Code Section 162a: What Qualifies as Deductible Business Expenses?

Businesses can lower taxable income by deducting certain expenses, but not every cost qualifies. The IRS permits deductions only for specific business-related expenditures under Code Section 162(a). Understanding these criteria helps businesses stay compliant and avoid audits.

To determine what qualifies, businesses must assess the nature and purpose of an expense and ensure it is properly documented.

Key Principles of Ordinary and Necessary Expenses

For an expense to be deductible under Code Section 162(a), it must be both “ordinary” and “necessary.” An ordinary expense is common and accepted in a trade or profession, such as advertising costs for a retail store or legal fees for a law firm. A necessary expense is helpful and appropriate for the business, though not necessarily essential.

The IRS and courts have clarified these definitions in various cases. In Welch v. Helvering (1933), the Supreme Court ruled that expenses must be customary within an industry to be considered ordinary. In Deputy v. du Pont (1940), the Court stated that necessary expenses must have a direct connection to business operations. These rulings highlight the importance of industry norms in determining deductibility.

Some expenses may seem necessary but fail to meet the ordinary requirement. For instance, if a small business owner buys a luxury vehicle far beyond industry norms, the IRS may challenge the deduction. Conversely, an expense might be ordinary but not necessary if it does not contribute to profitability or efficiency.

Travel Expense Criteria

To be deductible under Code Section 162(a), travel costs must be directly related to business activities and incurred while away from the taxpayer’s tax home, which the IRS defines as the primary place of business. Travel within the same metropolitan area as the tax home is generally not deductible.

A trip must serve a legitimate business purpose, such as meeting with clients, attending industry conferences, or visiting company locations. If a trip includes both business and personal activities, only the business-related portion is deductible. For example, if someone attends a three-day conference but stays two extra days for leisure, only expenses for the conference days qualify.

Deductible travel expenses include airfare, train or bus tickets, car rentals, lodging, and incidental costs like taxis and baggage fees. The IRS also allows deductions for business-related mileage in a personal vehicle at the standard mileage rate, which is 67 cents per mile in 2024. Commuting between home and a regular workplace does not qualify.

Lodging expenses must be reasonable in relation to the business activity. Staying at a standard hotel near a conference is typically acceptable, while booking a luxury resort without clear business justification may be scrutinized. The same applies to transportation—choosing a first-class flight when a standard fare would suffice could be challenged if deemed excessive.

If an employer reimburses travel costs, tax treatment depends on whether the reimbursement follows an accountable plan. Under such a plan, employees must substantiate expenses with receipts and return any excess reimbursement, keeping these amounts tax-free. Under a non-accountable plan, reimbursements are treated as wages and subject to income and payroll taxes.

Meal Expense Criteria

To qualify as deductible under Code Section 162(a), a meal expense must be directly associated with conducting business. This means it must involve a substantive business discussion with clients, employees, or industry contacts. Simply dining out while traveling or eating during the workday does not automatically qualify.

The deduction is generally limited to 50% of the total cost, including food, beverages, taxes, and tips. This applies whether the meal occurs in a restaurant, hotel, or catered business event. However, certain exceptions allow for a full deduction. Meals provided to employees for the employer’s convenience, such as those in an on-site cafeteria to ensure availability during shifts, may be fully deductible. Additionally, meals at company-wide events like holiday parties or annual meetings qualify for a 100% deduction.

Entertainment expenses, which were once deductible when tied to business meals, no longer qualify under the Tax Cuts and Jobs Act of 2017. While a meal itself may be deductible, associated entertainment—such as tickets to a sporting event—must be excluded. If a meal is bundled with entertainment, businesses must document the meal portion separately to claim the deduction.

Documentation Essentials

Proper documentation is necessary to substantiate business expense deductions under Code Section 162(a). The IRS requires taxpayers to maintain detailed records that validate the nature, amount, and business purpose of each expenditure. Without sufficient documentation, deductions may be disallowed, leading to additional tax liability, penalties, and interest.

Receipts, invoices, and canceled checks serve as primary evidence but must be accompanied by supporting details. Expense reports should include the date, vendor name, amount spent, and a clear description of the business purpose. Digital records are acceptable if they are legible and securely stored. The IRS allows electronic documentation under Revenue Procedure 97-22, but businesses should ensure records are backed up to prevent loss due to technical failures.

For payments to contractors or service providers, businesses may need to issue Form 1099-NEC if payments exceed $600 in a tax year. Failure to comply with reporting requirements can result in penalties ranging from $60 to $310 per form, with intentional disregard triggering a minimum penalty of $630 per form.

Distinctions Between Personal and Business Costs

The IRS strictly separates personal and business expenses, and misclassifying costs can lead to denied deductions or penalties. Business owners must ensure that only expenses directly tied to company operations are deducted. Personal expenditures—even if they indirectly benefit the business—do not qualify.

This distinction is particularly important for expenses where personal and business use overlap, such as home offices, vehicles, and technology. A home office deduction is only allowed if the space is used exclusively and regularly for business. A desk in a shared living area does not meet this standard. Similarly, vehicle expenses can only be deducted based on the percentage of business use, requiring detailed mileage logs. The same applies to cell phones and internet costs—if used for both personal and business purposes, only the business-related portion is deductible. Proper allocation and documentation are necessary to prevent IRS challenges.

Coordination With Reimbursement Arrangements

Businesses often reimburse employees for work-related expenses, but tax treatment depends on how these reimbursements are structured. Employers must establish clear policies to ensure compliance with IRS guidelines, particularly regarding accountable and non-accountable plans.

Under an accountable plan, reimbursements are not considered taxable income to employees if they submit expense reports with receipts and return any excess funds. This benefits both parties, as the employer deducts the expense while the employee avoids additional tax liability. Under a non-accountable plan, reimbursements are treated as taxable wages, subject to income and payroll taxes. Employers must report these amounts on Form W-2, increasing the employee’s tax burden.