Under IRC Section 162, trade or business expenses are deductible when they are ordinary and necessary and paid or incurred during the taxable year while carrying on a trade or business.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses That one sentence carries three gates. The activity has to qualify as a trade or business. The expense has to be both ordinary and necessary. And it has to be a current operating cost, not a capital investment or a personal expense dressed up as a business one. Everything else in the deduction rules is a refinement of those three ideas.
What “Ordinary and Necessary” Actually Means
An expense is ordinary if it is common and accepted in your particular industry. It does not have to recur every year. It just has to be the kind of cost someone else in your line of work would recognize as part of doing the job. Sales commissions, raw materials, software subscriptions, and professional dues all clear this bar without argument.
An expense is necessary if it is helpful and appropriate for your business. Courts read “necessary” generously. You do not have to prove the expense was indispensable, the cheapest available option, or the only way to accomplish the goal. Reasonable business judgment is enough.
The “carrying on” language in the statute matters too. It ties the deduction to a business that is actually operating. Costs that produce a benefit lasting well beyond the current tax year, such as buying equipment, constructing a building, or acquiring a patent, have to be capitalized under Section 263 and recovered over time through depreciation or amortization.2Office of the Law Revision Counsel. 26 USC 263 – Capital Expenditures
Personal expenses are off the table entirely. Section 262 prohibits deductions for personal, living, and family costs.3Office of the Law Revision Counsel. 26 USC 262 – Personal, Living, and Family Expenses The daily commute, a home internet connection used for streaming, and a personal cell line all fall on the wrong side of the line. When a cost has both business and personal uses, you must allocate it and deduct only the business share.
Spending Before the Business Opens
Money you spend before the business is actually open for business is not a Section 162 expense. It falls under Section 195 as a start-up expenditure, which covers things like market research, employee training, scouting locations, and lining up suppliers.4Office of the Law Revision Counsel. 26 USC 195 – Start-Up Expenditures
You can immediately deduct up to $5,000 of start-up costs in the year the business begins operations. That $5,000 shrinks dollar for dollar once total start-up spending passes $50,000, and disappears at $55,000. Whatever you cannot deduct right away is amortized evenly over 180 months starting the month the business opens.
The timing distinction is sharper than people expect. Spend $30,000 preparing to launch in 2025 but open in 2026, and none of that $30,000 goes on your 2025 return. Keep clear records of when planning ends and active operations begin.
Expense Categories With Their Own Rules
Several common deductions have specific caps, substantiation requirements, or outright prohibitions layered on top of the ordinary-and-necessary test. These are where audits most often produce adjustments.
Compensation
Salaries and wages are deductible if the compensation is reasonable for the services actually performed. “Reasonable” is measured against what similar businesses pay for comparable work. The IRS scrutinizes this most heavily in closely held corporations, where an owner-employee might inflate salary to pull profits out as deductible compensation rather than nondeductible dividends. If pay is deemed excessive, the excess is reclassified as a distribution, costing the business its deduction. Employment contracts, board resolutions, and industry pay surveys all help.
Travel and Mileage
Business travel is deductible when you are away from your tax home long enough that you need to stop for sleep or rest.5Internal Revenue Service. Publication 463 (2025), Travel, Gift, and Car Expenses Deductible costs include airfare, lodging, and local transportation at the destination. Day trips within your metropolitan area are not travel for this purpose, and daily commuting from home to a regular workplace is always personal.
For vehicle use, you choose between actual expenses (gas, insurance, maintenance, depreciation) and the IRS standard mileage rate, which is 72.5 cents per mile for business use in 2026.6Internal Revenue Service. IRS Sets 2026 Business Standard Mileage Rate at 72.5 Cents Per Mile The mileage rate is simpler, but taxpayers with expensive vehicles or heavy maintenance sometimes do better tracking actual costs. Either way, you need a contemporaneous log showing date, destination, business purpose, and miles for each trip.
Meals and Entertainment
Business meals are deductible at 50 percent of the cost, including tax and tip, as long as the meal is not lavish and you or an employee are present with a current or prospective business contact. The temporary 100 percent deduction for restaurant meals in 2021 and 2022 is gone.
Entertainment is generally not deductible at all. Tickets to concerts, sporting events, and golf outings cannot be written off, even when business is discussed.7Office of the Law Revision Counsel. 26 USC 274 – Disallowance of Certain Entertainment Expenses Narrow exceptions remain for recreational activities primarily benefiting rank-and-file employees, such as company picnics and holiday parties.
Home Office
If you use a dedicated portion of your home exclusively and regularly as your principal place of business, you can deduct a share of rent, mortgage interest, utilities, and insurance.8Internal Revenue Service. Publication 587 (2025), Business Use of Your Home The exclusive-use requirement is strict. An office that doubles as a guest bedroom fails. Narrow exceptions apply for inventory storage and in-home daycare.
A simplified method lets you deduct $5 per square foot of dedicated office space, capped at 300 square feet, for a maximum of $1,500.9Internal Revenue Service. Simplified Option for Home Office Deduction The regular method often produces a larger deduction for taxpayers with significant housing costs. Only self-employed individuals and independent contractors can claim this deduction. Employees working from home cannot.
Rent and Lease Payments
Rent for property used in the business, including office space, warehouses, and equipment, is fully deductible as long as you are not simultaneously building equity. A lease-to-own arrangement, where payments go toward eventual ownership, has to be capitalized rather than deducted currently. Leases between related parties receive extra scrutiny and must reflect fair market value.
Advertising and Insurance
Advertising and marketing costs are fully deductible, including goodwill advertising aimed at building brand recognition rather than selling a specific product. Insurance premiums covering business assets, liability, and business interruption are also deductible. The main exception is life insurance where the business is the beneficiary, which is not deductible even when the policy exists to protect against the loss of a key person.
Does Your Activity Qualify as a Trade or Business?
Section 162 only applies if the activity is a trade or business in the first place. Congress never defined the phrase. The working test comes from the Supreme Court’s 1987 decision in Commissioner v. Groetzinger: the taxpayer must be involved in the activity with continuity and regularity, and the primary purpose must be income or profit.10Legal Information Institute. Commissioner of Internal Revenue v. Groetzinger
Continuity and regularity rule out one-off transactions. Selling a single inherited property at a profit does not make you a real estate business; actively buying, renovating, and reselling properties throughout the year does. The IRS looks at how often you engage in the activity, how much time you invest, whether you keep separate books, and whether you operate like others in the field.
The primary purpose prong rules out activities you pursue mainly for personal enjoyment. You can enjoy the work and still pass, but a weekend pottery studio selling occasional pieces will draw scrutiny that a full-time retail shop will not.
The Hobby and Investment Boundaries
If the IRS reclassifies your activity as a hobby, Section 183 limits deductions to the income the activity generates, so you can never create a net loss.11Office of the Law Revision Counsel. 26 USC 183 – Activities Not Engaged in for Profit Even that limited deduction is currently unavailable: the Tax Cuts and Jobs Act suspended the miscellaneous itemized deduction hobby expenses fell under, and the One Big Beautiful Bill Act of 2025 made that elimination permanent. You still owe income tax on every dollar a hobby earns, but you cannot deduct anything you spend on it.
The IRS weighs nine factors from Treasury Regulation 1.183-2(b) to tell a business from a hobby. No single factor controls. The ones that carry the most weight in practice are how businesslike your records and methods are, your expertise in the field, the time and effort you devote, your history of profit or loss, and how much the activity resembles recreation. The IRS presumes a profit motive if the activity shows a profit in three of the last five years (two of seven for horse breeding).
Investment activities fall under Section 212 rather than Section 162.12Office of the Law Revision Counsel. 26 USC 212 – Expenses for Production of Income Section 212 allows deductions for expenses incurred to produce income or manage income-producing property, but those deductions were also classified as miscellaneous itemized deductions. The TCJA suspension, now permanent, means individuals cannot currently deduct investment management fees, safe deposit box costs, or similar expenses. The practical consequence is sharp: an active trader meeting the Groetzinger standard deducts trading expenses under Section 162, while a passive portfolio manager with the same expenses gets nothing.
Classification also drives which form you file. Sole proprietors report business income and expenses on Schedule C.13Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship) Investment and most rental income goes on Schedule E.
Documentation and the Cost of Getting It Wrong
Claiming Section 162 deductions for an activity the IRS later reclassifies, or for expenses that fail the ordinary-and-necessary test, creates an underpayment of tax. On top of the tax itself, Section 6662 typically imposes a 20 percent accuracy-related penalty when the mistake results from negligence or careless disregard of the rules.14Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments Interest runs on both the tax and the penalty from the original due date.
If the IRS questions a deduction, the burden of proof is on you. Keep separate bank accounts and books for the business. Hold onto receipts, mileage logs, and contact records. Preserve evidence of a profit motive, including a written business plan, documentation of changes you made after unprofitable periods, and records of advice you sought from industry professionals. Taxpayers who can show good-faith reliance on reasonable professional advice can sometimes avoid the penalty even when the underlying deduction is disallowed.