What Does “Ordinary and Necessary” Mean?

The IRS states that an ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business.

Ordinary and necessary business expenses can include everything from office supplies to liability insurance and work boots to computers.

Should you ever be audited, “ordinary and necessary” is a category the IRS will look at when determining your eligibility for deductions. It would be your responsibility to prove entries, deductions, and statements made on your tax returns—this is considered the burden of proof.

Remember: Should you ever be audited, you must be able to prove (substantiate) certain elements of expenses to deduct them.

Commonly Deducted Expenses

Following is a list of the most common, fully deductible business expenses that are pretty standard regardless of the business you're in:

• Accounting fees
• Advertising and marketing
• Bank chargesBusiness entertainment
• Business insurance
• Commissions and sales costs
• Consulting expenses
• Continuing professional education costs
• Contract labor costs
• Credit and collection fees
• Delivery charges
• Dues and subscriptionsElectricity
• Employee benefit programs
• Equipment rentals
• Insurance
• Interest paid
• Internet subscriptions, domain names, web hosting
• Legal fees
• Licenses
• Maintenance and repairs
• Office furnitureOffice supplies
• Pension and profit-sharing plans
• Postage
• Printing and copying expenses
• Rent
• Salaries, wages, other compensation
• Security
• Software
• Taxes
• Telephone
• Travel
• Worker’s compensation costs

Nondeductible Business Expenses

Some business costs are directly related to operating a business, but are not deductible under any circumstances. Things such as:

• Illegal payments (bribes or kickbacks)
• Fines and penalties
• Lobbying expenses or political contributions
• Dues and membership fees you might pay for social clubs unrelated to the type of business

Check out Publication 535, Business Expenses on the IRS website (www.irs.gov) for more in-depth information on non-deductible expenses.

How to Avoid the Double Tax: Let's Break It Down

We covered a lot of this in the Chapter 9 under the Business Structure section, so go back and review if you need a refresher on the terms.

The reason I needed to add this here is because of the tax implications and how it applies to the small business owner.

Corporations are always going to pay the most amount of tax—that's why they are called the double taxation corporation. They get nailed with corporate tax and personal tax—double tax.

However, an S corporation doesn't have to pay corporate taxes and only pays self-employment tax on its wages.

For example, let's say you currently make $100,000 in your business (as a sole proprietor). If you were operating as a sole proprietor or LLC that entire $100,000 profit (sole prop) is subject to self-employment tax, currently 15.3%, resulting in $15,300 for just that tax.

So let's say you elect to file as an S corporation and pay yourself a salary that's usual and customary in your industry, $40,000. Your salary is subject to the 15.3% self-employment tax resulting in $6,120 as your SETax. But the remaining $60,000 would not be subject to self-employment tax. This one shift in your business structure just saved over $9,000 in taxes!

There's a lot to keep track of when it comes to your taxes. That's why proper bookkeeping is critical. And why bookkeeping is one of the most important things you need to have in your business because without it you won't be able to take many of the deductions I've been talking about in the book! This results in you leaving thousands of dollars on the table and paying far more taxes than you need.

Hold a State of the Union Meeting

It's human nature to ignore that which we don't understand or enjoy.

Holding a state of the union meeting is something I started doing decades ago, and it radically changed my business and my personal wealth.

Keeping up to date and having a current financial picture of your finances is essential—for your business and your personal finances. It helps you make informed decisions that have the potential to make a big impact on your business, your growth, and your bottom line. It helps you know what's working, what you're spending too much on, and in what areas you can cut expenses.

Business at its core is all about numbers, and those numbers are telling you a story. If you want to be in business or build lasting personal wealth, you need to understand that financial story.

Take the time to invest in the skills everyone needs to build lasting wealth.

And if you find financial information intimidating or scary, you are not alone. Most of the entrepreneurs I work with used to avoid their numbers like the plague. But once they started learning it and doing the state of the union meeting, they realized it wasn't so scary—it was something to look forward to. And the only way to learn anything new is to start doing it!

The bottom line here is that you deserve better. You deserve to become wealthy, and when you know your numbers it helps you get there more quickly. Investing in this knowledge will build unshakable confidence in your business and your personal finances.

There are four steps to conducting your very own state of the union meeting:

1. Schedule a meeting with yourself once a month. This should ideally be by the 10th, but no later than the 15th of the month (so you have ample time for your bookkeeper to reconcile your bank accounts for the month prior).
2. Prepare and print your three critical business financial statements (or four, if you have investors) as well as your bank reconciliations. (If you don't yet have a business, you would run the financial reports, any expenses—credit card statements, bills, and loan payments of any kind—for your personal accounts.)
3. Prepare and print your point-of-sale (POS) and/or customer relationship management (CRM) reports (the system or software you process and keep track of sales) as well as any corresponding sales, customer, or employee data. The goal is to get all of the reports needed in order to get a full snapshot of your business.
4. The best part. My favorite part. Go to a restaurant, a resort, a coffee shop, or grab a glass of wine with a view and take everything with you—get out of the office. Make this a recurring two-hour appointment with yourself every month. Turn the phone on silent and flip it upside down. Review all the data and start to listen to what the numbers are telling you.

Pro tip: This is also a great time to record minutes in your corporate book.

Most states require S corporations to keep meeting minutes. Depending on what state you live in, you will likely be required to hold regular shareholder meetings and keep minutes of such meetings. If you are ever sued or become part of a lawsuit, any good business attorney is going to ask to see your corporate book in an effort to discredit your business and pierce the veil of any corporation or LLC you may have.

Piercing the Veil

Piercing the corporate veil (going around the business entity designed to protect you and going after the business owner themselves) is what every attorney will try to do and what every business owner needs to protect against. If they are successful in this, it will open you up to personal liability, and the court can hold you—and any other owners or shareholders—liable for the corporation's action or debts.

My friend Cody is a business attorney and a pit bull litigator. He's the guy you want protecting you, but the guy you don't want to be against in court. He has successfully broken through LLCs and corporations on countless occasions and was able to go after the owners personally.

Cody and I were talking about a case in which the corporate veil was pierced successfully because the owner was sloppy with finances. The business owner had been in business for nearly 20 years. His corporation agreed to services for a customer, a construction company. After beginning work on the project, the corporation abandoned the work.

The construction company obtained a $400,000 judgment against the corporation for breach of contract but was unable to collect on the judgment. The construction company then filed a new action seeking to pierce the veil of the corporation and recover personally from the owner.

The courts can work around that liability protection “if the corporation is undercapitalized, if it lacks separate books, if its finances are not kept separate from individual finances or individual obligations are paid by the corporation, if the corporation is used to promote fraud or illegality, or if corporate formalities are not followed” (Tidgren, 2018) (this is why I stress the importance of separate accounts and finances).

In this case, the court went through each formality and account one by one. It found insufficient evidence that could establish the business as undercapitalized or purposely underfunded by the defendant; the business operated for 20 years. They found no fraud occurred because the owner and the corporation were known as legitimate. But there was evidence that showed the owner did not maintain a separate entity from the businesses, and therefore, the court ruling was that the corporate veil should be pierced.

Unfortunately, although the business owner kept a separate bank account for the business, he also commingled its funds with personal finances. The owner used the accounts interchangeably for transactions of the corporation in question as well as his other businesses.

The defendant did not adequately track the business’ books, nor did he follow required corporate formalities. He could not produce a record of bylaws, corporate minutes, or a shareholder ledger, nor documentation of a shareholder meeting for the corporation.

The owner did file biennial reports after 2000, but the reports were often filed after the deadline. As a result, the corporation was administratively reinstated three times. Neglecting to follow such corporate formalities did not help the owner’s case and added weight to the other factors.

The case details clearly show that corporate protections apply only to businesses that follow the applicable laws. Remember that protecting the owner’s liability requires that business and personal finances (including specific books for all entities) remain separate. The law is clear on this issue. Here is the bottom-line: Adhere to the formalities of owning a corporation, including filing the required reports, holding the right meetings, and keeping proper books (shareholder, financial, and otherwise) accurate and up to date. In general, LLCs require fewer formalities. In this case, however, the results would likely have been the same even if the corporation were an LLC. Never commingle business and personal expenses; the quickest way to lose liability protection is to pay personal expenses out of business accounts and fail to keep separate books. If this happens, shareholders’ personal assets (your house, car, personal savings) may be exposed to liability for the corporation’s debts.

Having to keep meeting minutes may seem like a trivial thing, particularly for smaller S corporations, but failure to keep meeting minutes as governed by your state’s laws can attract serious consequences.

LLCs may not be required to keep corporate minutes, but annual reports and other documentation can be required depending on your state. Use your State of the Union Meeting to hold such review, and recorded minutes will keep you compliant and serve as protection should you ever be exposed to a lawsuit. You can find reasonable books for LLC or corporations on Amazon. I have my favorites tagged on: www.candyvalentino.com/shop.

Business Always Boils Down to Numbers and Data

Keep on top of your numbers yourself, but remember you don't actually have to do the grunt work of the data entry and bookkeeping. Bookkeeping is a perfect example of something you should outsource to pros to free up more of your time.

But unless you are at scale and have extensive systems in place, the one role you never want to outsource is “being on top of the numbers.” It's an easy way to be removed from your business while letting expenses get out of control or have an issue with theft or embezzlement. Embezzlers, thieves, and dishonest people in general, love business owners who ignore their numbers and outsource the effort of keeping the bird's-eye view of the business.

A bookkeeper is distinct from a tax strategist and/or tax preparer.

For example, a tax strategist first told me about the “Augusta Rule,” which allows me to rent my own home to my business, tax free. And Section 179 is a strategy for deducting a large portion of vehicles, including some luxury SUVs.

Much different than a tax preparer, having a tax advisor and strategist will pay for itself many times over.

What's the difference? If you're getting your taxes prepared, you're operating in a reactive state after your business year is over. If you're not proactively planning your taxes with monthly, quarterly, or semi-annual meetings, you're going to miss out on using massive tax reduction strategies and put hundreds, thousands, or even hundreds of thousands of dollars into the IRS's pockets, instead of yours.

Hiring someone who focuses on tax strategy and keeps up to date on business taxes is one of the most important investments you can make. Go to www.candyvalentino.com for help with business tax strategy.

Deductions the IRS Looks at a Little Closer

Even though the IRS only audited 0.4% of income tax returns in 2021, many people live in fear of a letter from the IRS questioning items on their return. Because of the possibility of facing an IRS audit, many people hesitate to claim all the tax breaks they are entitled to claim, and when they do this, they are leaving their money on the table (U.S. News and World Report, 2022).

Yes, you should deduct all legitimate expenses, but the IRS's Big Brother software keeps a keen eye for auditing businesses with large deductions.

Keep meticulous records for every expense related to these:

Home office: One of the most common tax deductions that people leave on the table is the home office deduction.

You can deduct your actual expenses, including a portion of your mortgage interest, homeowners or renters insurance, and utilities—gas, electric, garbage, Internet, and so on—based on the area of your home you use as an office. Keep records of all of those expenses. The IRS has been known to monitor these closely. You don’t ever want to take deductions that aren’t legitimate.

The alternative is the simplified option: $5 per square foot of your home office, up to 300 square feet, for a maximum deduction of $1,500.

Real-life example: Let's say you have a 3000 sq ft house and a 300 sq ft office (10% of the total square footage). You would get to deduct 10% of all related bills which could keep anywhere from $1,500 to $2,500 in your pocket–and not in Uncle Sam's.

It is important you work with an educated tax professional who understands business taxes. This used to be a common red flag that CPAs advised against, but in the modern era of everyone truly working from home, it can be a very real and valid deduction for business owners.

To qualify, you must use part of your home “regularly and exclusively” for business. It doesn't need to be in a separate room, but it has to be a space that isn’t used for anything but your office.

Meals and entertainment: Gone are the days of taking clients to strip clubs because in 2018, the government cracked down on this abuse and deducting entertainment became entirely disallowed. However, in 2022, you can deduct 100% of meals—food and beverages—provided by a restaurant. The 100% deduction is set to expire on December 31, 2022, and go back to the pre-pandemic amount of 50%. The IRS believes deductions for business meals are particularly prone to misuse, so you must document these deductions meticulously using the Six Ps of a Proper Deduction from earlier in the chapter and document each with purpose and person (the two that will not be included on a receipt).

Lots of cash transactions or large cash transactions: If you're in a cash-based business, cash transactions are inevitable—but keep meticulous records. And if you've got a suitcase of hundreds and want to buy something with it that you then deduct—it's probably better to deposit it in the bank first and use a check!

IRS auditors keep a keen eye on businesses who receive cash payments—grocery stores, restaurants, mobile food trucks, auto dealers and repair shops, salons and spas, landscapers, and gas stations. They are particularly interested in underreported income, and improper accounting for COGS (cost of goods sold). If you are in one of these businesses, be extra careful.

And remember that any cash transaction over $10,000 made at a bank, car dealership, trade, or business is required to be reported to the IRS by using Form 8300. You'll want to avoid that at all costs.

Amended returns: The IRS casts a more suspicious eye on amended returns (as they indicate you weren't very careful with your bookkeeping), late returns and late payroll taxes (which indicate disorganization), and paper returns (as they are much more prone to mistakes). If the amount you're going to gain from the amendment is trivial, it's probably best to avoid the extra risk. And these days, there's no reason to file a paper return!

Charitable donations: We all love great charities who do great work in the world. And donating to charitable causes meaningful to you is an important wealth habit. However, if you're more generous than normal with your business donations, the IRS can get skeptical. Make sure you get an acknowledgment letter from the 501c3 for any cash donations or even substantial in-kind (non-cash) donations. Keep those records safe should you ever need them.

Business losses: You can deduct a lot of expenses from your business. However, the IRS wants to make sure you did not set up a business just for the purpose of taking deductions. If you show net losses year after year, or barely any profit at a break-even point, this could raise concern and trigger an audit. The general rule of thumb is that reporting a loss more than two out of five years is a red flag. If the loss isn't that big, you might want to consider foregoing some deductions and report a small profit. You'll also forgo the carry-forward loss for next year, but you'll thereby avoid this big audit red flag.

Not reporting stock trades: Unless the investments are in a tax-deferred account, trades are taxable when you sell the shares. Most firms will send you a 1099B, and you need to report the capital gains and losses.

Crypto: The IRS increasingly sees cryptocurrency as a hotspot for tax avoidance. If you make any cryptocurrency trades, sales, or expenditures, be sure to fill out Form 8949, Sales and Other Dispositions of Capital Assets. Unfortunately, even if you use a cryptocurrency to buy something, it's considered a taxable event, subject to capital gains/losses. Figuring out the cost basis of every sale across multiple platforms you may use can be tricky. Fortunately, there are many software programs that can calculate and fill out your crypto taxes easily.

Math and general errors: If you're using lots of big round numbers, you're likely “guesstimating” your numbers, and the IRS can get skeptical. Always make sure you double-check for simple errors such as math mistakes, rounding up numbers, your name on the wrong line, an error in your Social Security number. Remember to always report all of your income. Income from a 1099 or W-2 is going to be reported to the IRS. They can easily check your income reported from employers, banks, and brokers against your tax returns. Always check the accuracy and work with a pro.

Business use of personal car: If you're doing this, you will need to document miles and business purpose of every single business ride. You can use the standard mileage rate or the actual expense rate to determine the amount you can deduct. If you have a car used only for business purposes, you may be able to deduct its entire cost. Topic No. 510 at irs.gov has more details.

Business use of personal cell phone: You need to document the percentage of cell phone use that is business, which means you literally need to track the minutes of every call, business and personal, to come up with a percentage. Again, who has time for that? It's far easier to have a separate phone for business than it is to try and keep track of the percentage you use your personal phone for business.

S corp salary: If you're an S corp, you need to pay yourself a “reasonable salary” for your field. If you give yourself an unusually low salary to avoid Social Security or other taxes, the IRS will notice, and this behavior will certainly increase your risk for an audit.

Out of the ordinary activity: If you've been filing your business returns for some time and have a large increase in deductions all of a sudden, it could look suspish. If you've suddenly discovered massive new categories of deductions, and you want to prioritize avoiding the headache of an audit, it's probably wise to ramp them up over a few years rather than jump wildly from one year to the next. But if they are legit deductions and it makes sense for you to reduce your taxable income now and you can substantiate the deduction, just make sure you can support the write-off. The IRS is going to compare your deductions to others in your similar income tax bracket and business industry/type. Having properly maintained books is crucial to your business should you ever have to prove legitimate deductions.

My point is this: Don't leave money on the table when it comes to taking the deductions. Take the ones you can legally take. Have clear records, keep all supporting documentation, and work with a tax strategist pro. No one wants to pay an arm and a leg to have their taxes done, but no one wants to pay any more in taxes than they're truly supposed to. And one corner you do not want to cut is trying to save a few bucks and file your taxes on your own.

Remember that every dollar you deduct from your taxable income is a dollar you can use to keep investing, hire more staff, develop new products and services, and continue to build your business. That's why reducing your taxes and keeping more of the money you make is a wealth habit that cannot be ignored.