Understanding Section 162: Business Deductions and Limits

Section 162 is the core federal tax rule that determines whether a business expense is deductible. It states that businesses may deduct “ordinary and necessary” expenses paid or incurred in carrying on a trade or business. But the rule is simple in wording and often complex in application: what counts as “ordinary” and “necessary,” how to allocate mixed-use costs, and when to capitalize rather than expense are frequent questions that drive both planning and audits.

Below I explain how Section 162 works in practical terms, common limits and exceptions you should watch for, documentation standards, and examples that show typical do’s and don’ts. In my experience advising business owners and CPAs, disciplined recordkeeping and a conservative, well-documented position go a long way toward preserving deductions and avoiding penalties.

Key requirements: ordinary, necessary, and reasonable

  • Ordinary: An expense is ordinary if it is common and accepted in your industry. For example, legal fees for contract review are ordinary for a consulting firm.
  • Necessary: An expense is necessary if it is helpful and appropriate for your business. “Necessary” does not mean “indispensable.” Buying software that streamlines bookkeeping is typically necessary.
  • Reasonable: For compensation (wages, officer pay), the IRS expects amounts to be reasonable for the services provided. Reasonable compensation rules are frequently applied to S corporations and owner-employees.

These tests are fact-specific. The IRS looks at industry norms, business size, and the taxpayer’s stated business purpose when evaluating deductions (see IRS Publication 535 for guidance: https://www.irs.gov/publications/p535).

Common deductible expenses under Section 162

Typical categories that qualify when properly documented:

  • Salaries and wages (reasonable compensation for services) — watch for contractor vs employee classification errors.
  • Rent for business property (not mortgage principal) and utilities.
  • Advertising and marketing costs.
  • Professional fees (legal, accounting, consulting) related to the business.
  • Office supplies, software subscriptions used in the business.
  • Repair and maintenance (routine, not improvements) to keep property in ordinary operating condition.
  • Business travel, lodging, and 50% of business meal costs (subject to substantiation rules).

Note: For travel and meals, see IRS Publication 463 (Travel, Gift, and Car Expenses) and the IRS business expense page (https://www.irs.gov/businesses/small-businesses-self-employed/business-expense-deduction).

Expenses that are limited, disallowed, or treated differently

  • Business meals: Generally 50% deductible as of 2023 and beyond for most business meal expenses, except limited temporary exceptions in prior years; meals must be properly documented and business-related (IRS Pub 463).
  • Entertainment: Most entertainment expenses are nondeductible after the Tax Cuts and Jobs Act. Expenses that are directly related to entertainment are generally not deductible.
  • Fines and penalties: Fines, penalties, and certain illegal payments to government entities are nondeductible under IRC Section 162(f).
  • Capital expenditures: Costs that produce benefit beyond the tax year (equipment purchases, building improvements) must be capitalized and recovered through depreciation or amortization (see IRC Section 263 and Section 179/bonus depreciation where applicable).
  • Personal expenses: Clearly personal expenses are nondeductible. Mixed-use expenses must be allocated between personal and business use.
  • Lavish or extravagant expenses: Excessive costs may be disallowed or limited.

Special situations and interactions with other code sections

  • Start-up costs: Under IRC Section 195, eligible start-up costs may be amortized or partially deducted in the first year, subject to dollar limits and phase-outs.
  • Capital vs expense rules: Repairs that keep property in ordinary condition are deductible; improvements that materially add value or extend life are capitalized. The repair/regulatory safe harbors and routine maintenance regs provide helpful tests.
  • Related-party transactions: The IRS scrutinizes transactions between related parties for reasonableness and substance.

Documentation and substantiation — what the IRS expects

Good documentation is the single most important safeguard for a Section 162 deduction. The IRS generally expects:

  • Receipts or invoices showing amount, date, and vendor.
  • Business purpose and business relationship for the expense (who, what, why).
  • For travel: dates, locations, business purpose, and receipts for lodging and transportation.
  • For meals: who attended and business purpose (names or titles and the business discussion topic).
  • Mileage logs for vehicle deductions (or use of the standard mileage rate) with dates, miles, and business purpose.

If audited, taxpayers who cannot substantiate amounts will likely lose deductions. For practical guidance, see the FinHelp article “Documenting Business Expenses: Best Practices for Deductions” which provides templates and examples: Documenting Business Expenses: Best Practices for Deductions.

Examples that illustrate common rulings

1) Advertising agency: Deducts website hosting, ad buys, and employee salaries as ordinary and necessary. Keep contracts and invoices. If the agency also runs a personal blog, allocate hosting cost proportionally.

2) Manufacturer: Routine machinery repairs are deductible; replacing a major engine that materially extends life is a capital improvement and must be depreciated.

3) Freelancer: Software subscriptions used solely for invoicing and production are deductible. If the freelancer uses a subscription 60% for business and 40% personally, allocate 60% as a business expense.

4) S-corp owner pay: An owner taking very low salary and large distributions risks IRS reclassification if wages are not reasonable. Reasonable compensation analysis is crucial.

Audit red flags and best practices to reduce risk

  • Large, repeated cash expenses with no receipts.
  • High percentages of meals and entertainment relative to gross receipts.
  • Low reported owner compensation with high distributions in pass-through entities.
  • Consistent round-dollar estimates and lack of third-party corroboration.

Best practices:

  • Keep contemporaneous records; don’t rely on memory.
  • Create a written expense policy for employees.
  • Separate business and personal accounts and cards.
  • Run an annual or quarterly review of expenses and classification; tie this to year-end tax planning. For additional deduction ideas that small businesses commonly miss, see: Top Tax Deductions for Small Businesses in 2025.

Practical tax planning tips

  • Review capitalization thresholds: Set a company policy for when items are expensed vs capitalized.
  • Consider Section 179 or bonus depreciation for eligible property to accelerate deduction (check limits and eligibility each tax year).
  • When in doubt, document the business purpose in writing. A short note saved with the receipt can prevent a lost deduction.
  • For recurring mixed-use expenses (home office, vehicle), compute reasonable allocation methods and apply them consistently.

When to consult a tax professional

Complex facts—like related-party transactions, business reorganizations, or closely held corporations—often require a professional opinion. In my practice, early consultation with a CPA or tax attorney during a disputed deduction, before filing an aggressive position, often reduces future penalties and interest.

Limitations of this article and professional disclaimer

This article explains common applications of IRC Section 162 using sources current as of 2025, including IRS Publication 535 and Publication 463 (see below). It is educational and not personalized tax advice. For specific guidance about your situation, consult a qualified tax professional.

Authoritative sources and further reading

Related FinHelp articles

By understanding the ordinary-and-necessary standard, applying capitalization rules correctly, and maintaining thorough records, businesses can protect legitimate Section 162 deductions and avoid costly adjustments during an audit.