Business Expenses: 3 Requirements To Qualify As Tax Deductions

As a home based business owner, one question that you may be wondering is what business expenses are deductible on your tax return.

There are no clear cut answer since most of us run different types of businesses. What may be deductible in one business may not necessarily be deductible in another.

Because it is difficult to identify and list all the expenses for your particular business, the IRS made a general rule that must be satisfied in order to qualify the business expense as a tax deduction. According to the IRS,  you may be able to deduct your business expenses if all the following requirements are satisfied:

1. It must be both ordinary and necessary
2. It must be reasonable in amount
3. It must be directly related to your business

 Ordinary and Necessary:

The first test is the business expense must be ordinary and necessary expense for your business. So let’s break it down this definition a little bit.

Ordinary expense – For an expense to be considered as an ordinary expense, it must be common and accepted in your trade or business and usually refers to expenses that are ongoing and frequent. Such types of expenses include your office supplies, utilities or accountant fees. However, this can also apply to something that you pay only once, such as an installation fee to set-up your computer network.

Necessary Expense – It is considered a necessary expense if it is helpful and appropriate for your trade or business. An expense does not have to be required or indispensable to be considered necessary.

• Example –  Joseph, who is a telecommunication engineer, is in the construction of cell sites business. Most of the time, the business requires him to work off-hours such as midnight to dawn and in a secluded area. He has experienced getting “held-up” at gunpoint for a few times. For security reasons, he bought his own gun. The expense incurred for the gun purchase is “necessary” but is not an “ordinary” expense and is therefore not deductible.

Reasonable in Amount:

The second test is that the business expense must be reasonable in amount. For the most part, there is literally no limit on how much expenses you can deduct on your tax return for as long as the amounts are reasonable. If you are wondering what is a reasonable amount, the IRS may claim that it depends on your particular situation. However, it should be noted that the IRS has actually put limitations on a few items such as entertainment, meals and business gifts because these expenses are usually considered extravagant in nature.

Directly related to business:

The last test is that the expense must be directly related to your business.  All this means is that you cannot claim a tax deduction if those expenses are used for personal use instead of your business. However,  some expenses may cross the both the business and personal use such as when you use a section of your home as your business office to which common expenses such as utilities and insurance are applied on a single account or if you sometimes use your personal vehicles in business. In cases like this, the business portion must be determined from the total cost and only the business portion goes on the business tax return section. The qualified personal expense portion is generally deductible only if the taxpayer is itemizing his/her expenses (using Schedule A).

Source: IRS Publication 535