Deductible business expenses are those which are “ordinary and necessary” and are incurred or paid during the taxable year in “carrying on” any trade or business. Both these criteria must be met for an expense to be deductible.

An “ordinary” expense is one that is common and accepted in the industry. These are expenses that are needed to run a business and are usually frequent and ongoing.  

A “necessary” expense is one that is helpful and appropriate for the trade or business. The term necessary for tax purposes has a wider definition than that found in everyday usage. Necessary does not mean that an expense has to be indispensable.

In addition, the ordinary and necessary business expenses are costs associated with running an existing business. For instance, organizational expenses and start-up expenses are deductible or amortizable under different set of rules. Similarly, cost of goods sold and capital expenses are   governed by yet a different set of rules and regulations.

Related taxpayers should be extra careful and not violate the “ordinary and necessary” part of the Section 162 language. Small business owners with more than one entity may inadvertently pay the expenses of another entity or attempt to balance income between entities. These types of maneuvers can get costly should the IRS make a discovery. Co-mingling funds and expenses, whether business or personal, should be avoided at all times.  

In most cases the “ordinary and necessary” requirement is straight forward and easily met. Some of the common expenses include: advertising, bank fees on business accounts, bad debts (for those who use accrual accounting),commissions and fees paid, dues for trade organizations and business organizations, casualty and liability insurance, interest on business debt, legal and professional services, office expenses, (supplies, telephone, printing, postage, etc.), pension and profit sharing plans, employee benefits, publications, rent and lease expenses, repairs and maintenance, services performed by independent contractors, utilities, and wages.

Some expenses require additional considerations and/or may be limited or recovered through depreciation and amortization. Examples of these types of expenses are: car and truck expenses (standard mileage or actual expenses, personal and business use of a vehicle), cost of goods sold (determine additional costs allocable to cost of goods sold), depreciation, gifts to customers, office-at-home deduction, business meals and entertainment, and travel expenses. 

A partial list of expenses that are not deductible include: bar or professional examination fees, charitable contributions by a business that is not a regular C- corporation, (sole proprietors can’t deduct charitable contributions as a business expense), charitable contribution of time or personal services, country club, social club or athletic club dues, commuting expenses (from home to place of business), estate taxes, expenses ( including interest) to generate tax-exempt income, federal income tax, fines and penalties (federal income tax penalties, traffic tickets etc.), gifts to employees or business contacts valued at more than $25.00, hobby losses, life insurance premiums ( if the business, or business owner is a direct or indirect beneficiary), lobbying expenses, personal, living, or family expenses, and  political contributions.   

Substantiation

Business deductions require substantiation. While some tax court cases have allowed expenses without substantiation and have relied on credible testimony, the bottom line is that the taxpayer must have evidence proving the amount of the expense and the character of the expense.   

Most taxpayers don’t receive canceled checks or copies of the checks anymore.  Also, taxpayers pay expenses by transferring funds electronically and pay expenses by credit cards. Rev. Proc. 92-71 addresses these circumstances and provides when an account statement prepared by a financial institution, or other evidence of payment, will be accepted by the IRS as proof of payment.  Under check truncation (safekeeping) system, the canceled checks are retained by the financial institution and bank regulations generally require the banks to retain checks for a period of five years. However, requesting copies of the checks can be very costly.

If a taxpayer can’t provide canceled checks to prove payment of an amount, Rev. Proc. 92-71 describes account statements that a taxpayer can provide. If neither a canceled check nor an account statement showing required information can be provided, the Service will require other evidence to prove a payment.

An account statement prepared by a financial institution showing a check clearance will be accepted as proof of payment if the statement shows:

1. Check number.
2. The amount of check.
3. The date of check.
4. The name of payee. (This is the problem-statements don’t show the payee’s name)

In case of electronic funds transfer and payments made by a credit card, if the statement shows the amount, date, and name of the payee, then a bank statement would be accepted as proof.

If a taxpayer can’t provide canceled checks or account statements described above, then other evidence of payment is required. An invoice marked paid, check register, payment acknowledgements, and an account statement showing the amount, date and check number. Even though the IRS often requests canceled checks they are not required if other acceptable proof can be provided. 

Time after time we have witnessed denial of legitimate business expenses due to lack of substantiation and proper documentation. Therefore, it is extremely important that complete records to substantiate income and expenses are kept at least for 3 years after the filing of a tax return. 

Should you have any specific questions and would need more detailed answers, please give us a call.