Necessary and ordinary expenses are costs that a business incurs in order for their business to operate. This article defines business expenses according to California law.
What are Necessary and Ordinary Expenses?
Necessary and ordinary expenses are expenses an individual incurs when operating their own business or are carrying on a trade. Necessary and ordinary expenses are associated with and used for income tax purposes. Accordingly, these expenses are usually tax deductible.
However, a cost must pass a relevancy and necessity test in order to qualify as necessary and ordinary. Unfortunately, there is no official list of what are considered necessary and ordinary expenses by the Internal Revenue Service (IRS).
As such, it is up to the taxpayer to determine what expenses they have are necessary and ordinary.
How does the IRS Define Necessary and Ordinary Expenses?
According to the IRS, necessary expenses are those that are appropriate and helpful for a business operation. These expenses do not have to be required for a business operation.
Ordinary expenses are expenses that are commonly found and accepted in most businesses or trades. Moreover, ordinary expenses must be commonly used by people in that specific industry. For example, a technology company that purchases software equipment can file for a deduction on that purchase. Necessary expenses also have to be ordinary expenses in order to be tax deductible.
Examples of necessary and ordinary expenses include:
- Insurance;
- Employee compensation;
- Rental expenses;
- Taxes;
- Retirement benefits; and
- Interest.
Businesses Operating in the Home
Business operating from home may qualify as tax deductible. As such, if a portion of a business owner uses a portion of their home for business operations, they may be able to deduct expenses pertaining to that portion.
However, a business owner must prove that their home is a place of business in order to qualify for a deduction. The business owner is responsible for calculating expenses and determining which were necessary and ordinary. Examples include repairs, utilities, and mortgage interest.
Deductible vs. Non-Deductible Expenses
Business expenses that can be fully or partially tax deductible include:
- Employee benefits;
- Membership dues;
- Home office, if the owner considers it a place of business;
- Bank and legal fees;
- Software;
- Rent and utilities;
- Payroll;
- Office supplies, equipment, and furniture; and
- Business Travel.
Although these examples are deductible, it is important to note that the IRS writes off capital expenditures over the course of several years. This means that an asset’s value decreases over time.
Non-deductible business expenses include:
- Government penalties and fines;
- Lobbying expenses;
- Illegal activities (ex: fraud, theft, and conflict of interest); and
- Political contributions.
When Can an Expense be Deducted?
When an expense can be deducted depends on the business’s chosen accounting method. Accounting methods are rules that determine how and when expenses are reported. The two most common methods are called Cash and Accrual.
The Cash method is an accounting method in which businesses deduct expenses in the tax year in which they are paid. By contrast, the Accrual method is an accounting method in which businesses deduct expenses when both of the following requisites are met:
- Economic performance has occurred; and
- All event tests have been met.
Frequently Asked Questions
Q: If I use equipment in my business, can that be considered a business expense?
A: Yes, if you use equipment at your business or trade, the equipment is a business expense. Examples of this include uniforms and software, such as computers.
Q: Can startups be tax deductible?
A: Yes. Most of the time, a startup (a new business) can be tax deductible. However, expenses will have to be spread out over the course of several years. The expenses from a startup are usually classified as capital expenses instead of necessary and ordinary business expenses for the IRS.
Q: What is an income statement?
A: An income statement, also known as a profit and loss account, shows the expenses and revenues of a company within a certain period.
Q: If an expense is not considered necessary or ordinary, can it still be tax deductible?
A: No. In order for a business expense to be tax deductible, it has to be considered necessary or ordinary.
Q: Can employees be reimbursed for work-related expenses?
A: Yes, under section 2802 of the California Labor Code, an employer has to reimburse employees who made work-related purchases. In essence, employees cannot waive their right to reimbursements. This prevents employees from taking on financial expenses for their company.
Examples of work-related reimbursements include:
- Cost for uniform;
- Work-related use of a personal phone;
- Fees for attending work-related events;
- Travel expenses; and
- Driving costs while using a personal vehicle.
Contact Pride Legal
If you or a loved one wishes to apply for a tax deduction, we invite you to contact us at Pride Legal for legal counseling or any further questions. To protect your rights, hire someone who understands them.