The
Meaning of Ordinary and
Necessary Expenses:
No Ordinary Matter But Absolutely Necessary!
The Internal Revenue Service classifies expenses into four different
categories:
- Business expenses;
- The expenses included in the determination of cost of
goods sold;
- Capital expenses;
- Personal expenses.
Section 162(a) of the Internal Revenue Code defines business expenses as the ordinary and necessary
expenses of carrying on a trade or business. Generally business
expenses are tax deductible. However, the IRS does not provide a
compendium of general business expenses, leaving it to the taxpayer to
divine such from its definable criteria, ordinary and necessary. In fact, the terms ordinary and necessary
were not defined in the original statute establishing the Internal
Revenue
Code, leaving it to the tax courts to establish their meanings through
case law.
The phrase itself, ordinary and
necessary, dates back to at least
1814 in Brown v. U S, 12 U.S. 110 (1814),
where it was applied to justify implicit powers conferred upon
governments during war. Shortly thereafter McCulloch v.
Maryland, 17 U.S. 4 Wheat. 316 316 (1819), separately defined the term necessary in a non-rigorous sense as
frequently importing "no more than that one thing is convenient, or
useful, or essential" or "appropriate". It rejected the limited
meaning that a necessary thing
had to be absolutely necessary or indispensable,
concluding that the facts and circumstances of the thing
as well as the intentions of the person using the word are relevant to
its meaning: "This word, then, like others, is used in various
senses, and, in its construction, the subject, the context, the
intention of the person using them are all to be taken into
view."
This landmark case's interpretation of the word necessary is referenced
again and again in subsequent court cases involving taxation.
Welch v. Helvering, 290 U.S. 111 (1933) references MuCulloch v.
Maryland in its assumption "that the payments to creditors of the Welch
Company were necessary for the
development of the petitioner's
business, at least in the sense that they were appropriate and
helpful." Similarly, Commissioner v. Tellier, 383 U.S. 687
(1966)
then references Welch v. Helvering in its support of the meaning of
"the term 'necessary' as
imposing only the minimal requirement that the
expense be 'appropriate and helpful'
for 'the development of the
[taxpayer's] business'". And in 1983, Rothner v. Commissioner,
United States Tax Court, T.C. Memo. 1996-442, Docket No. 26134-93 adds
that an
expense
need not be considered unnecessary
"simply because the taxpayer could have avoided it by pursuing a
different
course of conduct", further reinforcing a less rigorous
interpretation of its meaning.
Welch v. Helvering, 290 U.S. 111 (1933) was also a
landmark case in the definition of the term ordinary as well. It stated
that even though the term ordinary
always connotes "a strain of constancy
within it, it "is nonetheless a
variable affected by time and place and circumstance" and does not mean
that its referent expenditure "must be habitual or normal in the sense
that the same taxpayer will have to make them often", adding it "may
happen once in a lifetime...unique in the life of the individual
affected, but not in the life of the group, the community, of which he
is a part.... Here, indeed, as so often in other branches of the law,
the decisive distinctions are those of degree, and not of kind."
Again, as with the term necessary,
facts and circumstances and degree prevail over any absolute standard.
In Deputy v. DuPont, 308 U.S.
488, 495 (1940), the Supreme Court defined ordinary as “normal, usual, or customary”, reaffirming Welch V.
Helvering by explaining, that
though an expense happen but once in the taxpayer's lifetime, if the
transaction giving rise to it is of "common
or frequent occurrence in
the type of business involved", it is ordinary.
It concludes that
"the kind of transaction out of which the obligation arose and its
normalcy in the particular business...are crucial and controlling" in
determining whether the expense is ordinary
and, hence, deductible by
the taxpayer. A few years later, Commissioner v. Heininger, 320
U.S. 467 (1943) defines the term
"normal" as used in the prior
two court opinions quoted above in their
definition of ordinary, as an
expense arising "from an action that is
ordinarily to be expected of
one in the taxpayer's position".
As one can see from these landmark cases in tax law, the key words
associated with the
term necessary are convenient, useful, essential,
appropriate, and
helpful, while those associated with the term ordinary are habitual,
normal, usual, customary, common, accepted and expected. However,
the facts and circumstances surrounding the transaction, the intention
of the taxpayer, as well as the degree of the ordinariness and
necessity of the transaction in carrying on one's business or trade are
all involved in the determination of whether an expense is ordinary and necessary and,
thus, deductible on the taxpayer's tax return. Out of a necessity
for the taxpayer to understand what the tax courts regard as legitimate
business expenses, the Internal Revenue Service summarized and
published the findings
and opinions of their interpretations of ordinary and necessary in its
Publication 535:
To be deductible, a
business
expense must be both ordinary
and necessary. An ordinary expense
is one that is common
and accepted in your
trade or business. A necessary expense is one that is helpful and appropriate for your trade
or business. An expense does not have to be indispensable to be
considered necessary.
From this definition and the tax courts's rulings, we can draw the
following conclusions. Obviously, both criteria, ordinary and necessary, need to be met for the
expense to be deductible. For an expenditure to be an ordinary expense, it must be a common or usual expense in one's
business and an acceptable
or customary expense for
one's business. For example, if a certified public accountant
claims the purchase of ski boots
as a deduction on his tax return, my very best wishes on his next IRS
audit. Either he is a better CPA than I am, or he loves to live
dangerously. I do not know any CPAs commonly purchasing ski boots
in order to provide services as public accountants to individuals,
businesses, and
organizations. However, if a ski
instructor purchases ski boots, obviously they may very well be a
legitimate business
deduction. Their purchase would be both a common and an acceptable expenditure in the
conduct of his services teaching other individuals the technique of
skiing.
The term necessary for tax
purposes has a wider definition than that found in common usage
today. As the tax cases illustrate, the expense does not have to
be "absolutely necessary" in
the sense that it is "indispensable" to carrying on the business.
It only needs to be helpful
to one's business as well as appropriate
for one's business. For instance, renting an office is certainly helpful
to the practice of a certified public accountant, providing a place for
the CPA to meet with clients and for its employees to work.
However, renting an office is not absolutely necessary for a CPA to
conduct his trade, since many sole-proprietor CPAs work out of their
home and provide their services at their clients' places of
business. In addition, an office is very appropriate
for a public accountant, providing a workplace for him and his
employees to undertake their accounting, auditing, and tax work and to
meet
with clients, particularly those lacking an office of their own.
Some legal scholars have suggested that the IRS inserted a trite
phrase, "ordinary and necessary",
as a placeholder in that statute,
leaving it to the courts and future generations to wrangle over its
meaning. They have contended that the phrase itself is
essentially meaningless. Others argue that the term ordinary
appears in the statute to distinguish business expenses from capital
expenditures (c.f., Commissioner v. Tellier, 383 U.S. 687
(1966)) and that the term necessary
is there to distinguish them from
personal expenses (c.f., Welch v. Helvering, 290 U.S. 111 (1933)).
Whatever. What does matter, however, is that the business
deductions appearing on one's tax return contain those criteria
considered by the IRS and the tax courts to classify them as legitimate
business expenses, given their nature and degree as well as the facts
and circumstances of one's intentions, transactions, and business.
This article is provided for informational purposes and is
not intended to be construed as legal, accounting, or other
professional advice. For further information, please consult
appropriate professional advice from your attorney and certified public
accountant.
Have a tax or an accounting question? Please feel free to submit
it to William Brighenti,
Certified Public
Accountant, Hartford CPA Accountants. For information
and assistance on
any tax and accounting issue, please visit our website: Accountants CPA
Hartford.
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