Ordinary and Necessary Expenses (O & NE) For Business: Overview
There can be certain types of expenses you might be able to deduct when you either own a business or carry on a trade. Think of the areas of your business that are critical to business operations – are there any typical expenses that are essential? Have you been deducting them when you file your tax returns?
It can sometimes be overwhelming to understand what’s eligible as a deductible expense and what’s not. The good news? We put together this article to help break everything down for your personal benefit. Keep reading to learn all about ordinary and necessary expenses for your business, including how they work, what they mean, and how to classify them.
Table of Contents
KEY TAKEAWAYS
- Ordinary and necessary expenses are normal expenses incurred by an individual in business or when operating a trade.
- Essentially, ordinary and necessary expenses align with the cost of owning and operating a business.
- Some common ordinary and necessary expenses include wages, interest, rental expenses, and business-related software.
- If taxpayers use part of their home for business operations, some of these expenses may be tax-deductible. However, costs need to be carefully allocated based on what percentage of the home is used for business. Only the business area is deductible; personal space is not.
What Are Ordinary and Necessary Expenses?
Ordinary and necessary expenses (O & NE) are specific types of expenses incurred through taking part in a trade or owning a business. The ordinary and necessary components of the expenses are categorized for income tax purposes.
As well, these ordinary and necessary expenses are often tax deductible in the year they occur. The Internal Revenue Code outlines the details for ordinary and necessary expenses in Section 162(a). In order for an expense to get considered ordinary and necessary, it needs to be a common expense, relevant to business operations, and a necessity.
With all of that said, the Internal Revenue Service (IRS) doesn’t provide or publish a list of what expenses can be considered ordinary and necessary. Instead, it’s up to you as the taxpayer to make the appropriate determination.
How to Classify An Expense As Ordinary and Necessary
Section 162(a) of the tax code allows for a wide range of possible expense deductions. These deductions can range from software purchased for a computer to a work uniform. Startup costs can sometimes also be tax deductible.
But typically, the costs associated with setting up and launching a new business are spread out over more than one year. In this case, these costs aren’t going to be considered ordinary and necessary expenses. But, they are deductible capital expenses.
According to the IRS:
- An ordinary expense relates to anything that’s common and accepted for a trade or business to operate.
- A necessary expense is anything that’s helpful and appropriate for business operations, but not necessarily indispensable.
Here are a few examples of ordinary and necessary expenses:
- Insurance — This can include any kind of insurance coverage that’s needed for business operations.
- Interest — This includes interest expenses on any money borrowed to help cover business activity costs.
- Employee Compensation — The salaries or wages that get paid to employees for the work that they do.
- Retirement Plans — These can include plans such as 401(k), Simplified Employee Pension (SEP), Savings Incentive Match Plan for Employees (SIMPLE), and 403(b).
- Rental Expenses — Rental expenditures aren’t deductible if the owner has an equity stake or holds the property title.
How Do Ordinary and Necessary Expenses Work?
The simplest way to think of how ordinary and necessary expenses work is like this:
- A business owner claims ordinary and necessary expenses as a deduction when they file their taxes.
- Individual business owners such as sole proprietors claim expenses on Schedule C. Business owners will report how much they spent on travel, meals, and legal and professional services.
- These expenses help offset business revenue, in turn reducing total taxable income for the business. But it’s worth recognizing that the deductions aren’t always going to equal the purchase cost.
- The IRS doesn’t always make clear whether or not an expense is considered to be ordinary and necessary. In these instances, you can claim the deduction as long as you can justify the expense as ordinary and necessary.
What Do Ordinary and Necessary Expenses Mean for Individuals?
Ordinary and necessary expenses related to specific types of business expenses. However, an individual can still benefit from understanding how they work. For example, an individual could have an additional income stream outside of their primary job.
Or, if you’re thinking of starting your own business, understanding which expenses are deductible can be helpful. Speaking with a tax professional can give you the opportunity to ask questions and get further clarification to avoid any issues.
Example of Ordinary and Necessary Expenses
Let’s take a look at an example of expenses that are ordinary and necessary.
A business owner uses a portion of their own home to conduct operations. Since the portion of their home is dedicated to business use, certain expenses can get deducted. These can include mortgage interest, repairs, and utilities.
But before the business owner can have their home qualify as a deduction, they must prove it’s the principal place of business. Once they can prove this, the business owner can deduct ordinary and necessary business expenses. No deduction is allowed for personal, family, or living expenses, so home area must be divided into personal and business use in order to qualify.
Summary
Ordinary and necessary expenses are specific business costs that can get deducted from revenue. Doing this will allow you to determine your taxable income and details are outlined in Section 162(a) of the Internal Revenue Code.
Some common examples of allowable expenses include:
- Work uniforms
- Rental expenses
- Insurance
- Employee compensation
It’s important to note that the IRS doesn’t publish a list of ordinary and necessary expenses. It’s up to you to determine what is considered ordinary and necessary. As long as you can justify the expense, it can get deducted.
FAQs About Ordinary and Necessary Expenses
Yes, ordinary and necessary expenses are generally deductible. However, you must be able to justify the expense to ensure they are allowable business expenses.
For an expense to get classified as ordinary and necessary, it must be commonly incurred for business or trade purposes.
Ordinary and necessary trade business expenses are those that are accepted and common in the specific trade or business in question. It’s important to recognize which common expenses can get deducted since some don’t necessarily fit into a particular category.
These can range depending on the specific situation, but typically you may be able to deduct the cost of work-related education expenses. Some common education expenses you can deduct include tuition costs, books, and certain transportation and travel costs associated with your education.
Again, this can depend on the specific type of business or trade, but any expenses that don’t contribute to the common and accepted practices of a business are not deductible. This can include personal expenses, for example.
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