The IRC allows a deduction for "ordinary and necessary" expenses of a trade or business. It goes on to give examples, such as reasonable compensation for services actually rendered, traveling expenses away from home in pursuit of a trade or business, and rent for business property.
There are many other types of expenses, but the key is whether the expenses are both "ordinary", in the sense of typical or customary, and "necessary" in the sense of appropriate. There are no complete definitions of what is "ordinary and necessary". A deductible expense must meet both tests. Ordinary and necessary expenses would often include office rent, utilities for the office, office supplies, business liability insurance, advertising, legal and professional fees, business loan interest, repair and maintenance costs , and many others. What would be ordinary and necessary would be the kind of expenses that were standard to all businesses in your particular industry.
Similarly, what compensation is "reasonable" has been the subject of much litigation and is essentially a factual inquiry. A reasonable expense would be an expense where the amount of the expense makes sense related to your income and other expenses. If you are paying $1,000 a month for office rent and have gross income of $15,000 a month your rent expense would be likely to be considered to be reasonable as it is less than 10% of your monthly gross income.
Examples of "ordinary and necessary and reasonable"
Example 1: You are a tax consultant and you have an office where your employees work and where you perform most of your work. Your office is where you see all of your clients. You also have set up an office in your home and you do quite a bit of work there, after hours, but you do that for your own convenience. The IRS will not consider deductions for an “office in the home” to be reasonable or necessary as you see no clients there and work there merely for your own convenience.
Example 2: On the other hand, if you are a sales representative, and your territory is where your home is located, but your company’s offices are in another state, you do need a place to do all your paperwork, communicate with the company and handle any web-based communication. Your company's management does not feel that it is cost effective to rent offices, as clients are visited in their own places of business. Therefore you work out of your home. You have a designated work space. That would be a valid office in the home and the expenses would be deductible, as it is for the convenience of your employer.
Exxample 3. You are self employed plumber and have a cell phone with an unlimited plan that you use extensively for business. However, your cell phone is also used extensively for communication with your family and friends. Only the percentage of your cell phone usage that can be traced to your self employment is deductible. The same would apply to internet connections.
Car lease payments
Another example of a questionable expense involves car lease payments. The IRS lets you deduct vehicle expenses, on Schedule C, Form 1040, in one of two ways: actual cost method or the standard mileage rate, but not both, and not a combination. If, for example, John leases a luxury car through his company and splits usage between business and personal purposes, his lease payments are not 100% deductible. If John leased the car in his own name, and kept a good mileage log, then John could choose to deduct the actual cost (i.e., lease payments, oil, gas, insurance, maintenance) or claim the standard mileage rate (currently 51 cents a mile for the first half of 2011, and 55.5 cents a mile for the second half of 2011) for all business miles. If John wishes to use the standard mileage rate he must elect the option the first year the vehicle is in operation. He can switch from the standard mileage rate to actual expenses, but you cannot switch from actual expenses to the standard mileage rate.
Business or work clothing
The deductibility of business or work clothing is another example that often bears extra scrutiny by the IRS. While it might be tempting to claim a deduction for the costs of the suits that you wear to work and any associated dry cleaning expenses, it is not a business tax deduction. Only work clothing that is not suitable for everyday use is deductible. Examples are uniforms and work boots.
Business meals and entertainment
One of the biggest areas of business expense that is a “hot spot” for the IRS is business meals and entertainment. While business meals and entertainment can certain be a valid deduction (generally only deductible at 50% of the expense) there must be a true business reason for the meal or entertainment. Taking your biggest client out to lunch once a month to discuss his account is a valid business expense. Taking your best friend and his wife out to dinner, along with you and your wife, and mentioning your business during the course of the evening, is not a valid business expense.