Defining ‘Ordinary and Necessary’ Business Expenses
As a self-employed business owner, the IRS allows you to deduct all “ordinary and necessary” business expenses. But be careful: This is a subjective and arbitrary area of tax law. What may be deductible for one business may not be a bona fide write off for another company.
For example, a junk yard owner’s deduction for the care and feeding of Dobermans used for security purposes would be a valid “ordinary and necessary” business expense. But if the same owner were running a beauty salon and attempted to claim the same deduction, an auditor would roll his eyes and holler, “disallowed!”
What’s allowed to be written off is so subjective that there have been court cases on the matter. Here’s an interesting one: In 2002, the owner of a janitorial service franchise, which was an S Corporation, took a female friend, his bodyguard and an employee on a trip to St. Maarten. It was not a business trip-- it was purely for fun and games. During the trip, the female friend suffered fatal cardiac arrest after ingesting a large amount of cocaine and died. The woman’s mother sued the business owner alleging that he provided and plied her with the drugs and caused her death.
He offered to pay $250,000 to settle the case. His board of directors was worried about the unpredictable nature of juries and that franchisees would “jump in for a second helping of litigation” if the case hurt their business. So the board approved a settlement of up to $5 million in addition to the owner’s contribution of $250,000.
The case settled for $2.3 million. The corporation reimbursed the owner for the $250,000 that he contributed. Then the corporation attempted to write off the deduction. And it’s easy to see why: A high-profile case like this could damage business, and it was important to keep the story quiet. Not to mention that legal fees to protect an income stream are generally deductible.
But in this case the IRS disallowed the deduction.
In the words of the court, the IRS asserted:
"…however jumbled and wrinkly the legal topography created by the collision of the code, regulations, and case law may sometimes seem, it cannot possibly hide a crevice dark enough to successfully shelter an argument that the price paid for the death of the boss’s girlfriend is a deductible corporate business expense.”
I can see its reasoning. First of all, the focus of the trip was not for business. It was considered a vacation.
But even if the trip was for business, an illegal activity was performed: using illegal drugs. This would be the second strike. And two strikes were all that was needed - personal purpose and illegal activities.
The important thing to note is that the conduct did not arise from profit-seeking activities and was therefore disallowed as a business deduction.
Now, if the purpose of the trip to St. Maarten was business related, like finding new franchisees to expand into that area, and through the fault of the owner or employee the female companion were killed, say in a boating accident, then the claim would certainly be considered in a different light.
Keep this premise in mind when considering what a valid deductible expense for your business is.