From the Desk of Lauran Corcoran
It’s a Write-off, Right? Business Deduction Requirements and Rules, Part I
It might sound silly, but the first step in determining the validity of a deduction is to identify what your business is. The key terms for valid business deductions are “necessary” and “ordinary.” It is only after identifying what your business is that you can properly deduct what is ordinary and necessary for your business.
What is a “necessary” and “ordinary” business expense? Not surprisingly, there is not an objective standard to apply. “Necessary” has been interpreted to mean expenses that the taxpayer deems appropriate and helpful to the taxpayer’s business. “Ordinary” is a common and accepted business expense in the particular business activity of the taxpayer. The additional twist to “ordinary” is that the business expense is determined to be “ordinary” based on the ability of the taxpayer to substantiate and verify the position that the expense is common and accepted business expense in their business. In a nutshell, a business expense is deemed “necessary” and “ordinary” when a taxpayer is able to show that it was necessary to carry out his particular business and he has the records to back up that position.
If audited, the IRS will immediately attack business deductions for failing to be necessary and ordinary. Sadly, the IRS will many times win on this point. The IRS will win not because the taxpayer took deductions that were not legitimately business related but because the taxpayer could not provide sufficient information on the nature of the expense and what it had to with the business activity.
For each business deduction you should be able to answer the following: What? Why? When? Who? And How much? There is no particular form of record keeping required by the IRS, but the record keeping must be able to provide answers to the above questions for each expense. Not only will a business deduction be denied if there are incomplete records but the IRS will likely assess an additional penalty for “substantial understatement of tax.” This penalty and other penalties related to proper record keeping and reporting will be addressed in next week’s post.