can deduct interest, particularly affecting calculations of adjusted taxable income (ATI) for interest expense limitations.¹⁸

Limitations and Criticisms

While the concept of ordinary and necessary expenses allows for significant tax deductions, it comes with notable limitations and has faced scrutiny. One key limitation is the IRS's broad definition, which leaves room for interpretation and potential disputes. The agency does not provide an exhaustive list of what qualifies, instead relying on the taxpayer to make the initial determination based on whether the expense is "common and accepted" and "helpful and appropriate."¹⁷ This subjective nature can lead to challenges, particularly during an IRS audit, where taxpayers must adequately substantiate their claims with detailed financial records.¹⁵, ¹⁶

Another common area of dispute involves expenses that have a dual business and personal use, such as a home office or vehicle expenses. While portions directly related to business are deductible, separating these from personal use can be complex and requires meticulous record-keeping. The IRS closely scrutinizes deductions that appear to be primarily for personal benefit.¹³, ¹⁴ Furthermore, the "reasonableness" of an expense can also be a factor, even if it meets the ordinary and necessary criteria. Excessive payments, even for otherwise deductible items, may be disallowed by the IRS or challenged in tax court.¹²

Ordinary and Necessary Expenses vs. Capital Expenses

Ordinary and necessary expenses are distinct from capital expenses, although both represent costs incurred by a business. The primary difference lies in their benefit period and how they are treated for tax purposes.

Ordinary and necessary expenses are typically recurring, short-term costs that are consumed or benefit the business within the current tax year. These are considered operational costs, such as monthly rent, utilities, salaries, office supplies, and advertising. They are fully deductible in the year they are incurred.¹⁰, ¹¹

In contrast, capital expenses (also known as capital expenditures or CapEx) are investments in assets that provide long-term benefits to the business, generally extending beyond one year. Examples include purchasing a building, machinery, vehicles, or making significant improvements to existing property. Instead of being fully deducted in the year of purchase, capital expenses are capitalization and their cost is recovered over their useful life through depreciation or amortization.⁹ This distinction is crucial for accurate accounting method and financial reporting, as it impacts a business's balance sheet and income statement over multiple periods.

FAQs

What does "ordinary" mean in this context?

An "ordinary" expense is one that is common and accepted in your specific trade or business. It doesn't mean the expense happens frequently, but rather that it is typical for businesses in your industry.⁸

What does "necessary" mean for tax deductions?

A "necessary" expense is one that is helpful and appropriate for your trade or business. It doesn't have to be indispensable or absolutely required, just useful to the business's operation.⁷

Can personal expenses ever be considered ordinary and necessary?

No. Expenses must be directly related to and incurred for a trade or business. Personal, living, or family expenses are generally not deductible, even if they might indirectly benefit a business.⁵, ⁶

What kind of records should I keep for ordinary and necessary expenses?

It is crucial to keep accurate and detailed financial records, including receipts, invoices, canceled checks, and ledgers, to substantiate all claimed expenses. These records should show the amount, date, purpose, and the business relationship for the expense.³, ⁴

Is there a limit to how much I can deduct as ordinary and necessary expenses?

While there isn't a specific dollar limit in the tax code for total ordinary and necessary expenses, the expenses must be "reasonable" in amount. Excessive payments for goods or services may be questioned. Additionally, certain types of expenses, like meals and entertainment, have specific deduction limits.¹, ²