Question

Code Section 162 requires that all expenses for a self-employed business be ordinary and necessary. Discuss this as well as all other requirements for the expense to be acceptable to the IRS.

Answer 1

          Ordinary and Necessary Expenses

Ordinary and necessary expenses are expenses incurred by individuals as the cost of owning a business or carrying on a trade. "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. However, the IRS does not publish a compendium of what expenses can be considered ordinary and necessary to the pursuit of running a business or carrying on a trade, so it is the responsibility of the taxpayer to make this determination.

Typically,

1. O&NE are generally the expenses you incur as a cost of owning a business.

2. Common ordinary and necessary expenses include business-related software for a computer or rental expenses.

3. Portions of the home used for business are sometimes tax-deductible.

Understanding Ordinary and Necessary Expenses (O & NE)

Section 162 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.

Start-ups 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 but are instead usually deductible as capital expenses.

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:

1. Employees Compensation: wages or salaries paid to employees for services rendered.

2. 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.

3. 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.

4. Taxes: any local, state, federal or foreign taxes paid that are directly attributable to a trade or business.

5. Interest: any interest expenses on money borrowed, to cover the costs of business activities.

6. Insurance: any type of insurance acquired for a professional business.3

In general, “ordinary expenses” refers to those that are commonly and typically used by people in your trade or industry. “Necessary expenses “refers to those expenses that are helpful and appropriate; necessary expenses must also be ordinary expenses in order to be tax deductible.

Requirements for Deducting Business Expenses:

Complete and file Schedule C or Schedule C-EZ with the tax return to itemize all business costs and to calculate how much business income is left over after deducting them. Schedule C-EZ would be appropriate if the business expenses for the year were $5,000 or less, if the cash method of accounting is used, if on inventory was held, and there is no net loss.

The resulting number from Schedule C is then entered on line 3 of Schedule 1 of the 2019 Form 1040. This is the taxable income from business. The total of Schedule- 1, which is found on Line-9, then transfers to Line- 7a of the Form 1040.

The 2019 Form 1040 is different from the returns that were in use in previous years. With the exception of Schedule C, these lines and tax schedules do not apply to years 2018 and earlier.

Tax deductions for the self-employed are not necessarily self-evident. They're found on a wide variety of different tax forms and apply in different situations. While Schedule C is an important tax form for the independent contractor, self-employment deductions can also be taken in other parts of income tax return.

This list of self-employment deductions includes brief descriptions and the forms on which they are found. The purpose is not to give exhaustive details, but to recognize potential self-employment deductions in the daily course of business.

1. Half of Your Self-Employment Tax

When employed, the employer pays half Medicare and Social Security taxes, and employee pays the other half through payroll taxes. In case of self-employed, one must pay all of it as self-employment tax. However, as an employer, one is entitled to deduct half of those taxes. That deduction, which will be calculated on Form SE, reduces the total taxable income for both self-employment tax and income taxes.

2. Use of Home Office

Taking a home office deduction can be an important self-employment deduction, but there are many IRS rules regarding this deduction. In general, deductible home office expenses are related to how one uses ones home office. They're also partially deductible in proportion to the amount of space the office takes up within the home and the amount of business one do there.

To calculate the deduction for use of home office, Form 8829 is used. The deductible amount is then entered on Schedule C. One can deduct one of two ways: Use $5 per square foot of home office, or use the percentage of home square footage used for business times the indirect expenses.

3. Rent and Mortgage Interest

If one rents or own facilities that is used in the business, rent and mortgage interest are deductible on Schedule C. However, this self-employment deduction is limited to space outside the home. Home office deductions of rent and mortgage interest are only partially deductible.

4. Utilities, Internet, and Phone Costs

If one own or rent office space outside the home, utilities are fully deductible. Again for home offices, these are mostly considered indirect expenses and are only partially deductible. Utilities might include gas, electric, and security systems.

Phones used for business are legitimate self-employment deductions. This includes cell phones for business use and second phone lines in the home office. While one cannot deduct the base cost of the home phone line, one can deduct the cost of business calls made on it. These are deductible on Schedule C.

5. Supplies

The supplies one use to run ones business are deductible on various lines of Schedule C. Consumable office supplies like toner, paper, and envelopes are deducted in Part II of Schedule C. (Equipment such as computers, cameras, printers, and calculators are deducted separately.) One must keep these items separate from those for personal use and organize the receipts.

These types of incidental supplies are deducted separately from the raw materials used if the business is one that makes and sells goods. Part III of Schedule C is used for deducting the cost of raw materials and merchandise.

6. Equipment

Office equipment, tools, or machinery are deducted on line 13 of Schedule C, or the "Depreciation and Section 179" line. First, use Form 4562 to calculate depreciation on assets. One can use this form whether one is depreciating the equipment over multiple years or in one year with a Section 179 deduction.

7. Repairs and Maintenance

This includes the cost of actual repairs as well as service contracts for business equipment and office. These are taken on Schedule C.

8. Retirement Plans

When one is employed, contributions to retirement plans (within the established limits) reduces the taxable income on ones 1040, even if one don't itemize deductions. The same is true for the self-employed. One can establish individual retirement accounts (IRA), such as SEP or SIMPLE IRAs, for self and the employees.

9. Self-Employed Health Insurance Premiums

To deduct self-employment health insurance premiums for self and the family, one must have a net profit on Schedule C, and must not be eligible for coverage on another plan (e.g., spouse's plan). Other restrictions for self-employed health insurance deduction also apply. This deduction is taken on ones 1040.

10. Other Insurance

This would include business, property, liability, malpractice, worker's comp, and any other business insurance. If one have a home office, a portion of the homeowner's insurance is deductible as an indirect expense on Form 8829. If one use a personal vehicle for business, one may deduct a portion of auto insurance (if one is not just deducting the standard mileage). These are taken on Schedule C, except for the homeowner's insurance, which calculated on Form 8829 as mentioned above.

11. Employee Wages and Benefits and Payments to Contractors

One can deduct the cost of labour paid to independent contractors and employees on Schedule C. However, these self-employment deductions are on separate lines: contract labour (Line 11) and salaries and wages (line 26). If one provides benefits to employees, such as health insurance and life insurance, these are also deductible

12. Taxes and Fees

Just as one may deduct the employer portion of Medicare and Social Security for self, one can also deduct these taxes for their employees. However, unlike own taxes, employees' payroll taxes are deducted on Schedule C. Additionally one can deduct sales tax paid, unemployment taxes, and fees for licenses and permits. Property taxes on real estate used exclusively for business purposes are deductible. The property tax on a home in which one have an eligible home office is partially deductible.

13. Interest

Just as mortgage interest for real estate used for business is deductible, other types of interest are deductible as well. This includes financing costs and credit card interest. Separate credit cards for business must be kept to make this interest easy to calculate. This is deducted on Schedule C.

14. Advertising, Promotion, Dues, and Subscriptions

These might include the cost of advertising, websites, business cards, brochures, mailings, memberships, and professional journal subscriptions. Most of these would be deductible on line 48 of Schedule C.

15. Business Travel

The IRS defines business travel expenses as "the ordinary and necessary expenses of travelling away from home for the business, profession, or job." The purpose of the trip should be primarily business not personal. And expenses for family members travelling along are not deductible. Deductible travel expenses may include transportation, car, lodging, meals, and incidental costs.

It may be noted that while employees use Form 2106 to report business travel expenses, self-employed persons report it on line 24a of Schedule C. As per the Internal Revenue Service, for the 2019 tax year, the standard mileage rate is 58 cents per mile.

6. Meals

Meal expenses for business are usually 50% deductible. These expenses might include dining with a client in ones local area or meals while travelling on business. Report them on line 24b of Schedule C. Under the 2017 Tax Cuts and Jobs Act, entertainment is no longer a deductible expense.

17. Transportation and Auto Expenses

Commuting costs are not deductible. However, if the home office is one’s principal place of work, travelling to other sites where one do business may be deductible. When deducting automobile expenses (Schedule C, Line 9) one can either take the standard mileage deduction or one can calculate actual expenses and depreciation and multiply that by the business usage percentage.

Accurate records of the business vehicle use must be kept. Parking fees and tolls should also be added to these figures before entering them on Line 9.

18. Professional Services

Legal fees and tax preparation costs for the business are deductible on Schedule C. The cost of having the personal income tax prepared is not deductible, though, accountant can itemize his or her fees.

19. Business Bad Debts

To write off a business bad debts (an unpaid debt owed to one and incurred in business operation), one must be using the accrual method of accounting, which means one must report your income as it is earned not as it is paid. Because most small companies, independent contractors, and freelancers use the cash accounting method, this is not a common self-employment deduction—but it's useful to know nonetheless. Bad debts are deducted in Part V of Schedule C.