What are the ordinary and necessary expenses (O & NE)?
Ordinary and necessary expenses are expenses incurred by individuals such as the cost of owning a business or carrying on a commercial activity. “Ordinary and necessary” expenses are classified as such for income tax purposes, and these expenses are generally considered to be tax deductible in the year they are incurred.
These expenses are described in section 162 (a) of the Internal Revenue Code and must pass basic tests of business relevance, as well as necessity. However, the IRS does not publish a collection of expenses that can be considered ordinary and necessary for the continued operation of a business or the pursuit of a commercial activity, it is therefore incumbent on the taxpayer to take this decision.
Key points to remember
- O&NE are usually the expenses you incur as the cost of owning a business.
- Current ordinary and necessary expenses include business-related software for a computer or rental costs.
- Certain parts of the house used for business are sometimes tax deductible.
Understand ordinary and necessary expenses (O & NE)
This section of the tax code is the source of a large number of deductions by individuals, especially during the years of transition between jobs or careers. Typical expenses that can be included in the “ordinary and necessary” group include a work uniform or professional software purchased for a personal computer.
The start-up costs associated with setting up a new business can also be tax deductible, but must generally be spread over several years; these costs are not considered ordinary and necessary for IRS purposes but are generally deductible as capital expenses.
The IRS defines an “ordinary” expense as anything that is “common and accepted” for a specific business or enterprise. The IRS defines a “necessary” expense as anything that is “useful and appropriate”, but not essential. Here are some key examples of “ordinary and necessary” business expenses:
- Employee compensation: wages or wages paid to employees for services rendered.
- Retirement plans: money allocated to employee sponsored pension plans, such as 401 (k), 403 (b), SIMPLE (employee savings plan) and SEP (simplified employee pension plan) .
- Rental fees: money for a property that a business owner rents but does not own. Rental expenses are not deductible if the business owner receives equity or holds title to the property.
- The taxes: local, state, federal or foreign taxes paid directly attributable to a business or enterprise.
- interest: all interest expense on borrowed money, to cover the costs of business activities.
- Insurance: any type of insurance acquired for a professional business.
In general, “ordinary” expenses refer to those that are commonly and generally used by people in your trade or industry. “Necessary” expenses are expenses that are useful and appropriate; the necessary expenses must also be ordinary expenses in order to be tax deductible.
Professional use of your home
Business owners may be able to deduct expenses related to the parts of their home that are used for commercial use. These expenses may include utilities, mortgage interest and repairs. But for business owners’ homes to be considered as deductions, they have to prove that their home is their main place of business, even if someone is involved in ancillary activities outside the home. In addition, the deductions for a home office are based on the percentage of a home that a business owner spends for his professional use. Therefore, people who operate outside the home are responsible for this calculation.