Definition of Ordinary and Necessary Expenses (O & NE)
Expenses incurred by individuals for their business or primary employment. "Ordinary and necessary" expenses are categorized as such for income tax purposes, and these expenses are generally considered tax deductible in the year they are incurred.
These expenses are outlined in Section 162(a) of the Internal Revenue Code and must pass basic tests of relevance to business, as well as necessity.
Understanding Ordinary and Necessary Expenses (O & NE)
This section of the tax code is the source of a large number of deductions by individuals, especially in years of transition between jobs or careers. Typical expenses that can be included in the "ordinary and necessary" group include a uniform for work or business-related software purchased for a home computer.
Startup costs associated with setting up a new business may also be tax deductible, but typically must be spread out over several years; these costs do not qualify as ordinary and necessary for IRS purposes.
The IRS defines an "ordinary" expense as anything that is "common and accepted” to a specific trade or business. The IRS defines a "necessary" expense as anything that is "helpful and appropriate,” but not indispensable. Key examples of “ordinary and necessary” business expenses include:
- Employees Compensation: wages or salaries paid to employees for services rendered.
- Retirement Plans: money allocated to employee-sponsored retirement plans such as 401(k), 403(b), SIMPLE (Savings Incentive Match Plan for Employees), and SEP (Simplified Employee Pension) plans.
- Rental Expenses: money for a property a business owner leases but does not own. The rental expenditures are not deductible if the business owner receives equity in, or holds title to the property.
- Taxes: any local, state, federal or foreign taxes paid that are directly attributable to a trade or business.
- Interest: any interest expenses on money borrowed, to cover the costs of business activities.
- Insurance: any type of insurance acquired for a professional business.
Business Use of Your Home
Business owners may be able to deduct expenses related to the portions of their homes that are allocated toward business use. These expenses may include utilities, mortgage interest, and repairs. But for business owners’ homes to qualify as deductions, they must prove their dwelling is their principal place of business—even if an individual conducts ancillary business at locations outside of the home. Furthermore, deductions for a home office are based on the percentage of a home that a business owner dedicates to business use. Consequently, individuals who operate out of the home are responsible for making this calculation.