Many small businesses, start-ups and independent contractors rely on their own research and on tax preparations systems to maximize their tax deductions. To make the most of year-end deductions you must know what expenses you may and what you may not apply, as well as how best to apply them. The most common, and probably, the most important question accountants are asked is:

“What is an allowable tax deduction?”

Your accountant will help you answer this question, but you may value some important background information. The IRS has rules about what you can claim against business profits. Knowing the answer to the question is critical. The IRS employs two basic principles. The answer to the question, therefore, is that the expenses you wish to deduct must be “ordinary” and “necessary.”

Section 162 of the tax code says: “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

The IRS, unfortunately, does not define what ordinary and necessary mean. It does, however, provide some valuable information to help you so you can plan ahead. A good way of answering the question is to ask yourself another one:

“Do I honestly believe this expense that I am using to reduce my tax bill is an ordinary and necessary one?”

If you honestly say to yourself “Yes, it is,” then you should be safe. Here is more information to help you answer the question.

Is the Expense Ordinary?

You know your business, your premises, the turnover, how many employees you have, how many contractors you use, etc. The IRS takes such things into account when they apply the “ordinary” test, so you can too.

Here is a simple example. You have a family celebration, and you take your spouse out for the evening. Your spouse is a part-time employee. You charge the dinner and theater visit to your business credit card. The celebration and theater have nothing to do with marketing, office administration or production, so it is not “ordinary” expenditure, so you should not claim it as a business expense.

If, however, you want to discuss business matters with a customer, and you spend a reasonable amount of money to entertain them with the intention of helping to bring in more business or to keep them from going to the competition, then it is fair to conclude that some of the expenditure may be “ordinary”.

The IRS may look at the size of the entertainment bill, and ask “How important is this customer compared to overall turnover?” The IRS may also compare that entertainment expense with similar businesses and how much they spend on entertainment before deciding if it is “ordinary”.

Is the Expense Necessary?

Your business may use raw materials or hire skilled contractors. You may purchase office cleaning services, and office consumables; you may employ a part-time CFO, etc. All these things help to keep your business running and, possibly, expanding. It is also reasonable to say that marketing is a necessary expense. You pay to run advertisements or your business has a website that has to be managed. These are examples of essential expenditure.

It may be fun to run a marketing campaign by hiring an RV and taking it to expensive vacation spots where you give out flyers advertising your company’s services. The IRS would ask the question, “Is this sort of campaign ordinary for this type of business, and is this level of expenditure necessary to make the campaign a success?” If not, then making the claim could red-flag your tax return.

The Take-Away

It always pays to seek appropriate professional advice. If the planned or actual expenditure is honestly justifiable, helpful, and appropriate, then use it to lower your tax bill.

You may have many questions about tax planning, or completing your tax return. We are here to help, advise and to guide our clients. We are also here to help our clients plan next year and the years after that, so please just click this button to contact us.