Key Takeaways
- Business expense must be "Ordinary" and "Necessary" under §162.
- "Ordinary" = common and accepted in the trade/business.
- "Necessary" = helpful and appropriate (not indispensable).
- "Reasonableness" applies strictly to compensation and related parties.
- Personal expenses are never deductible (§262).
- Business vs. investment vs. personal = critical distinction.
Ordinary & Necessary Test
Why This Matters for the Exam
The "Ordinary and Necessary" test is foundational to Part 2. Every business expense question starts here. The exam tests the definitions and the reasonableness requirement.
Exam Note: For the May 2025 - February 2026 testing window, you are tested on §162 rules as of December 31, 2024 (Tax Year 2024).
Expect at least 3-4 questions on this standard.
Section 162: The Foundation
| Element | Meaning |
|---|---|
| §162 | Trade or business expense deduction |
| Ordinary | Common and accepted in the industry |
| Necessary | Helpful and appropriate (not essential) |
| Reasonable | Amount must be fair market value |
The "Ordinary" Test
| Factor | Description |
|---|---|
| Industry standard | Common in that specific business |
| Context matters | Varies by taxpayer's field |
| Not recurring | Doesn't need to happen every year |
Example: Professional athlete's supplements = ordinary. Freelance accountant's supplements = probably not ordinary.
The "Necessary" Test
| Factor | Description |
|---|---|
| Helpful | Contributes to profit potential |
| Appropriate | Fits the business purpose |
| NOT required | Does not need to be essential |
Key Point: IRS won't second-guess business judgment unless expense is clearly unrelated.
The "Reasonableness" Requirement
| Area | Application |
|---|---|
| Officer compensation | Excess = constructive dividend |
| Related party transactions | Must be at FMV |
| Result of excess | Disallowed or reclassified |
Officer Compensation Example
| Company Payment | IRS Analysis |
|---|---|
| Owner-employee salary: $500,000 | |
| Comparable non-owner salary: $200,000 | |
| Reasonable: | $200,000 |
| Excess (constructive dividend): | $300,000 |
| C corp consequence: | Double taxation |
Business vs. Personal vs. Investment
| Category | Code Section | Deductibility |
|---|---|---|
| Trade or business | §162 | Fully deductible (above-the-line) |
| Investment | §212 | Limited (below-the-line) |
| Personal | §262 | NEVER deductible |
Capital vs. Expense
| Type | Treatment |
|---|---|
| Expense | Deduct fully in year paid/incurred |
| Capital | Benefit >1 year = capitalize + depreciate |
Real-World Scenario
Scenario: Owner pays 16-year-old daughter $50,000/year for 10 hrs/week phone work. Market rate is $15/hr.
- Reasonable compensation: 52 weeks × 10 hrs × $15 = $7,800.
- Excess: $50,000 - $7,800 = $42,200 (non-deductible gift).
- Deductible: $7,800 only.
On the Exam
Expect 3-4 questions on the O&N test, typically:
- Definition Questions: "What does 'necessary' mean?"
- Reasonableness Questions: "How much salary is deductible?"
- Classification Questions: "Is this business, investment, or personal?"
The key is to remember: Ordinary = common in industry. Necessary = helpful (not essential). Reasonable = FMV. Personal = never deductible.
Tech startup buys $500 coffee machine. IRS says $50 would suffice. Is the $500 deductible?
Owner pays daughter $50,000/year for 10 hrs/week. Market rate $15/hr. Deductible amount?
Which Code section defines business deductions?