IRS Code 162: What Is an Ordinary and Necessary Business Expense?

 

One of the most litigated tax issues every year is business expense deductions related to tax code 162(a).

In today’s post, I’m breaking down everything you need to know about code 162(a) so that you can follow the letter of the law and keep on deducting those business expenses like the boss that you are.

What is IRS Code 162?

The Internal Revenue Code (IRC) are the laws the Internal Revenue Service (IRS) applies when collecting federal taxes. IRC section 162(a) is the law that deals with business deductions for expenses that are deemed ordinary and necessary in a trade or business.

Specifically, IRC 162(a) applies to deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Code 162(a) also explains that these deductions apply to:

What does IRS Code 162 really mean?

Although IRC 162 is great news for business owners, it is tricky and can lead to audits, appeals, and court cases because the terms and phrases within the code are open to interpretation.

For example, due to questions about what is considered a trade or business, the Supreme Court has upheld that the taxpayer must be involved with the trade or business with continuity and regularity. They’ve also said that the main purpose of the business should be to produce income and make a profit. In other words, hobbies don’t qualify as a trade or business.

What is an “ordinary and necessary” business expense?

Even though these terms cause confusion and are ambiguous, here are some things we know for certain based on the IRC and past court cases:

  • A trade or business expense must be both ordinary and necessary in order to be deductible.
  • The amount of the expense must be reasonable.
  • The Supreme Court defines an “ordinary” expense as an expense that is customary or usual.
  • To be an “ordinary” expense, the Supreme Court has said that the expense must also occur commonly or frequently in a particular type of trade or business.
  • The Supreme Court defines a “necessary” expense as an expense that is appropriate and helpful for developing the business.
  • The expense must be paid or incurred (billed or charged) during the taxable year.
  • There must be proof that the expense was paid.
  • The business must be able to provide records or books that show its income, deductions, credits, and expenses.

What is the Cohan rule?

What is now known as the “Cohan rule” was established in a 1930 court case, Cohan v. Commissioner, which was decided by the Court of Appeals for the Second Circuit. Basically, this case was about whether George Cohan, an actor, could claim business expenses on his tax return even though he didn’t have documentation to support all of the deduction he was trying to claim.

The court determined that even though the full amount couldn’t be deducted, something should be allowed, so the court made its own “reasonable approximations” based on the financial evidence Cohan could provide.

What this means today is that if taxpayers can show that expenses were incurred and they can provide at least some credible evidence proving those expenses, then they can be allowed the business deductions. However, this loophole-of-sorts does not apply to deductions for:

  • Travel expenses
  • Entertainment, amusement, or recreation expenses
  • Gifts
  • Certain types of property

So although it’s interesting to know this precedent or rule exists, as a business owner, it’s always better to avoid tax problems and costly legal trouble by maintaining accurate and detailed records of all business expenses.

Of course if you have questions about your business expenses and deductions, you should contact a certified public accountant with experience in the small business world. You might also find my other free tax posts helpful:

Double Tax-Saving Strategy: Donate Stocks to Charity

Tax Rules for Giving Money to Family

 
Amy Northard, CPA

Amy Northard, CPA

Founder of The Accountant for Creatives®
+ taxes + bookkeeping + consulting
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