IRC Section 162: Ordinary and Necessary Business Expense Rules

Under Section 162 of the Internal Revenue Code, a business can deduct the ordinary and necessary expenses it pays or incurs while carrying on a trade or business, so federal income tax applies to net profit rather than gross receipts.¹ That covers wages, rent, insurance, interest, professional fees, advertising, supplies, and much more. The catch is that each expense has to clear a specific set of legal hurdles, and several common categories carry dollar caps, percentage limits, or documentation rules that go well beyond the basic test.

The Two-Part Test

An expense is ordinary if people in your industry commonly incur it. It is necessary if it is helpful and appropriate for the business, though it does not have to be essential or unavoidable.¹ A freelance photographer buying editing software passes both tests easily. The same photographer buying a boat has a harder case to make.

You also have to be “carrying on” a trade or business at the time. The Supreme Court in Commissioner v. Groetzinger said that means pursuing the activity with continuity and regularity, with income or profit as your primary purpose.² A monetized hobby does not qualify. Neither do costs you incur before the business actually opens, which follow separate startup rules.

Compensation, whether to yourself or to others, must be reasonable for the services provided. The IRS looks at the employee’s training and experience, the duties involved, the time devoted to the work, and what comparable businesses pay for similar roles.³ This matters most in closely held businesses where the owner sets their own salary. Inflating your pay to pull money out of the company as a deductible expense rather than a nondeductible profit distribution is one of the faster ways to draw scrutiny.

Everyday Expenses That Qualify

Most of the routine costs of running a business fall inside Section 162 without controversy. Employee wages, salaries, and benefits are usually the largest single category.¹ Rent for office space, warehouses, or storefronts is deductible so long as you do not own the property.⁴ Insurance premiums covering business risks like fire, theft, or liability qualify, as does interest on loans used for business purposes.

Professional fees paid to accountants, attorneys, or consultants for business-related work are deductible. The same goes for office supplies, advertising, utilities on a dedicated workspace, and the smaller recurring costs that add up across a year.

Categories With Extra Rules

Several categories are deductible only within limits or with specific documentation. This is where most deductions are won or lost.

Business Meals

You can deduct 50% of the cost of a business meal when you or an employee is present and the food is not extravagant.⁵ The meal can be with a client, a prospect, a consultant, or another business contact.⁶ A brief note on the receipt recording who attended and what was discussed is enough to substantiate the deduction.

Entertainment is different. Since 2018, the Tax Cuts and Jobs Act has eliminated deductions for activities like sporting events, concerts, and golf outings, even when clients are along.⁶ Dues for social, recreational, or business clubs are also nondeductible.⁵ If you take a client to a ballgame and grab dinner afterward, the tickets are out but the meal can still qualify at 50% if it is billed separately.

Vehicle Expenses

For 2026, the IRS standard mileage rate is 72.5 cents per mile driven for business.⁷ The rate applies to all vehicle types, including electric and hybrid cars. The alternative is the actual expense method, where you track gas, oil, repairs, tires, insurance, registration, and depreciation, then multiply by your business-use percentage.⁸ Parking and tolls for business trips are deductible on top of either method.

If you own the vehicle, you have to choose the standard mileage rate in the first year of business use. After that, you can switch between methods. For a leased vehicle, once you pick the standard rate you are locked in for the whole lease.⁷

One line the IRS enforces strictly: commuting from home to your regular workplace is never deductible. Driving from your regular workplace to a temporary work location in the same trade or business is. If your home qualifies as your principal place of business, trips from home to any other work location in the same business are deductible regardless of distance.⁹ A temporary work location is one where you realistically expect the assignment to last a year or less.

Business Travel

Travel expenses become deductible when work takes you away from your tax home long enough that you need to stop and sleep. The IRS calls it the sleep-or-rest test: your duties must keep you away substantially longer than an ordinary workday, and you need rest to meet the demands of the job.¹⁰ Napping in your car does not count, but you do not need to be gone dusk to dawn either. Once you meet the test, transportation, lodging, and meals (at 50%) all qualify.

Home Office

If you use part of your home exclusively and regularly as your principal place of business, you can deduct a portion of your housing costs.¹¹ “Exclusively” means the space cannot double as a guest room or playroom. It does not need a permanent wall, but it must be a separately identifiable area used only for business.¹²

If you do most of your work at client sites but handle billing, bookkeeping, and scheduling from home, the home office still counts as your principal place of business, so long as you do not have another fixed location where you do substantial administrative work.¹² The deduction also applies if you regularly meet clients or customers in that space.

Instead of tracking actual housing costs, you can use the simplified method: $5 per square foot, up to 300 square feet, for a maximum deduction of $1,500 a year.¹³ The simplified method saves paperwork; the actual-expense method often produces a bigger deduction for taxpayers with high housing costs.

Startup Costs Are a Separate Regime

Expenses you pay before the business begins operating are not current Section 162 deductions, because you are not yet carrying on a trade or business. They fall under Section 195. You can deduct up to $5,000 of startup costs in the year the business opens, but that $5,000 phases out dollar-for-dollar once total startup spending passes $50,000.¹⁴ Whatever is left is amortized over 180 months beginning with the month you open. A separate $5,000 first-year deduction with the same $50,000 phase-out applies to organizational costs for forming a corporation or partnership.¹⁵ Once the business is running, the same categories of ongoing expense shift over to Section 162.

Costs Section 162 Won’t Cover

Some payments look like business expenses but are blocked by statute.

Personal expenses. Section 262 flatly prohibits deductions for personal, living, or family expenses. Household rent, groceries, and personal clothing do not become deductible because you own a business.¹⁶ When an item has both a personal and business component, like a cell phone used for both, only the business portion is deductible.

Capital expenditures. Costs to acquire or improve assets with a useful life beyond the current year must be capitalized under Section 263 and recovered through depreciation rather than deducted in one year.¹⁷ Machinery, buildings, and major improvements fall into this category. A de minimis safe harbor lets businesses without audited financial statements elect to expense items below roughly $2,500 per item rather than capitalize them.¹⁸

Fines and penalties. Amounts paid to a government for violating a law, or in connection with a government investigation into a potential violation, are nondeductible under Section 162(f).¹ There is a narrow exception for restitution and payments to come into compliance with the violated law, but only if the court order or settlement specifically identifies the payment as such.

Bribes and kickbacks. Illegal payments to government officials, including anything violating the Foreign Corrupt Practices Act, are nondeductible. The same applies to illegal payments to private parties that could bring criminal penalties or cost you a business license.¹

Lobbying and political contributions. Spending to influence legislation, participating in political campaigns, or communicating with executive branch officials to influence their official actions cannot be deducted.¹⁹

Executive pay above $1 million. Publicly traded companies cannot deduct more than $1 million a year in compensation to covered employees, meaning the CEO, CFO, and the next three highest-paid officers.¹ For tax years after December 31, 2026, the definition expands to include the next five highest-paid employees beyond the CEO and CFO. The cap does not affect small businesses or private companies.

Records You Need to Keep

Section 6001 requires every taxpayer to keep records sufficient to support the deductions claimed on a return.²⁰ For Section 162, that means receipts, bank statements, and invoices showing the amount, date, and business purpose of each payment. Vehicle deductions need a contemporaneous log recording date, destination, miles, and reason for the trip. Meal deductions need a note of who attended and what was discussed.

How long you keep records depends on the risk you carry. The general rule is three years from the date you filed the return or two years from the date you paid the tax, whichever is later.²¹ If you underreport gross income by more than 25%, the IRS has six years.²² If a return is fraudulent or was never filed, there is no time limit at all. Keeping records for at least seven years is a practical safeguard for any business with complicated deductions.

Where to Report the Deduction

The form depends on how your business is organized. Sole proprietors and single-member LLCs report income and deductions on Schedule C, attached to their personal Form 1040.²³ C corporations file Form 1120. Partnerships and S corporations file Form 1065 or 1120-S and pass deductions through to partners or shareholders on Schedule K-1.

Organizing your records into categories that match the line items on the applicable form makes reporting simpler. Schedule C has separate lines for advertising, car expenses, insurance, legal and professional services, office expense, rent, repairs, supplies, and utilities. Totaling each category before you sit down with the form beats sorting receipts at the last minute.

1
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
2
Legal Information Institute. Commissioner of Internal Revenue v. Groetzinger
3
Internal Revenue Service. Wage Compensation for S Corporation Officers
4
Internal Revenue Service. Small Business Rent Expenses May Be Tax Deductible
5
Office of the Law Revision Counsel. 26 USC 274 – Disallowance of Certain Entertainment, Etc., Expenses
6
Internal Revenue Service. Tax Cuts and Jobs Act – Businesses
7
Internal Revenue Service. IRS Sets 2026 Business Standard Mileage Rate at 72.5 Cents per Mile
8
Internal Revenue Service. Topic No. 510, Business Use of Car
9
Internal Revenue Service. Revenue Ruling 99-7
10
Internal Revenue Service. Publication 463, Travel, Gift, and Car Expenses
11
Office of the Law Revision Counsel. 26 USC 280A – Disallowance of Certain Expenses in Connection With Business Use of Home
12
Internal Revenue Service. Publication 587, Business Use of Your Home
13
Internal Revenue Service. Simplified Option for Home Office Deduction
14
Office of the Law Revision Counsel. 26 USC 195 – Start-Up Expenditures
15
Internal Revenue Service. Publication 583, Starting a Business and Keeping Records
16
Office of the Law Revision Counsel. 26 USC 262 – Personal, Living, and Family Expenses
17
Office of the Law Revision Counsel. 26 USC 263 – Capital Expenditures
18
eCFR. 26 CFR 1.263(a)-1 – Capital Expenditures; In General
19
Internal Revenue Service. Nondeductible Lobbying and Political Expenditures
20
Office of the Law Revision Counsel. 26 USC 6001 – Notice or Regulations Requiring Records, Statements, and Special Returns
21
Internal Revenue Service. How Long Should I Keep Records
22
Internal Revenue Service. Time IRS Can Assess Tax
23
Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss From Business