Definition
The term Ordinary and Necessary Business Expenses refers to costs incurred in the routine operation of a business that are both common (ordinary) and helpful and appropriate (necessary) for the business. According to the IRS, these expenses can be deducted from a company’s income to lower the total taxable income for that year.
Ordinary expenses are defined as those that are common and accepted in your trade or business. Necessary expenses are defined as those that are helpful and appropriate; although an expense does not have to be indispensable to be considered necessary.
Examples
- Office Supplies: Pens, paper, printer ink, and other consumable items used in daily business operations.
- Rent: Costs associated with renting office space for business operations.
- Utilities: Costs such as electricity, water, and internet services required for business operations.
- Salaries and Wages: Compensation paid to employees for their services.
- Insurance: Business insurance premiums covering liabilities, property, or workers’ compensation.
- Professional Services: Fees paid to accountants, lawyers, or consultants.
- Travel Expenses: Costs incurred for business travel, including transportation, lodging, and meals.
Frequently Asked Questions (FAQs)
Q1: What is the difference between an ordinary expense and a necessary expense?
A1: An ordinary expense is one that is common and accepted in the business industry, while a necessary expense is one that is helpful and appropriate for the business. Note that a necessary expense does not need to be indispensable.
Q2: Can personal expenses be claimed as ordinary and necessary business expenses?
A2: No, personal expenses are not deductible as ordinary and necessary business expenses. Only expenses directly related to business operations qualify.
Q3: Where should sole proprietors report their ordinary and necessary business expenses?
A3: Sole proprietors report their ordinary and necessary business expenses on Schedule C of Form 1040.
Q4: Are capital expenditures considered ordinary and necessary business expenses?
A4: No, capital expenditures, which are costs associated with purchasing or improving long-term assets like buildings and equipment, are not classified as ordinary and necessary business expenses. These expenses must be capitalized and depreciated over time.
Q5: What documentation is required to substantiate ordinary and necessary business expenses?
A5: Proper documentation such as receipts, invoices, and bank statements are necessary to verify and substantiate ordinary and necessary business expenses for tax purposes.
Capital Expenditure: Costs incurred to acquire or upgrade long-term assets like buildings, machinery, or equipment. These costs are capitalized and depreciated over the asset’s useful life rather than being deducted in the year they are incurred.
Schedule C: A form attached to IRS Form 1040 used by sole proprietors to report income, expenses, profits, and losses from their business activities.
Depreciation: The process of allocating the cost of a tangible asset over its useful life, allowing the expense to be spread out in financial statements and tax returns.
Online References
Suggested Books for Further Studies
- Tax Savvy for Small Business by Frederick W. Daily
- Deduct It! Lower Your Small Business Taxes by Stephen Fishman
- JK Lasser’s Small Business Taxes 2023: Your Complete Guide to a Better Bottom Line by Barbara Weltman
Fundamentals of Ordinary and Necessary Business Expenses: Taxation Basics Quiz
### What qualifies an expense as "ordinary" in business terms?
- [ ] Any expense, regardless of its nature.
- [x] An expense that is common and accepted in your trade or business.
- [ ] Only expenses that are absolutely indispensable.
- [ ] Expenses that are high in cost.
> **Explanation:** An ordinary expense is one that is common and accepted within a particular trade or industry.
### Why might an expense be categorized as "necessary"?
- [ ] It must be the cheapest option available.
- [ ] It must cover all aspects of personal and business needs.
- [x] It must be helpful and appropriate for the business.
- [ ] It must be approved by all employees.
> **Explanation:** A necessary expense is one that is helpful and appropriate for the business, making it possible to operate effectively.
### Can capital expenditures be deducted as ordinary and necessary business expenses?
- [ ] Yes, in the year they occur.
- [ ] Yes, but only for small businesses.
- [x] No, they must be capitalized and depreciated over time.
- [ ] No, such expenses must be expensed immediately.
> **Explanation:** Capital expenditures must be capitalized and depreciated over time, rather than being deducted as ordinary and necessary business expenses in the current year.
### Which IRS form is used by sole proprietors to report ordinary and necessary business expenses?
- [ ] Form W-2
- [ ] Form 1099
- [x] Schedule C of Form 1040
- [ ] Form 1065
> **Explanation:** Sole proprietors use Schedule C of Form 1040 to report their ordinary and necessary business expenses.
### What is required to substantiate an ordinary and necessary business expense?
- [x] Proper documentation such as receipts, invoices, or bank statements
- [ ] Only verbal confirmation
- [ ] Witness testimonies
- [ ] A notarized letter from a business owner
> **Explanation:** Receipts, invoices, bank statements, and other proper documentation are required to substantiate ordinary and necessary business expenses.
### Which of the following is an example of an ordinary expense?
- [ ] Cost of purchasing a building
- [ ] Home mortgage
- [x] Office supplies
- [ ] A personal gym membership
> **Explanation:** Office supplies are common and accepted expenses in business operations, making them ordinary expenses.
### Are personal expenses deductible as ordinary and necessary business expenses?
- [x] No, personal expenses are not deductible.
- [ ] Yes, if they are somewhat related to the business.
- [ ] Yes, if they amount to less than $500.
- [ ] No, unless approved by the IRS.
> **Explanation:** Personal expenses are not considered deductible as ordinary and necessary business expenses.
### What kind of expense is a business insurance premium?
- [x] Necessary expense
- [ ] Capital expenditure
- [ ] Non-deductible expense
- [ ] Personal expense
> **Explanation:** A business insurance premium is a necessary expense, as it is helpful and appropriate for safeguarding business operations.
### Under which circumstances would salaries and wages not be considered ordinary and necessary expenses?
- [ ] When they exceed $50,000 annually.
- [ ] When paid in cash.
- [ ] When there are no employees.
- [x] When they are excessively high and unreasonable.
> **Explanation:** Salaries and wages must be reasonable to be considered ordinary and necessary expenses. Excessively high and unreasonable salaries are not deductible.
### What primary factors determine whether an expense is ordinary and necessary?
- [ ] Employee consensus and financial cost.
- [x] Commonality, acceptance in the trade, and helpfulness.
- [ ] Legal standing and IRS approval.
- [ ] Minimum cost and maximum utilization.
> **Explanation:** Ordinary expenses must be common and accepted in the trade, while necessary expenses need to be helpful and appropriate for the business.
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
