Ordinary and Necessary
The very first question any new entrepreneur has is…”can I expense that?”
Understanding what you can and cannot expense is one of the first lessons you will learn.
You will also find out that every accountant and their interpretation of the Internal Revenue Code (“Code”) Sec. 162 – Trade or Business Expenses – is different.
Some are more comfortable being aggressive with clients, while others would prefer a conservative approach. It makes sense, this area of the Code is not exact (frankly most areas of the Code are not black and white).
Also did you notice, that as tax accountants we use the word expense and deduct interchangeably? Yes, you are not crazy, we do.
Think of that difference as an accountant expensing an item that was paid for, versus a tax accountant thinking through the reduction of taxes as a deduction.
So let’s chat briefly about Ordinary and Necessary.
The Code and Regulations give explicit examples, such as salary or compensation, traveling while away from home, health insurance cost for self-employed (will get into at a later date), advertising, other insurance premiums, supplies repairs, and so on.
The most important part of this is that “business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business.” This is super important.
It is the expenses directly associated with your business. Action steps are to ask yourself if the expense is:
- Something you cannot do without…NECESSARY.
- Something which represents a common expense in your industry…ORDINARY.
Example:
Sally runs and operates a small bakery.
She regularly purchases flour, sugar and butter.
This expense is NECESSARY for her to make her product, and the expense is ORDINARY in the industry she participates.
To the contrary, Christina operates a consulting business, the flour, sugar and butter she may have to buy to bake a cake for a gather might not be considered an expense, but if she just bought the cake it could be supplies for advertising or the like. (I know super basic, but still important and confusing.)
Let’s go big this time.
Mike is a boat captain, and he is broadening his business into charter fishing excursions.
He buys a new boat. This expense could be ORDINARY and NECESSARY. You see NECESSARY because he cannot broaden his business without the new boat, and ORDINARY because he is in the industry of charter fishing (caveat: this could be start-up expenses…)
On the other hand, Marco has a real estate brokerage. As a real estate broker, the new boat is not NECESSARY and definitely not ORDINARY, thus not deductible.
However, a conservative accountant would say that is not a business expense, but a more aggressive accountant would try to have standing that the boat was part of an advertising promotion. This is why it gets a little tricky!
At the end of the day, you would be surprised how much is truly deductible.
Big red flag areas are anything that will be used for PERSONAL purposes, or something that is clearly not the industry you participate.
If you are running a business, and spending funds on anything from supplies for the printer, to a meal to generate business, those expenses can be deducted.
If I can give any hints, it would be setup your business as an OPERATING BUSINESS from the get-go.
Have a separate bank account and separate credit card, this will help to make sure all expenses are captured. If you charge something on the business, most likely it is for the business.
An experienced tax accountant can always be there for additional review, but take some stress out of it and know that at the end of the day the IRS is not looking to punish those who use reason…there is the old idiom…Pigs get fat, and hogs get slaughtered.
Remember that and you will be fine.
