Business Income, Deductions, and Accounting Methods
- [LO 1] What is an “ordinary and necessary” business expenditure?
“Ordinary” and “necessary” imply that an expense must be customary and helpful, respectively. Because these terms are subjective, the tests are ambiguous. However, the ordinary is interpreted by the courts as including expenses that may be unusual for a specific taxpayer (but not for that type of business) and necessary is not interpreted as only essential expenses. These limits can be contrasted with the reasonable limit on amounts and the bona fide requirement for profit motivation.
- [LO1] Explain how the cost of goods sold is treated when a business sells inventory.
Under the return of capital principle, the cost of goods sold represents a reduction in gross income rather than a business expense. For example, if a taxpayer sells inventory for $100,000 and reports a cost of goods sold of $40,000, the business’s gross income is $60,000 ($100,000 – 40,000) not $100,000.