Substantiating business expenses is a common problem for businesses going through an audit with either the Internal Revenue Service (IRS) or the Minnesota Department of Revenue (MDR). In previous blog articles, we addressed the first, second, and third steps of a four step process in an IRS or MDR substantiation audit. This article will focus on the fourth step: proving a business expense is “necessary.”
Section 162 of the Internal Revenue Code (IRC) allows business taxpayers to deduct “ordinary” and “necessary” business expenses from gross income. In general, these expenses must be:
- paid or incurred during taxable year;
- for carrying on any trade or business;
- an ordinary expense; and,
- a necessary expense. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 112 S. Ct. 1039 (1992).
The requirement that an expense is “necessary” appears more demanding than it actually is in practice. The United States Supreme Court has “consistently construed the term ‘necessary’ as imposing only the minimal requirement that the expense be ‘appropriate and helpful’ for ‘the development of the taxpayer’s business.’” Welch v. Helvering, 290 U.S. 111, 113 (1933); Cf. Kornhauser v. United States, 276 U.S. 145, 152 (1928); Lilly v. Comm’r, 343 U.S. 90, 93-94 (1952); Comm’r v. Heininger, 320 U.S. 467, 471 (1943). Generally, if a taxpayer can prove it paid the expense as a cost of attempting to operate a profitable business, the expense will withstand this “necessary” test.
The IRS and MDR typically do not challenge whether a business expense was “necessary” as the requirement for a business deducting the expense is minimal. However, these agencies might challenge a business expense under the “necessary” test if the amount or nature of the expense is unreasonable when compared to the business purpose of the expense.
One example we occasionally see is when a company purchases and utilizes a corporate jet. The IRS and MDR will likely not object to corporate jet expenses as “necessary” if the company deducting the expenses has a national or world-wide presence. The IRS and MDR are more likely to object to corporate jet expenses as “necessary” if the company deducting the expenses has no presence outside of a small geographic area.
This article is the last describing the four step process of substantiating most business expenses in an IRS or MDR audit. These four articles do not explain the substantiation requirements for all types of business expenses. The IRC has “special” requirements for substantiating some types of business expenses, like: travel expenses, meals and entertainment expenses, and expenses for “listed property.” Please watch for further articles in this blog explaining these “special” requirements.