Understanding Section 162: What Qualifies as a Tax-Deductible Trade or Business Expense

For small-business owners navigating the tax code, one question surfaces repeatedly: which expenses can I actually deduct? The answer lies in Section 162 of the Internal Revenue Code, which establishes the foundational principle for determining what counts as a legitimate business deduction. Under this section, the IRS allows deductions “for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This framework—built on section 162—shapes every decision you make about what to claim on your tax return.

The Foundation: Section 162 and the “Ordinary and Necessary” Standard

Section 162 isn’t simply a list of approved expenses. Instead, it establishes a legal standard: an expense must be both ordinary and necessary to your particular trade or business. What does this mean in practice? An ordinary expense is one that’s common and accepted in your industry. A necessary expense is one that’s appropriate and helpful for conducting your business operations.

The IRS recognizes that different industries have vastly different expense profiles. Consider how section 162 applies differently across sectors. A consulting firm built on client relationships naturally incurs meals and entertainment costs—these are ordinary and necessary when you’re regularly meeting prospects and clients. A construction company expects high labor costs through contract workers and day laborers, whereas an office-based accounting firm typically pays salaried employees with standard withholding. These industry-specific differences mean that the same type of expense might be deductible for one trade or business but questionable for another.

The tax code also allows deductions for expenses that “enhance” your business beyond the purely necessary. This includes professional development like continuing education, business assets such as computers and office furniture, advertising campaigns, and even vehicles in certain industries. The challenge is distinguishing between what’s required to operate and what simply improves your operations—a distinction that varies significantly based on your trade or business structure.

The Scope of Section 162: What the IRS Explicitly Allows

When you examine the actual language in section 162, the IRS provides specific examples of deductible expenses. These include reasonable compensation for services rendered to your business, traveling expenses (including meals and lodging, though not lavish or extravagant amounts) while you’re away from home pursuing your trade or business, and rental payments or property usage fees required to continue operations.

The framework of section 162 is intentionally broad, giving business owners flexibility while requiring them to apply judgment. For a sales professional, travel and client entertainment fall squarely within section 162’s parameters. For a retail shop owner, those same expenses might raise red flags because they don’t align with typical retail operations. The determining factor is always whether the expense is ordinary and necessary for your specific type of business.

Common Deductible Expenses: Where Most Business Owners Focus

While section 162 provides the legal framework, most small-business owners focus on practical deductions. Vehicle expenses consistently rank at the top—but only if you document business mileage with detailed logs. Office supplies, internet service, and cell phone bills are typically straightforward deductions. Home office deductions have become increasingly common and are fully allowable under section 162 guidelines, provided your home office is used regularly and exclusively for business purposes.

Meals represent another frequent deduction, though one requiring careful documentation. When you claim a meal as a business expense, the IRS expects you to keep the receipt and note which client or associate attended, what was discussed, and the business purpose. This documentation transforms a questionable claim into a defensible one aligned with section 162 principles.

The specific amounts you claim for each category should reflect what’s ordinary and necessary for your trade or business. A technology startup’s equipment budget might dwarf that of a service business. A consultant’s travel expenses could legitimately exceed those of a local accounting practice. The key is ensuring your deductions are proportional to your industry norms.

Documentation: The Bridge Between Deductions and Proof

Claiming an expense is one thing; proving it’s legitimate is another. The IRS requires meticulous records for all section 162 deductions. For vehicle expenses, you need a contemporaneous mileage log—many smartphone applications now make this nearly automatic. For meals, your receipt plus notes about the business purpose suffice.

Beyond these common deductions, if you’re uncertain whether an expense qualifies under section 162, consulting a tax professional is wise. A qualified tax advisor familiar with your specific trade or business can provide guidance tailored to your situation, helping you maximize legitimate deductions while minimizing audit risk.

The DIF Score Factor: Understanding Audit Selection

Not all questionable deductions trigger an IRS audit. Instead, your tax return receives a Discriminant Function System (DIF) score—a computer-generated number that measures your return against industry benchmarks. The DIF score compares your claimed deductions and other figures against those of similar businesses in your trade or business category.

The higher your DIF score, the greater the likelihood of examination. This means that deducting expenses that deviate significantly from industry norms—even if they technically qualify under section 162—increases scrutiny risk. A construction company claiming unusually low labor expenses or a consulting firm with minimal travel costs might trigger review simply because these figures don’t match typical patterns.

The takeaway is straightforward: accuracy matters. While claiming a questionable deduction won’t automatically invite an audit, maintaining records that support your section 162 deductions and ensuring they align with industry standards substantially reduces your examination risk. As a small-business owner committed to compliance, working with a knowledgeable tax professional who understands your particular trade or business ensures you’re claiming everything you legitimately can while staying well within acceptable ranges.