Key Takeaways
– “Ordinary and necessary” (O&NE) expenses are business costs that are common in a trade (ordinary) and helpful/appropriate for the business (necessary). The rules are in IRC §162(a) and explained in IRS guidance. (IRC §162; IRS Pub. 535)
– O&NE expenses are generally deductible in the year paid or incurred, but some costs (startup, capital improvements) must be capitalized and amortized or depreciated. (IRC §195; IRS Pub. 535)
– Special rules apply to home-office expenses, vehicle use, meals/entertainment, and startup costs. Proper allocation and contemporaneous records are essential. (IRS Pub. 587; Pub. 463)
What Are Ordinary and Necessary Expenses?
– Ordinary: expenses that are common and accepted in your business or industry.
– Necessary: expenses that are helpful and appropriate for your business (not necessarily indispensable).
– Legal basis: Internal Revenue Code §162(a) permits deduction of “ordinary and necessary” trade or business expenses. The IRS provides detail in Publication 535 (Business Expenses). (IRC §162; IRS Pub. 535)
Common Examples of O&NE
– Rent for business premises
– Utilities and phone/internet used for business
– Employee wages and payroll taxes
– Office supplies, postage, and business software
– Advertising and marketing
– Professional fees (accountants, attorneys)
– Business insurance and interest on business loans
– Travel and lodging for business travel (subject to rules)
– Vehicle expenses for business use (standard mileage or actual expenses)
– Repairs and maintenance (routine repairs are deductible; improvements usually capitalized)
Expenses That Are Not Straightforward
– Startup and organizational costs: Generally capitalized and amortized under IRC §195; a limited immediate deduction may be available. (IRC §195; IRS Pub. 535)
– Capital expenditures (equipment, buildings, improvements): Recovered via depreciation or amortization, not immediate deductibility.
– Meals and entertainment: Governed by special rules; some entertainment deductions are disallowed and meals may be only partially deductible (see IRS Pub. 463 and Pub. 535).
– Employee unreimbursed business expenses: Treatment depends on whether you’re self-employed or an employee; many miscellaneous employee deductions have been suspended for tax years 2018–2025 under the Tax Cuts and Jobs Act (check current law). (IRS Pub. 535)
Business Use of Your Home
– Home office deductions are available only if:
– You use part of your home regularly and exclusively for business, and
– The home is your principal place of business (or you use the space for meeting clients or as a separate structure).
– Two methods to calculate the deduction:
– Simplified method: $5 per square foot up to 300 square feet (max $1,500).
– Regular method: Calculate actual expenses (mortgage interest, utilities, repairs) and multiply by the percentage of the home used for business.
– Keep measurements, floor plans, and records supporting exclusive use and percentage calculations. (IRS Pub. 587)
Startup Costs and Capital Expenses
– Costs to investigate and create a new business are generally capitalized under IRC §195 and amortized over 15 years, though a limited immediate deduction may be allowed (subject to dollar limits and phase-outs).
– Equipment and other long-lived assets are generally depreciated under the tax code rather than deducted immediately (special rules for Section 179 expensing and bonus depreciation may apply).
Practical Steps to Determine and Claim O&NE Deductions
1. Decide whether the expense is business-related
– Ask: Was the expense incurred in carrying on a trade or business? Is it common in my industry? Did it serve a business purpose?
2. Apply the “ordinary” and “necessary” tests
– Ordinary: Would others in your trade commonly incur this expense?
– Necessary: Was it helpful and appropriate (not strictly indispensable)?
3. Determine whether the cost is current vs capital
– If it creates or improves a long-lived asset, treat as capital (depreciate/amortize).
– If it’s a routine business expense, deduct in the year incurred.
4. Allocate mixed-use expenses
– For expenses that are partly personal and partly business (home utilities, internet, vehicle), calculate a reasonable business-use percentage and apply it consistently.
5. Choose the correct method and forms
– Self-employed: Schedule C (Form 1040) or relevant business return; vehicle expenses can use standard mileage (with mileage log) or actual costs (with receipts).
– Home office: elect simplified or actual expense method and fill required lines on Schedule C or Form 8829 where relevant.
6. Keep contemporaneous documentation
– Receipts, invoices, contracts, bank/credit card statements
– For vehicle: date, business purpose, odometer readings (start/end), miles driven (business vs total)
– For travel: dates, location, business purpose, names of business contacts
– For home office: floor plan, square footage calculations, utility bills, mortgage/lease statements
7. Report on the correct tax return and watch special rules
– Follow instructions in IRS publications (Pub. 535, Pub. 587, Pub. 463).
8. When in doubt, consult a tax professional
– Complex issues (capitalization vs expense, related-party transactions, large one-time costs) merit professional review.
Recordkeeping: Best Practices
– Keep receipts and proof of payment for at least three years (some items may require longer retention).
– Maintain a mileage log with date, purpose, start/end odometer, and miles.
– Use accounting software to separate business and personal transactions.
– Record contemporaneous notes for business meetings, travel, and client interactions.
Common Pitfalls & Audit Red Flags
– Poor documentation or missing receipts
– Claiming personal expenses as business expenses
– Incorrectly allocating mixed-use expenses (home, vehicle)
– Improperly treating capital expenditures as current deductions
– Excessive or unusual meal/entertainment deductions without business substantiation
Quick Checklist Before Claiming a Deduction
– Was the expense ordinary and necessary for the business?
– Is the expense appropriately classified (current vs capital)?
– Did you calculate a reasonable business-use percentage for mixed expenses?
– Do you have documentation (receipts, logs, invoices) supporting the deduction?
– Are you using the correct deduction method (simplified vs actual) and tax form?
Where to Read More (Primary Sources)
– Internal Revenue Code §162: Trade or business expenses (law text)
– IRS Publication 535, Business Expenses: https://www.irs.gov/pub/irs-pdf/p535.pdf
– IRS Publication 587, Business Use of Your Home: https://www.irs.gov/pub/irs-pdf/p587.pdf
– IRS Publication 463, Travel, Gift, and Car Expenses: https://www.irs.gov/pub/irs-pdf/p463.pdf
– IRC §195: Start-up expenditures and organizational costs
– Investopedia: “Ordinary and Necessary” overview: https://www.investopedia.com/terms/o/oandne.asp
Final Note
Tax law changes and specific facts materially affect deductibility. This article explains the general rules and practical steps but does not substitute for professional tax advice. For complex situations or large deductions, consult a CPA, enrolled agent, or tax attorney.