By not understanding the concept of “ordinary and necessary business expenses” small business owners are overpaying in taxes. 

Here’s an example: My husband and I were enjoying an outdoor meal when a cute little dog wandered over from a nearby table straining on his leash to seek attention. I pet him a few times and began talking with his owner, who told me that he’s a therapy dog.

“So he’s a write-off! Your cute little tax deduction,” I said as I nuzzled his chin.

“What? A write-off?” The owner was genuinely puzzled.

I explained to her that all she needed was a prescription or letter from a doctor showing that she needs the dog and she could deduct all expenses relating to the dog as a medical expense.

She further explained to me that she didn’t require the dog but that she is a therapist and he accompanies her to nursing homes as a tool for helping the elderly cope. This is even better news for her taxes: the dog is an ordinary and necessary business expense, which means she can deduct him as a business expense and save money not only on income taxes but on self-employment tax as well.

She was flabbergasted.

Every business owner needs to evaluate their expenses in light of the concept of “ordinary and necessary” business expense.  It’s a subjective area open for debate, and oftentimes I find myself in such a debate not only with clients but also with IRS auditors.

It’s tempting to put a spin on personal expenses to justify them as business deductions—but be warned, they won’t fly with the IRS. You cannot say, “I need to maintain a good business image, therefore a manicure, pedicure and haircut are ‘ordinary and necessary’ business expenses.  Nope, that won’t work. The IRS looks at these expenses as personal and will not budge.

A few years ago there was an interesting court case in which a topless dancer attempted to deduct a breast augmentation as a medical expense. It was disallowed in audit, but at the tax court level she won. The deduction was not allowed as a medical expense (cosmetic procedures are not deductible) but as a business expense. And for her, it certainly was. After all, those are the tools of her trade, in much the same way as a good ladder is a tool for a painting contractor.

When you analyze your financial transactions, think in terms of intent. Are you spending money on something because it is for your personal needs or is it for your business? The facts and circumstances surrounding every transaction come into play in making the decision as to whether or not it is a write off.

An auditor will also look at your transactions in terms of whether they are reasonable. This concept normally occurs when dealing with related parties.  I‘m not talking about your brother-in-law, necessarily. Related parties could mean the relationship between you as a shareholder and your corporation or between you and a business partner. So we’re talking about fair compensation in terms of fair market value and willing buyer/willing seller as well as the business necessity of such a transaction.

Your ordinary and necessary business expenses should not be “lavish and extravagant.” This is another subjective term bandied about usually on the topic of meals and entertainment. There are no firm rules defining this term. Here again, it’s all about facts and circumstances.

Discuss your concerns with a tax professional and as always, keep supporting documentation in the event of audit.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook

Bonnie Leehttp://global.fncstatic.com/static/v/all/img/external-link.png is an Enrolled Agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebookhttp://global.fncstatic.com/static/v/all/img/external-link.png