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Business Expenses Must Be ‘Ordinary and Necessary’

Oct 31st 2016
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Many businesses have learned the hard way that just because they incur expenses for business reasons it doesn’t mean those outlays automatically qualify as deductible. Code Section 162 mandates that these expenditures are allowable only if they pass a two-step test. The first requirement is that they’re “ordinary.” The second is that they’re “necessary.”

Both the IRS and the courts have characterized “ordinary” expenses as those that are customary or usual. Understand that they needn’t be customary or usual for the taxpayer, as long as they’re customary or usual for the taxpayer’s particular trade, industry, or community.

The US Supreme Court held that even a one-time-only expenditure falls within the definition. Likewise, the Court of Appeals for the 2nd Circuit, a tribunal one rung below the Supreme Court, defined “necessary” as “appropriate” and “helpful,” rather than necessarily essential to a taxpayer’s business.

But gray areas abound, which accounts for the reasons so many ordinary-and-necessary disagreements get kicked around in IRS administrative rulings or resolved by the courts.

Most businesses that take their disputes to court opt for the Tax Court. Going that route allows them to have their cases heard without having to first pay the taxes in issue. Of course, if they lose, they then pay the taxes, plus interest and any penalties.

Distinguishing between business and pleasure. The Tax Court had an easy time with J. Michael Springmann, ex-commercial attaché at the US Embassy in New Delhi. It decreed no deductions for payments to the diplomat’s servants, regardless of his need to maintain his social standing in cast-conscious India. It was similarly unimpressed with a lawyer/CPA who argued that the red, white, and blue pennant bearing the number “1040” he flew over his boat was a gimmick that generated tax clients.

A judge’s one-liner that “hope springs eternal in the heart of the American taxpayer” might have served as the inspiration for a Los Angeles physician who deducted payments to his children for answering the telephone at home. Predictably, the Tax Court saw nothing special in his situation and reminded him that “children normally answer the family home telephone.”

The court ruled that the IRS was mistaken when it prohibited professional athletes from deducting costs incurred to answer fan mail. The dispute in this case involved a hockey player. It was immaterial, the court decided, that his contract didn’t require him to answer letters.

Even those IRS spoilsports are sometimes willing to make distinctions. A remodeling firm’s president sought an IRS OK for deducting his payments for transcendental meditation seminars. He contended that the practice of TM made him more creative on the job.

Unfortunately for him, the karma was wrong. Although the agency acknowledged that the seminars “may have been of some benefit to the business,” that was insufficient reason to authorize approval: “TM by its very nature generates benefits which are primarily personal.”

But the agency agreed that an executive who leaves his attaché case stuffed with important business documents on the train is entitled to deduct a reward for its return, as well as for a newspaper ad offering the reward.

Additionalarticles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 130 and counting).

Stay competitive with your fellow accountants who turn to the articles when, say, they correspond with clients or they want to show clients how to nimbly sidestep pitfalls while capitalizing on opportunities to diminish, delay, or deep-six payments of sizable amounts that would otherwise swell IRS coffers.

Also be mindful of the articles when you strive to build name recognition, a goal attainable only by choosing and implementing strategies that set you apart from ferocious competition. Use the articles to prepare talks to audiences, such as business owners, investors, and retirees.

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