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William Brighenti, Certified Public Accountant
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The Meaning of Ordinary and Necessary Expenses:
No Ordinary Matter But Absolutely Necessary!

The Internal Revenue Service classifies expenses into four different categories:
  1. Business expenses;
  2. The expenses included in the determination of cost of goods sold;
  3. Capital expenses;
  4. 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.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.
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