Ordinary & Necessary Business Expenses: Examples and What Not to Do

In a continuation of episode 4, in this episode of How Tax Works, host Matt Foreman gives examples of what you can deduct as a business expense, including home office deduction, family trips to the Pumpkin Patch, hiring your children, and the so-called Augusta Rule.  This episode is for business owners, attorneys, accountants, and their advisors, as well as anyone who has ever wondered “can I deduct this?”

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:00]:
Welcome to the fifth episode of How Tax Works. I'm Matt Foreman. In this episode I'll discuss ordinary and necessary business expenses under sections 162 and 212 of the Internal Revenue Code. This is the second part of a two parter, so if you have not, you should probably go back and listen to the first part, which is episode four. Recommend listening to that first, although you could really listen to them separately. I really think you'll get more out of this one and I will be basically constantly referencing the previous episode, so I think it'll be helpful. And this episode's really going to be an opportunity for me to discuss some of the most important tax cases that deal with this and give common examples of problematic situations that that arise under these.

Matthew Foreman [00:00:47]:
The most important case, and I'll get into disclaimers in a second, is Cohan v. Commissioner, which is a case I talk about far too often because I think its applicability is really, really broad, even though it's sort of a more minor tax case than actually it probably should be. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and businesses choices we all make. Before we get started, a few Administrative Things episodes again every two weeks. The next episode is going to be another two parter.

Matthew Foreman [00:01:26]:
Sorry, not sorry. I'm going to talk about the tax consequences of different types of equity grants, focusing especially on profits, interests and how and when to make an 83B election. How it works, what to look for. I think that'll be an interesting one as well. And I don't think I can do it in 20 to 30 minutes, which is how I target these. So it's going to split up into two. I'll probably talk about the different types of equity grants in one and then the second one talk about profits interest in detail and and how 83B election works. I'll sort of figure out the exact split, but that's the idea.

Matthew Foreman [00:01:56]:
If you have any questions, comments or constructive criticism, you can email me my FRB email address. We can find you or your favorite search engine. And now we're going to discuss, right, we're going to talk about ordinary and necessary business expenses under sections 162 and 212 of the internal Revenue Code. Before, you know, we get into any detail, I want to Talk about Cohan v. Commissioner citation for those who want to read it. 39 Fed. 2nd 540. It's a 2nd Circuit case written by Justice Learned Hand, whose actual first name is Billings, but he went by Learned Hand.

Matthew Foreman [00:02:25]:
Heck of a. Heck of a name. His brother was also, my memory serves me right, a Second Circuit Court of Appeals judge, which is. It's pretty impressive in and of itself. Second Circuit case. So. So Vermont, New York, Connecticut, and that's it. That's.

Matthew Foreman [00:02:39]:
That's the entire. I think Puerto Rico's actually in the Second Circuit, too. I could be wrong on that. Don't quote me, but I think that's the entire Second Circuit, but it's really the case everywhere. It's a 1930 case, so it's been around for a while, and it's actually just really good general law. I should note that Cohan would lose today, but I think the fact pattern is really pretty interesting. First off, I like to sort of mention, you know, who was George M. Cohan, right? He was a Broadway writer, producer, actor.

Matthew Foreman [00:03:03]:
You may not know him today unless you are very much into Broadway. I would not have known who he was, even though I live in New York, go to Broadway shows without having run into this case. But I will tell you that you absolutely know his work. Right over there, he wrote it. Your grand old flag. That was George M. Cohan as well, involved in a lot of other shows, a lot of other songs, a lot of other things. He has a statue in Times Square next to the TKTS booth.

Matthew Foreman [00:03:27]:
There is pretty much always pigeon poop on it. They. They sit on it and pigeons poop everywhere. So. So that's it. I don't know if that'll get me explicit rating, but I hope not anyway. So the premise of the Cohen case is pretty, pretty straightforward, really. What he used to do as.

Matthew Foreman [00:03:42]:
As marketing. He would throw parties and he would invite, you know, his friends, right? But his friends were famous people in New York. Again, 1930 case. So this is all in 1920. So you think about who was who in New York, right? This person. And that person, George Cohan, kept no receipts. Zero. None whatsoever.

Matthew Foreman [00:04:02]:
But he was able to tell you, you know, how much he spent and what it was and what it was for and things like that. So the case was basically how much documentation you needed in order to prove that these are your expenses. These are ordinary and necessary business expenses he had literally at the trial level, he had his friends come and testify. Now, George, he throws these parties. It's totally reasonable. The food's crazy. Everyone's getting drunk. Stuff's wild.

Matthew Foreman [00:04:28]:
It's amazing, right? You know, people always say, oh, it's his friends, it's his friends. But his friends were sort of a very select group of people. As I said, he was very famous. The most famous person who testified on his behalf by. By a significant margin probably is Babe Ruth, right? You think about how famous a person is, you know, Babe Ruth has been dead for, you know, nearly 100 years, probably 80 years or so by now. And it's really hard to not know who he is, right? You have to be almost intel intentionally to do it. If you live in the United States, you don't know who Babe Ruth is. Right? Cultural icon.

Matthew Foreman [00:04:57]:
He testified on his behalf. That level of fame, that level of friends, things like that. So I think it's important, you know that Cohan wins, right? They say, look, you don't have to have exact receipts. You don't have to have a perfect business purpose. But the idea was marketing, right? Bring his friends over, they get excited for his shows. He's right. He'd raise capital to do his shows. He would use that as this is marketing for his shows, things like that.

Matthew Foreman [00:05:21]:
And that was really important because it was in. It was in the newspapers that he had parties, you know, stuff like that. I always point out that Cohan would lose today. His expenses were for ordinary necessary, but they were for food. And now under Treasury Reg. 1.2 74/5 C2 Roman AT. I think it's Roman AT3 and notice 95, 50 if the amount you pay exceeds $75 for business travel, vehicle expenses, gifts, things like that, you know, you need a receipt. So he probably need a receipt today.

Matthew Foreman [00:05:49]:
They'd have a real, real tough time winning. But he lost. But the idea is still there, right? Substantiation. You don't need perfect documentation. The IRS will tell me that I'm wrong. They're wrong. What you really need is documentation to show that, you know, you spent it on this. This was the amount.

Matthew Foreman [00:06:04]:
This is what it was for. You can have contemporaneous documentation. There's a lot of documents, a lot of case law on that that I think were really helpful and talk about different things you're going for. So. So keep documents, keep records. That's the important thing. As we go into it, just a reminder, ordinary necessary business expenses. I'm largely going to ignore 212 today because I don't.

Matthew Foreman [00:06:22]:
I don't think it's as applicable, so. Especially given current law. So I'm really going to talk about 162, but again, 162 very similar to 212, right. There are four requirements. There must be a trade or business. The expense must be an ordinary expense and a necessary expense. Three, the expense must be incurred carrying on a trade or business, that same trade or business. And four, it must be paid or incurred during the tax year.

Matthew Foreman [00:06:46]:
So, so keep those in mind. The first one we're going to talk about is hiring children, right? People talk about they pay their kids, they pay their kids wages, things like that. It's important to note that in order to hire your kids, you know, market rates are really important. Have a contract, don't violate labor law and hiring your kids, don't hire an 8 year old for a 14 hour day, right? That's maybe good for tax purposes. You might get a huge penalty and that's bad. Penalties are generally not deductible. So it'd be even worse, right? They must actually perform the services for which they're paid. You can't just have a no show job for a nine or.

Matthew Foreman [00:07:20]:
Right. That's an easy audit, that's an easy loss. And they're going to be like, you're going to pay penalties because we're not happy about what you did. Right. So I always tell people, you know, maybe, maybe don't do it, maybe not, right? But there are certain situations when you do. Right. I know a lot of people, you know, the example I always give is a pediatric dentist. People like pictures of them doing things.

Matthew Foreman [00:07:38]:
Everyone loves pictures of cute kids. So, you know, pictures with the kids, right? Could be your child, you can pay them, find out what market rates are, things like that. That's really important. There are situations, you know, I can tell you. In high school, my dad was a dentist. I worked in his office sometimes and I did administrative filing in his office. I did work that a high schooler could do and I did it and my father paid me a wage. It was not a whole lot above the minimum wage, but you know, it was what he would normally pay for this type of work.

Matthew Foreman [00:08:04]:
So that's really important. But you know, make sure to withholding taxes, you know, withhold the actual income taxes, withhold payroll taxes, things like that. File the return, you get it back. In this situation with hiring children, again, you know, keep records, right? And contracts is important. I tell a lot of people that a Roth IRA or college students who work and things like that that have just very low rates because their total income is very low. Roth IRAs can be great because it's earned income. Right. And if you can take them and you can say, okay, well, you're not going to get the money.

Matthew Foreman [00:08:33]:
I'm not going to let you, you know, spend it on whatever you can have half of it or part of it, put it into a Roth ira. Tax rate's very low, never taxed. That can be a great way to do it, especially since the Roth limitation is so low. Right. Couple thousand dollars. So that's one thing you can do. The second one is one that I'm not entirely convinced fits perfectly into this because it really doesn't deal with ordinary necessary business expense. But I'll get there because I think it's one that you hear in a similar vein.

Matthew Foreman [00:08:58]:
Right? Ways to save money, ways to not pay taxes. Right. And it sort of backs into it. It's the Augusta Rule, Section 280, Cap A of the Internal Revenue Code. There's no section 280. There is a cap A, cap B, cap C goes through. I think there's like G or H. There's a lot of.

Matthew Foreman [00:09:13]:
I'm sure someone will tell me I'm wrong. That's fine. And it's often referred to two 80 cap G, subsection C, it's called the de minimis Home Rental Rule, commonly referred to as the Augusta Rule. And the premise behind it is if you rent your house or really anything for less than 15 days, then you do not include the rental income in your income. Right. It's excluded from your income. So it's. It's free money.

Matthew Foreman [00:09:39]:
So what a lot of people do is they rent their house to their businesses for business meetings or to be used by the business, things like that. So you have, you know, a business with an entity, llc, corporation, whatever, is paying money to them as individuals, and they're say, well, it's for less than 50, 15 days, and therefore it is excluded. The amount that you pay in rent has to be reasonable. Okay. There's a recent case on it from last year. Sinopoli S I N O P O L I T C Memo 2023, 105. They paid a lot of money to themselves for it. So the issue was not whether they rented it for less than two weeks there for less than 15 days.

Matthew Foreman [00:10:19]:
They did. The issue was they decided they were going to pay themselves $4 billion. Right. I'm exaggerating here, but that's the idea. That's what you want to think about is what is the actual, again, similar to hiring children. Augusta Rule. What is the market rate so you needs to be a reasonable amount, how much would you actually do it for these services? You know, it's called the Augusta Rule because of Augusta national, right? And for the Masters, people rent their house for two weeks. I like to call it the US Open rule because it's all US Open, right? Tennis up here is about two weeks as well, and everyone's allowed to attend.

Matthew Foreman [00:10:49]:
It's not like the Augusta Rule, which it's only Augusta national, which is a private invite only tournament. So something to think about there. One point, you know, I always bring up with this is, does a State actually follow two 80A sub G, right? Is that something that the state does and people say, well, of course they do, that's the law. And this is, you know, an interesting kind of quirk. But, you know, and you'll have to look at this for everyone, right? States can have different rules, different laws than the federal government. The starting point for Internal Revenue, for state tax codes is the Internal Revenue Code is federal law. But they do something called decouple. They can change.

Matthew Foreman [00:11:20]:
They can not go with current advancements. They can have case law that's different or they can just say, yeah, we're not following it. It's very common in a lot of situations. And I think that that's one thing that's really important to make sure to think about. And that's really it also for the Augusta Rule. And this is really important not only, you know, what what happened was the Augusta Rule was blown on an income level because they paid way too much. And this is where it goes back to 162. This is, this is a mount question question.

Matthew Foreman [00:11:45]:
Okay, how much is the amount that you actually can deduct if you just make the amount way too much, right? It has to be an amount that's ordinary, right? So it can't just do $5,000 a day. The amount to rent a house or to rent a room, you know, for a board meeting or something like that might be a couple hundred dollars, right? What would you rent a conference room for? And that's important to note that it's, it's not always as much as people think it is. So I always point that out and take a quick, quick couple second break and come back with a few more. Okay, and we're back. So the next one is the home office deduction. This is one that, you know, I tell most of my clients, like, honestly don't. It's really not worth it. And it's for two reasons.

Matthew Foreman [00:12:34]:
First off, most of the time, most People don't meet the requirements. Right? Because the requirements, and I'm summarizing, I'm skipping some things, is that you have to have exclusive use of that space in your home for your home office. Right? So if you have an extra bedroom that people stay in sometimes, if it's a room that during the day is your office, but at night your kids play in it, that's not exclusive use. That's not a home office from an income tax perspective, and therefore it's not deductible. The auditors will come to your house, they will ask for pictures and they will not believe a word you say. So it's really important. The burden, you'll say, oh, the auditor has to prove. And I say this quite often, right? You have the burden as the taxpayer to prove exclusive use.

Matthew Foreman [00:13:18]:
They will walk around the rest of your house and say, well, where, where do your kids sleep? You know, why is there a pull out couch in this room? You know, and things like that, right? You say, well, you know, occasionally. Well, occasionally is not exclusive use. So I think that that's really important. The amount that you can deduct is really interesting. I've seen people who deduct their entire mortgage don't do that. I see people who deduct all of their rent, again, don't do that. What you're supposed to do is take the percentage of your house that is that and that's what you're going to deduct. There's also a revenue procedure.

Matthew Foreman [00:13:48]:
Can't believe it was more than 10 years ago now, but RevProc 2013-13, if I have the citation, right? And basically what they did was they said, okay, there's going to be a standard rate per square foot multiplied by the square footage of the room and that's how much you get. Not Going to be great for people in New York. Going to be really good for people, you know, in lower rent, lower cost of living areas. There's also a fact pattern that I think is really not, you know, one that I don't want to say this is common. I'll give an example of a client, a former. I don't think they ever actually became a client of mine. They had, you know, they lived upstate. I think they lived in Rockland county, which is just north of Manhattan, just north of New York City.

Matthew Foreman [00:14:25]:
And they had a home office there. They had an office in Rockland county, it was about five miles away. And they had an office in Manhattan. And they were deducting both offices and actually their entire Mortgage, right? And I remember having a conversation saying, like, well, you. You can't do that, right? You think about it from a reasonableness perspective. You know, I think even the most aggressive people would say, wow, that seems a little off. That seems a bit much. So I think it's important to say, you know, reasonable, reasonable, reasonable.

Matthew Foreman [00:14:56]:
On things like the home office deduction, people said that I see things only as black and white. Or that I take the IRS's stand, which I don't think is true. And there's a great Calvin and Hobbes comic. Bill Waterson, the. The author of Calvin and Hobbes, was in a. I'll say a tiff with the distributor. I think it was the Universal press syndicate of his comic. And he didn't want to license his Calvin and Hobbs for merchandise, right? He was sort of the outlier in that regard.

Matthew Foreman [00:15:24]:
And they accused him of seeing everything in black and white. And there is a great Calvin and Hopps comic, a lot of great Calvin Hobbs comics. And the whole thing is, you know, Calvin sees everything in black and white and black and white. And at the end of it, his father says, you know, Calvin, not everything is black and white. You know, why do you always see things in black and white? Everything's black. When I'm sure I'm getting it wrong and someone will correct me on it. And he says, because that's sometimes that's the way it is. And I always say there's shades of gray, there's a lot of color, and you need to think about it.

Matthew Foreman [00:15:55]:
But sometimes there are things you hear and you just go, hmm, that's not right. Or you think, oh, yeah, that works, right? And so it's important to know where those different striations are, where the different stuff you're going for. And I think it's really, really important to understand fundamentally where those lines are and. And know what the audit risk. And that's a lot of times what people do, you know, when they go to a professional and they say, look like, what are my risks? So it's important to engage a professional who's done this before, who's thought through this, who's gone through audits, which. Which I have. The next one is, you know, a bit of a quicker one. And I call it.

Matthew Foreman [00:16:26]:
You know, I talked about a little bit with hiring children, but I call it, let's go to the pumpkin patch, right? And what the idea is here is you take a family outing, right? Pumpkin patch, fun thing to do, you know, fun fall, right? Getting cooler. Everyone goes Pick a pumpkin, you get some apple pie, whatever, pick some apples, that kind of thing. And you take pictures with your children, your family, and then you put them up on your website, right? There's a level of humanity that helps sort of take people who have professional and technical jobs and really humanizes them by saying, well, they have kids, they do things other than prepare tax returns, analyze the Augusta rule, make sarcastic comments, right? That's something they do. And you put on your company website these pictures on social media or whatever. And this is one that really goes into ordinary and necessary as a prong of the ordinary and necessary expense, right? Under Swan 62. And the way I always say, is the obligation itself for the expense arose from the business, right. Appropriate and helpful. Is it helpful? Yes, but it's not appropriate or helpful.

Matthew Foreman [00:17:27]:
It's both. It is that the expense itself is both appropriate and helpful. So again, people tell me that I see things incorrectly, right? I see things in black and white. But this is one where it's really tough to do. If you are a wedding photographer or you are a person who takes pictures of families and doing things like this, and you do this for your family, you have a better argument. But for most of us, honestly, deduct the cost of the photographer and call everything else a day, you know, that's it. That's the most. Don't deduct the pumpkin patch, don't deduct the gas, don't deduct the lunch, don't deduct the family outing.

Matthew Foreman [00:18:04]:
I'm not even entirely sure you should be deducting the photographer themselves. So I think it's really important to think through, you know, what should you be do? Because is it really. Is this an appropriate expense also, you know, from ordinary necessary. You think about the. For the necessary problem, you think about the normalcy of the obligation, right? It must be reasonable to do this. Is it wrong to do this? No. Is it reasonable? Does an accountant, does an attorney, you know, does someone who runs a car dealership, do they really need pictures on their website, right? As in the business expense of a trip, a family trip, right? That's. That's not where you're going for.

Matthew Foreman [00:18:40]:
And I think it's really important to think through, you know, what is normal, what are people trying to do and things like that. Reasonable is the key here, right? You know, you don't want to be the pig because pigs get slaughtered, right? It's a term about picking stocks. But bulls and bears make money. Hogs get slaughtered. Don't be the hog, right? That's really the way to look at it. So think about it. The last one I always do is a really, really challenging one to quantify and to really qualify. Like, is this correct? Is this what we're looking for? Is this the problem, right? And it's one where people, they go on vacation and they look at real estate to invest in.

Matthew Foreman [00:19:18]:
And it's a really tough one to really create anything that even remotely resembles a bright line test. Because you have people who are real estate professionals, right? They invest in real estate, they're investing throughout the Northeast, throughout the country, whatever. They go on vacation and suddenly they're, you know, ostensibly evaluating real estate in Milan, right, While they're there. And they're like, well, I deduct my entire family's vacation patient. That's a tough one to do. The entire family, like, well, you know, I deduct my hotel room, right, which my wife stays in, my spouse stays in, whatever. I deduct, you know, my flight, I deduct food for two or the three days when I'm there. I do this and I do that.

Matthew Foreman [00:19:55]:
And I always say, you know, going back to ordinary, necessary, right? Is it ordinary to bring your entire family on vacation, right? Is that necessary? Could you have done this less expensively? And that's always the quantification, right? How to think about it, how to qualify whether the expenses are ordinary and necessary. If you have never invested abroad before or you've never looked at this type of property, right? You don't have to have done the business before. Absolutely not. I talked about that in the last episode. But there's an extension where you're going so far above and beyond. If you invest in properties on the Jersey Shore is a trip out of the country to look at, you know, real estate where you spend three hours looking at real estate on a 10 day trip. Is that really, you know, is that really an ordinary necessary business expense? And do you want to be in the situation where you suddenly have $20,000 of deductions that you need to take back and pay tax on with interest and penalty? So I always say, you know, and this to me is always really important is think about the reasonableness, right? Ordinary and necessary. Is this necessary, is this ordinary for this type of business to take this deduction? And I always point that out, have the discussion, you know, I don't prepare tax returns, so I don't know what a lot of these people end up doing.

Matthew Foreman [00:21:11]:
But it often turns into a situation where I think, people think, well, I'm going to Save so much money, I'm going to write off all my expenses. And what they're doing sometimes is just opening themselves up to audit risk. And for an amount of money that maybe is worth it, maybe not. And sometimes it's, you know, I always tell people, sometimes it's just worth not doing it, have no audit risk, don't worry about anything. And I think that that's the real. The real thing to think about. That's the real qualifier is, is this worth the risk? And that goes back, you know, hiring children, Augusta rule, home office deduction, going to the pumpkin patch, things like that. You know, is it worth it to do it? Is it worth it to have this audit risk? And I bring this up in many contexts.

Matthew Foreman [00:21:51]:
So that brings me to my final point. You know, what do I do? Hire a qualified advisor and make a decision? Do you deduct it? Do you not deduct it? Do you take the risk? Do you say, look like it's a. It's an ordinary necessary business expense. This is why I do it for my business. This is what I'm doing, and this is what I want to think about, right? And that's it. Have that conversation. It's important to do it. So that was the fifth episode of How Taft Works.

Matthew Foreman [00:22:15]:
I hope you learned something. I'll be back in two weeks. It'll be the second sixth episode. And I'm going to talk about the tax consequences of different types of equity grants, profits, interests, 83, 83B elections. And I hope you enjoy it. Thank you. And take care. Of.