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What are ordinary & necessary business expenses? It depends

Every tax filing season we hear the stories. Folks claim, often successfully, a variety of wacky tax deductions.

Arnold-schwarzenegger-bodybuilding-posterThere's the bodybuilder (No, not Arnold, but c'mon, what a great poster shot! I had to use it!) who was allowed to write off body oil as a business expense.

The exotic dancer whose breast implants were deemed deductible stage props for her job. (Did you really think I'd go there with the image choice for this post?)

The gas station owner who gave his customers free beer and then legally deducted the brewski promotion as a business expense.

As all my tax savvy readers have already noticed, it is much easier to claim deductions when they are business related.

Ordinary AND necessary: The key for business write-offs is that they be ordinary and necessary expenses.

So what does that mean exactly?

First, note the "and." The expense, as detailed in section 162 of the Internal Revenue Code, must be both, not one or the other.

Section 162 doesn't define either ordinary or necessary. The Internal Revenue Service, however, takes a stab at playing Merriam-Webster.

An ordinary expense, says the IRS, is one that is common and accepted in your trade or business. This means that what may be deductible for one business may not be allowed off for another.

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.

Determining ordinary and necessary: In many situations, it's pretty obvious what is ordinary and necessary for a business.

Generally, use your common sense.

There's also what has been referred to as the laugh test. As you enter the item on your tax return, can you do so without laughing about how you're getting the better of the tax collector?

Here's a great example from a U.S. Tax Court case:

Mr. Henry, an accountant, deducted his yacht expenses, contending that because the boat flew a pennant with the numbers "1040," it brought him professional recognition and clients. The matter ended up before the tax court. The court ruled that the yacht wasn't a normal business expense for a tax professional, and so it wasn't ordinary or necessary." In short, the yacht expense was personal and thus nondeductible. (Henry v. Internal Revenue Commissioner, 36 TC 879 (1961))

More than 50 years later, that standard, which got Mr. Henry laughed out of court without his write-off, stands.

Document, document, document: Also remember that for a business expense to be allowed, you need to be operating a business. That means you're doing whatever it is you're doing in order to make a profit.

If the IRS determines your activity is actually a hobby, you still might be able to use the expense for some tax relief, but not as much.

And in every case, it comes down to substantiation.

If the IRS asks -- and if an examiner is chuckling at something on your return, you can be sure there will be questions -- be prepared to show exactly how your claimed deduction is ordinary for your occupation and necessary for the operation of your business.

Don't deduct that! All this talk about ordinary and necessary expenses brings us to today's Daily Tax Tip. Today's items looks at 10 deductions you shouldn't dare claim. If you do, you'll end up talking to a tax auditor, which likely will mean more taxes, penalties and interest.

But fear not. Today's tax tip also offers related tax breaks that do pass IRS muster.

So gather up your tax material and supporting documents and with a smile (not a laugh!), deduct away!

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