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Lesson 1: Introduction, Background, and Review
Authorization to Deduct Business Expenses | Video
Video 1.2. Chapter 1 Overview
You may recall from ACCTG 310 that the income is to be applied to “all income from whatever source derived” (U.S. Constitution, 16th Amendment and IRC §61(a)). A strict interpretation of this wording lead to the conclusion that all income was to be taxed and no expenses deducted. Fortunately, Congress thought better of that interpretation and created IRC §162, which grants authorization to deduct business expenses.
Specifically, §162 states:
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 . . .
This is a relatively broad and ambiguous authorization to deduct business expenses. This ambiguity has led to many regulations and court decisions. In an effort to clarify some of the ambiguity, the courts have ruled that there are three criteria that must be satisfied for a business expense to be deductible. It must be ordinary, necessary, and reasonable. Click below to learn more about ordinary, necessary, and reasonable business deductions and to see examples.
Ordinary
To qualify as ordinary, an expense must be appropriate for the business under the circumstances. Some might call this the reasonable person criteria. That is, would a reasonable person in this business under these circumstances have incurred this expense? The courts have also asked whether other businesses in this industry normally incur the expense. That means an ordinary expense can vary across industries and even between businesses in the same industry, if they use different business models.
Necessary
A necessary expense is one that is conducive to the business activity. However, the courts have noted that a necessary expense does not have to be essential to the business, only helpful in running the business. Again, necessary expenses can vary across industries and between businesses in the same industry.
Reasonable
The reasonable criterion refers to the amount of the expense. An expense is deductible only to the extent the amount is reasonable.