 Hello and welcome to this session in which we will discuss the deductibility of business expenditure which is which is called business deductions business deductions they must be ordinary and necessary as well as reasonable this is an important topic in the real world because in the real world businesses like deductions now you might be saying but deduction incur cost why do we like to incur additional cost the reason is as your cost as your deduction if you can take more deduction your tax bill goes down so you want to earn or you want to qualify for any business deduction that's out there because you will be able to reduce your tax bill and the IRS they might look at your business deduction as a form of audit so they might want to look at your business deduction whether they are acceptable or not now the IRS has specific guidelines for what is considered deductible for business expense but the guidelines are not clear cut the expense must be ordinary and necessary also the compensating for services wherever you pay for services must be reasonable and this is where the term ordinary and necessary and reasonable those three terms so in this session we will try to explain what does the IRS means by those three terms when it comes to business deductions because business deductions are good businesses like deductions before we proceed any further i have a public announcement about my company farhat lectures dot com farhat accounting lectures is a supplemental educational tool that's going to help you with your cpa exam preparation as well as your accounting courses my cpa material is aligned with your cpa review course such as becker roger wiley gleam myles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions through false questions as well as exercises go ahead start your free trial today let's go ahead and start with the term ordinary what is what is what is ordinary well an ordinary expense it's it's one that is common they don't tell you exactly what type of expense just they give you a definition that's common and accepted in your trade or business so what's common and accepted in your traded in business may not be common and expected in another trade of business for example you might for example have a subscription for youtube why because part of your business is your youtuber well you want to have some additional features of youtube if that's your business if you are in the construction business a subscription to youtube and you don't use youtube may not be an ordinary type of business for you so it all depends on your business it's an expense that would not be out of place or unusual to find out in that type of business that you are running simply put it's normal usual and customary now the expense that you incur does not have to be incurred on the regular basis or frequently so it doesn't have to be incurred all the time as long as it's normal usual acceptable for your type of business the other indication if other businesses also incur the same type of business then it's considered ordinary so how would the IRS look at this well if you're incurring this business they would look at similar businesses if similar businesses are incurring the same type of expense then this expense is considered ordinary and therefore it meets the ordinary for example if you own a restaurant expenses for قد تفعل is or when you own a restaurant or cooking ingredient cleaning supplies for the kitchen uniform for your staff our ordinary expenses because there are typical and accepted in restaurant industry this is what an ordinary is an example of an ordinary something that you would use in your trade and business the second component of this is ordinary and او بيزنس. ماذا يجب أن تساعد؟ يجب أن تساعد. now it doesn't have to be absolutely critical okay to be considered helpful and appropriate to be considered necessary it doesn't have to be indispensable to be considered necessary as long as a prudent business person incurred that expense then it's necessary as long as a business person another business person they may not but if they do it it is necessary what could be an example now let's assume you have a business can you run your business without advertising sure you can run your business without spending one dollar in advertising so advertising costs for your business would be considered necessary because even though your business could technically operate without advertising you don't have to advertise but it's considered helpful and appropriate to advertise to bring customers so that's what necessary is another example you could be a graphic designer or in the graphic design business so a necessary expense would be the purchase of a graphic design software well we can say well you really don't need the software because theoretically you can work with a pencil and a paper well using a professional software though is necessary because it's more efficient and standard in your industry so it's necessary because you can live without it but it's helpful for your business it's helpful and appropriate therefore it's considered necessary now the third condition is is reasonable it has to be ordinary and necessary then the word reasonable again the word reasonable is not defined but imply that the expense cannot be excessive it cannot be too much okay and would be acknowledged as reasonable by peers in the same industry so simply put if you run this number by someone in your business and in the similar business of yours if if they think it's reasonable what you paid for your services then it's reasonable so it's not something that's it's hard to kind of judge the IRS would generally look at whether the cost would seem reasonable to a disinterested third party how would they know whether it's reasonable or not if a third party pay for this another party pay for the same service the same amount then that's considered reasonable now bear in mind bear in mind if the transaction is between related party transaction what does that mean it means it's between the owner of the business and the business itself so for example you have an S corporation you have the owners they have the owners have rental property now the owners are renting the property to the S corporation well you have to look at this little bit more a little bit more closer because there's a related party when there's a related party transaction the IRS will open their eyes a little bit further at the end of the day you have to look at it from a third party perspective or the third party pay for this pay for this service this much again if the expense appear to be excessive or out of line what would be typically expected in your industry it will be deemed unreasonable and what would happen if it's deemed unreasonable let's assume you're paying rent worth of eight thousand dollar per month but the fair market value should be five thousand let's assume that's the case or four thousand because they look in your area and and the most expensive rental office that you're using is five thousand why are you paying yourself eight thousand why you're paying maybe that you own the rental property or your friend or your boyfriend girlfriend relative well if that's the case it's a related party transaction and it's not reasonable so they will just basically say you we cannot take the five you cannot take the eight thousand you have to consider three thousand another example would be if you're on a small small business home-based business and decide to host a meeting at a high-end luxury resort the IRS might determine that the cost is excessive and not reasonable for a not reasonable business expense if you hosted this meeting at a local office shop or renting a modest conference room it would be not reasonable now at the end of the day bear in mind it's subject to interpretation and assessed case by case basis so it's not like maybe maybe let's assume you are a small business but you decided to host this in a high-end luxury resort luxury resort well the IRS would say well hold on a second that's not reasonable you'd say look i am trying to attract high-end client i'm changing my client base i want to show a different image of the company well then it becomes reasonable so it's case by case there's no answer for these ordinary necessary and reasonable ordinary and necessary it's easy because you could look at other businesses whether it's reasonable or not it gets a little bit complicated especially when you have related party transactions involved the best ways to take a look at an example to illustrate these concepts okay let's take a look at this example adam who works independently as a tax lawyer so he's an attorney along his employee sue participate in a tax conference in las vegas hosted by the american institute of certified public accountant now if you are if you are another student member of this organization i suggest you do so and if you're not a member of your state society whatever for example i'm in pennsylvania i'm a member of the pi cpa if you're in new jersey you want to make sure you join the new jersey cpa society so make sure you do that but always the american institute of certified public accountant so they are having a conference in las vegas his attacks attorney and they paid the following adam paid registration fee for the a icpa conference 1200 it's a three day three day conference and and he paid for sue 1200 sue is his employee they flew from philadelphia to nevada to las vegas nevada adam paid 650 sue paid 400 maybe he traveled first class sue traveled regular class or they paid or they or they bought the ticket at a different time uber from the airport and from the air from the airport to the hotel 80 dollars lodging in las vegas adam 800 sue 550 okay they stayed in a different hotel or maybe adam upgraded it does not matter assuming and we're gonna be assuming all these amounts are reasonable which one of these amounts is considered taxable taxable not taxable deductible for for adam's tax office what we're gonna assume because he's a tax lawyer he wants to learn more about accounting so registration fee for adam is deductible it's necessary ordinary maybe it's also is a tax lawyer they may be getting continuous a professional education cpe credit they may need it for that even required not only necessary and ordinary it might be required for sue adam wants sue to learn more about the business that's ordinary and necessary can they get to las vegas can they get to nevada without flying well they can drive that's another option but they took a plane well if they drove it's gonna take them few days to to get there therefore that's even normal necessary and it costs 650 it might cost up to a thousand dollar the flight that's also deductible ordinary necessary and reasonable uber 80 dollars again you need to get from the airport to the hotel and maybe from the hotel to the conference maybe the conference inside the hotel it doesn't really matter uber is reasonable lodging you want to stay there okay 800 for adam 554 so we're gonna assume these are reasonable let's assume adam wanted to stay in the and adam paid you know 7000 dollar well the irs might might might look into this well it's might be not reasonable okay it may not be reasonable or adam might have paid 7000 but that weekend those were the market prices so adam had no choice so notice even if we go from 800 to 7000 would that be reasonable or not giving the circumstances for that weekend maybe that weekend there was a some you know important event concert and all the hotels were fold fold and the prices were skyrocket and if he paid 7000 that's under the circumstances that is reasonable that is reasonable assuming he did not have any other alternative so this is what we buy ordinary necessary and reasonable again it's case by case but you need to have a good idea about what does that term mean because business deduction to take a deduction it means you are lowering your taxes when you lower your taxes businesses like to lower their taxes the government don't like this so they tell you it's ordinary necessary and reasonable they keep it vague for what purpose they can always question you what should you do now go to farhat lectures whether you are a CPA candidate enrolled agent or an accounting student look at additional mcqs true false resources that's going to help you understand these concepts and get ready for the exam good luck study hard and of course stay safe