Business expenses must be considered ordinary and necessary to be tax-deductible. Expenses outside of a business’s trade are considered personal expenses and are not deductible for the business. All business expenses must pass a five-part test to qualify as a deduction allowable under Section 162. The five-part test states that expenditures must:
Be paid or incurred during the taxable year
Be for carrying out a business or trade
Be an expense
Be necessary
Be ordinary
Business startup expenses are not deductible until a business is out of the startup phase and is actively attempting to sell or market its goods or services.
Taxpayers are required to maintain records to substantiate expenses claimed on their tax returns. The court will not accept the shoebox method for maintaining records. The IRS expects documents to be organized and will not sort through a box of unorganized documents and receipts.
If a taxpayer is unable to substantiate the precise amount of an expense, but they are able to establish that they did incur a deductible expense, the court may approximate the deductible amount. The taxpayer must still present sufficient evidence for the court to make an estimate. Estimates are not permitted for certain types of expenses including travel and entertainment.
