IRC 162: The Ordinary and Necessary Expense Test
What Section 162(a) Actually Says
The operative sentence is short. Under 26 U.S.C. 162(a), there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Three named examples follow: a reasonable allowance for salaries or other compensation for personal effort actually rendered, traveling expenses while away from home in pursuit of the business, and rentals for property the taxpayer does not own and is not acquiring equity in.
Unpack that and you get five separate requirements, each of which the IRS can attack independently. The item has to be an expense rather than a capital outlay. It has to be ordinary. It has to be necessary. It has to be paid or incurred during the taxable year, which turns on your accounting method. And it has to be connected to carrying on an existing trade or business, not investigating one or preparing to start one.
The deduction is above the line for a sole proprietor filing Schedule C, for a partnership, for an S corporation, and for a C corporation. That matters more after 2017 than it did before, because the elimination of miscellaneous itemized deductions means an employee who pays a business expense out of pocket generally gets nothing, while the same expense reimbursed through an accountable plan under Treasury Regulation 1.62-2 is deductible by the employer and tax-free to the employee. Same dollar, entirely different result, decided by paperwork.
One more structural point. Section 162 is a rule of allowance. Sections 263, 274, 280A, 280E, and a dozen others are rules of disallowance that sit on top of it. Passing the ordinary and necessary test gets you to the starting line, not across it.
Ordinary and Necessary: What the Courts Made of Two Words
The Supreme Court got to ordinary first, in Welch v. Helvering, 290 U.S. 111 (1933). Thomas Welch had been an officer of a grain company that went bankrupt. Years later, working in the same industry on his own account, he voluntarily paid the discharged debts of the old company to restore his standing with customers. Justice Cardozo agreed the payments were necessary, appropriate and helpful to Welch’s new business, but held they were not ordinary. Paying somebody else’s discharged debts to build reputation was capital in nature, closer to buying goodwill than to buying supplies. The opinion is famous for admitting the line is blurry: life in all its fullness must supply the answer to the riddle.
Ordinary does not mean recurring. A lawsuit you defend once in forty years is ordinary if litigation is a normal hazard of your line of work. In Deputy v. du Pont, 308 U.S. 488 (1940), the Court framed it as whether the transaction giving rise to the expense is of common or frequent occurrence in the type of business involved. The test looks at the industry, not at your own history.
Necessary turns out to be the easier hurdle. It means appropriate and helpful to the business, not indispensable. In Commissioner v. Heininger, 320 U.S. 467 (1943), a dentist deducted the legal fees he spent fighting a Post Office fraud order that would have destroyed his mail-order denture business. He lost the fight. The deduction was allowed anyway. In Commissioner v. Tellier, 383 U.S. 687 (1966), the Court allowed a securities dealer to deduct the legal fees of an unsuccessful criminal defense on securities fraud charges, reasoning that the federal income tax is a tax on net income and not a sanction against wrongdoing.
Reasonableness rides along quietly. The statute writes it into the compensation clause, and courts read it into the rest. A $400,000 salary to an owner’s college-age child who answers the phone on weekends is not deductible in full, not because the category is wrong, but because the amount is not reasonable for the effort actually rendered. That is the most common IRC 162 adjustment in a closely held business examination, and it usually arrives with a payroll tax question attached.
Carrying On a Trade or Business, and the Startup Problem
The phrase carrying on does real work. Section 162 covers an active business, not a plan for one. In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court held that a taxpayer is in a trade or business if the activity is pursued full time, in good faith, with regularity, for the production of income, and not as a hobby or amusement. Continuity and regularity are the operative words.
So what happens to the money you spend before the doors open? It goes to Section 195. Startup expenditures, market research, advertising before launch, employee training before launch, travel to line up suppliers, professional fees for the feasibility work, are capitalized, then a taxpayer may elect to deduct up to $5,000 in the year the business begins. That $5,000 is reduced dollar for dollar to the extent total startup costs exceed $50,000, and whatever is left is amortized ratably over 180 months beginning with the month the active business starts. Spend $63,000 getting a restaurant open and the immediate deduction is zero; the whole $63,000 amortizes over fifteen years.
The date the business begins is therefore worth thinking about carefully, and it is not the date you formed the entity. It is the date you began the activity for which the business was organized, for a retailer, generally when the doors open to customers; for a service firm, generally when you are open for business and holding yourself out, not when you sign the first client. Organizational costs of the entity itself follow a parallel rule under Section 248 for corporations and Section 709 for partnerships.
Section 183 sits on the other side of the same question. An activity not engaged in for profit gets deductions only to the extent of income from it, and after 2017 even those are effectively lost for individuals. The regulations list nine factors, and the ones that decide real cases are whether you keep complete books, whether you changed methods after losses, and whether you have expertise or hired advisers who do.
Deduct Now or Capitalize: The Line at Section 263
Section 263 disallows a current deduction for amounts paid for new buildings or for permanent improvements or betterments that increase the value of property. INDOPCO v. Commissioner, 503 U.S. 79 (1992) pushed the boundary further, holding that investment banking and legal fees incurred in a friendly takeover had to be capitalized because they produced significant future benefits, even though no separate asset was created.
Practitioners spent a decade arguing about how far INDOPCO reached. The answer arrived in the tangible property regulations, which are unusually taxpayer-friendly for something that runs to a hundred pages. Three safe harbors do most of the work:
The de minimis safe harbor in Treasury Regulation 1.263(a)-1(f) lets a taxpayer with an applicable financial statement expense items costing up to $5,000 per invoice or per item, and a taxpayer without one expense items up to $2,500, provided a written accounting policy is in place at the beginning of the year and the treatment matches the books. The election is annual and made on a statement attached to the return.
The routine maintenance safe harbor in Regulation 1.263(a)-3(i) treats as deductible the recurring activities you reasonably expect to perform more than once during a ten-year period for a building, or more than once during the property’s class life for other property.
The small taxpayer safe harbor in Regulation 1.263(a)-3(h) lets a business with average annual gross receipts of $10 million or less elect to deduct improvements to a building with an unadjusted basis of $1 million or less, up to the lesser of $10,000 or two percent of that basis.
Outside the safe harbors, the test is whether the work is a betterment, a restoration, or an adaptation to a new use. Replacing one of ten rooftop units is a repair. Replacing all ten is a restoration. The difference between deducting $180,000 this year and depreciating it over 39 years on Form 4562 is real money, and it is decided by facts you should document while the contractor is still on site.
The Disallowance Rules Buried Inside Section 162
The section that grants the deduction also takes a good deal of it back. Reading only 162(a) and stopping is how a business ends up deducting things that were disallowed by Congress decades ago.
| Subsection | What it disallows |
|---|---|
| 162(c) | Illegal bribes and kickbacks, payments to foreign officials that violate the Foreign Corrupt Practices Act, and kickbacks under Medicare or Medicaid |
| 162(e) | Lobbying and political expenditures, including amounts paid to influence legislation and the portion of trade association dues used for lobbying |
| 162(f) | Fines and penalties paid to, or at the direction of, a governmental entity in relation to the violation of any law |
| 162(g) | Two-thirds of treble damages paid under the antitrust laws following a criminal conviction or guilty plea |
| 162(m) | Compensation above $1,000,000 paid to a covered employee of a publicly held corporation |
| 162(q) | Settlements and attorney fees related to sexual harassment or abuse where the settlement is subject to a nondisclosure agreement |
Then come the neighbors. Section 274(a) disallows entertainment, amusement, and recreation expenses outright. That change arrived with the 2017 tax act and it did not sunset. Section 274(n) limits most business meals to 50 percent. Section 274(b) caps business gifts at $25 per recipient per year, a figure set in 1962 and never indexed. Section 280A restricts the home office deduction to space used regularly and exclusively as a principal place of business. Section 280E denies every deduction other than cost of goods sold to a business trafficking in a controlled substance, which is why state-legal cannabis operators pay federal tax on gross profit.
Fines, Penalties, and the 162(f) Trap
Section 162(f) was rewritten by the 2017 act and it is broader than the old rule. No deduction is allowed for any amount paid or incurred, whether by suit, agreement, or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such an entity into the potential violation of any law. Note the reach: not just fines after a finding of liability, but payments in settlement of an investigation that never produced a charge.
Three exceptions survive. First, amounts constituting restitution or remediation of property, or paid to come into compliance with a law, remain deductible, but only if the amount is identified as such in the court order or settlement agreement and the taxpayer can establish that it was in fact restitution, remediation, or compliance. The identification requirement is strict, and the regulations at Treasury Regulation 1.162-21 make clear that a taxpayer’s later characterization does not cure a silent agreement. Second, amounts paid under an order in a suit where no governmental entity is a party. Third, amounts paid as taxes due.
Two carve-outs from the exceptions catch people. Reimbursing the government for the costs of its own investigation or litigation is never deductible, even if the settlement calls it restitution. And any amount paid at the direction of a government to a third party still falls under the disallowance unless it fits an exception.
There is now a paper trail, too. Section 6050X requires governmental entities to report covered settlements to the IRS and to the payer on Form 1098-F, Fines, Penalties, and Other Amounts, when the aggregate amount is at or above the reporting threshold set in the regulations. Box 2 shows the total, Box 3 shows the restitution or remediation amount, and Box 4 shows the amount for compliance. If the settlement agreement is silent, the form will be silent, and the deduction disappears. Negotiating the allocation language is a tax decision that has to happen while the lawyers are still at the table.
The Million-Dollar Cap on Executive Pay Under 162(m)
Section 162(m) denies a publicly held corporation any deduction for compensation over $1,000,000 paid to a covered employee in a taxable year. The number has not moved since 1994 and is not indexed.
The 2017 tax act changed the provision in three ways that matter. It repealed the exception for qualified performance-based compensation and commissions, which had let companies deduct unlimited amounts paid through stock options and shareholder-approved bonus plans. It expanded the definition of a publicly held corporation to include companies with publicly traded debt that are required to file reports under Section 15(d) of the Securities Exchange Act, so a private equity portfolio company with registered bonds can be caught. And it made covered employee status permanent: once an individual is a covered employee for any taxable year beginning after 2016, they remain one for every later year, including after they retire and including payments to their estate.
Covered employees are the principal executive officer, the principal financial officer, and the three other highest compensated officers for the year. Legislation enacted in 2021 expands the group to include the five highest compensated employees who are not already covered, effective for taxable years beginning after December 31, 2026, so this is the change public company tax departments are modeling right now, and unlike the officer group it is determined fresh each year rather than carrying forward.
A limited grandfather still exists for compensation payable under a written binding contract in effect on November 2, 2017 that has not been materially modified. Those arrangements are aging out, and a routine amendment can destroy the protection.
The planning question is narrower than people expect. Deferring a bonus does not help if the executive is a covered employee in the payment year too, which is now always. Entity structure is what remains: partnerships and S corporations are not publicly held corporations.
Records That Survive an Audit
Section 6001 requires every taxpayer to keep records sufficient to establish the amount of gross income and deductions. That is the baseline, and for most expense categories the standard is flexible. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), Broadway producer George M. Cohan, whose travel and entertainment records were nonexistent, established that a court may estimate a deductible amount when it is convinced some expense was incurred, bearing heavily against the taxpayer who created the uncertainty.
Congress took the Cohan rule away for the categories most likely to be abused. Section 274(d) provides that no deduction is allowed for traveling expenses, gifts, or listed property unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating their own statement: the amount, the time and place, the business purpose, and for gifts the business relationship of the recipient. There is no estimating around it. A vehicle log reconstructed in the waiting room outside the examiner’s office is worth exactly nothing.
What adequate records look like in practice: a contemporaneous log or app entry made at or near the time of the expense, a receipt for lodging and for any expense of $75 or more, and a note of purpose that a stranger could understand two years later. Bank and credit card statements alone prove payment, not purpose, and purpose is the element examiners test.
New York adds nothing new to the analysis and everything to the stakes. The state’s personal income tax begins with federal adjusted gross income, so a deduction the IRS disallows under IRC 162 disappears from the New York return as well, and New York City’s unincorporated business tax layers its own adjustments on top for partnerships and sole proprietors operating in the city. One federal adjustment can produce three assessments.
This page is general information and not tax or legal advice. Whether a specific expense clears IRC 162, and how much of it survives Sections 263 and 274, depends on facts a licensed CPA needs to see, get your situation reviewed before you file, not after a notice arrives.
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Frequently Asked Questions
What does IRC 162 actually let a business deduct?
Everything ordinary and necessary that you pay or incur in carrying on an active trade or business, minus everything another section takes back. That framing matters, because the statute is written as a broad grant and the limits live elsewhere. Start with the grant, then run the list of disallowances.
The categories that clear Section 162 without argument are the ones every business has. Wages and salaries for effort actually rendered, along with the employer share of payroll taxes. Rent for space and equipment you do not own. Utilities, insurance, and telephone. Supplies consumed in the year. Professional fees for accounting, legal, and consulting work connected to operations. Advertising and marketing. Interest on genuine business debt, subject to the separate limitation in Section 163(j) for larger taxpayers. Contributions to qualified retirement plans for employees. Repairs that keep property in ordinary operating condition. Bank charges, software subscriptions, licenses, and continuing education that maintains or improves skills required in your current work.
The ones that generate examinations are predictable. Vehicle expense, because personal use is always in the picture and Section 274(d) demands mileage records. Travel, because the away-from-home requirement and the business-purpose requirement both have to be met. Meals, because Section 274(n) allows only 50 percent and the taxpayer or an employee has to be present. Home office, because Section 280A requires regular and exclusive use. Compensation paid to family members, because reasonableness is a live question. And anything paid to a related entity, because the IRS will ask what was actually received.
Then the disallowance layer. Entertainment is gone entirely under Section 274(a), the client’s ballgame tickets, the golf outing, the theater seats, all of it, even when the business purpose is genuine. Political contributions and lobbying are out under 162(e). Fines and penalties are out under 162(f). Business gifts are capped at $25 per recipient per year under Section 274(b). Life insurance premiums are nondeductible where the business is directly or indirectly a beneficiary. Federal income taxes are never deductible, though state and local business taxes generally are. The IRS summary of deductible business expenses is a reasonable starting index, and Publication 334 works through the categories for small businesses in more detail.
Here is a year that shows the arithmetic. A design studio organized as a single-member LLC in Queens has $520,000 of revenue. It pays $180,000 in wages to two employees plus $14,000 of employer payroll tax, $48,000 of rent, $9,600 of business insurance, $22,000 of contractor payments to freelancers reported on Form 1099-NEC, $7,400 of software subscriptions, $11,000 of client travel, $6,200 of meals with clients, $3,900 of entertainment at industry events, $2,400 of political contributions to a trade group’s advocacy fund, and $18,000 for a new server room buildout. It also pays the owner $95,000 in draws.
What survives IRC 162: the wages, the payroll taxes, the rent, the insurance, the contractor payments, the software, and the travel, $292,000. The meals come in at 50 percent, so $3,100. The entertainment is entirely disallowed under Section 274(a), so zero of the $3,900. The political money is disallowed under 162(e), so zero of the $2,400. The server room buildout is a capital expenditure under Section 263 and is depreciated rather than deducted, unless it fits the de minimis safe harbor per invoice, which a single $18,000 project will not. And the owner’s draws are not a deduction at all, because a single-member LLC owner is not an employee, that $95,000 is simply distributed profit already taxed on Schedule C.
The common mistake: treating the business bank account as the test. Money that left the account is not automatically deductible, and money that never left the account can be. Accrual taxpayers deduct when the all-events test is met and economic performance occurs, which can be before payment. Cash taxpayers deduct when paid, except that prepaying a three-year insurance policy does not buy a three-year deduction. The twelve-month rule in the regulations allows a current deduction only for benefits that do not extend beyond the earlier of twelve months or the end of the following tax year. The second common mistake is running personal expenses through the business on the theory that the risk is small. It is not small. An examiner who finds three personal items in a sample expands the sample, and the accuracy-related penalty under Section 6662 is 20 percent of the resulting underpayment.
Owner-level expenses need their own handling, and the rules differ by entity. An S corporation shareholder who works in the business is an employee, so business expenses she pays personally are deductible by the corporation only if reimbursed under an accountable plan meeting Treasury Regulation 1.62-2, substantiated within a reasonable period, with excess amounts returned. Without that plan the corporation gets no deduction and she gets nothing either, because unreimbursed employee expenses are not deductible for individuals under current law. Health insurance premiums for a more-than-2-percent shareholder follow their own path: the corporation deducts them as wages, includes them in Box 1 of the shareholder’s Form W-2, and the shareholder takes the self-employed health insurance deduction under Section 162(l) on her personal return. Handled correctly it is deductible once and taxed never. Handled by writing a check from the business account with no payroll entry, it is a distribution and a disallowance. Publication 463 covers the reimbursement mechanics for travel and vehicle costs specifically.
Owners of pass-through entities should also watch the interaction with the qualified business income deduction. Every dollar of IRC 162 expense reduces qualified business income, so a deduction is worth slightly less than the marginal rate suggests when the 199A deduction is in play. That is not a reason to skip deductions. It is a reason to be precise about which entity and which year they land in.
Going forward, the discipline that pays is separating categories at entry rather than at year end: a distinct account for meals, another for travel, another for entertainment you already know is nondeductible, another for capitalizable purchases. A chart of accounts that mirrors the tax rules turns filing into transcription. Our bookkeeping team builds those structures for New York businesses. This is general information rather than advice about your return; have a licensed CPA review the specific expenses before you claim them.
What do ordinary and necessary mean under IRC 162 in real cases?
They are two separate tests under Section 162(a), and the courts have spent ninety years keeping them separate. An expense can be plainly necessary and still fail because it is not ordinary. That is exactly what happened in the case that defines the standard.
Welch v. Helvering, 290 U.S. 111 (1933), involved a man named Thomas Welch who had been secretary of a grain company that went through bankruptcy. He later started work as a commission agent for the same suppliers, and to rebuild his reputation he paid off the discharged debts of the failed corporation out of his own commissions. The government conceded the payments helped his business. Justice Cardozo wrote that they were necessary in the sense the statute uses, appropriate and helpful, but not ordinary, because voluntarily paying somebody else’s discharged debts to build a reputation is a capital-like investment in goodwill rather than a recurring cost of doing business. The opinion closes by conceding that the standard resists definition, which is a strange thing for a foundational tax case to say and the reason the case still gets cited.
Deputy v. du Pont, 308 U.S. 488 (1940), sharpened the test: the transaction giving rise to the expense must be of common or frequent occurrence in the type of business involved. Notice the reference point. It is not whether you personally do this often. It is whether businesses like yours do. A manufacturer that faces a product liability suit for the first time in its history still incurs an ordinary expense, because litigation is a normal hazard of manufacturing.
Necessary is a much lower bar. Commissioner v. Heininger, 320 U.S. 467 (1943), allowed a dentist to deduct legal fees spent unsuccessfully fighting a Post Office fraud order aimed at his mail-order denture business. Commissioner v. Tellier, 383 U.S. 687 (1966), allowed a securities dealer to deduct the fees of an unsuccessful criminal defense. The Court in Tellier said the deduction of costs of defending a business does not amount to public subsidy of wrongdoing, because the income tax is a levy on net income rather than an added sanction. Congress has since carved out specific items, fines under 162(f), illegal payments under 162(c), but the defense costs themselves generally remain deductible.
Reasonableness is the third word that is not in the general clause but shows up everywhere in practice. The statute writes it into compensation, and courts and the IRS import it broadly. An expense in a legitimate category can be reduced to a reasonable amount.
A worked example makes the tests concrete. A construction firm in the Bronx spends the following in one year: $46,000 defending a wrongful termination claim by a former foreman; $12,000 on a settlement paid to that foreman; $28,000 on a chartered fishing trip for its three largest general contractors; $9,000 on a scholarship fund the owner created in his father’s name at his alma mater; and $150,000 in salary to the owner’s spouse, who handles scheduling roughly fifteen hours a week.
The legal fees are ordinary and necessary, employment litigation is a common hazard for a firm with 40 employees, and fully deductible. The settlement is deductible as well, since no governmental entity is involved and 162(f) does not reach it. The fishing trip is entertainment, disallowed in full under Section 274(a) regardless of business purpose. The scholarship fund is a charitable contribution, not a business expense; a C corporation deducts it under Section 170 subject to the 10 percent taxable income limit, and a pass-through owner takes it personally as an itemized deduction. And the $150,000 spousal salary is deductible only to the extent it is reasonable for fifteen hours a week of scheduling work, if the market rate for that role is $45,000, an examiner will propose disallowing $105,000, with a matching argument that the excess is a distribution.
The last item shows why these cases still matter. Nobody disputes that the spouse works. Nobody disputes that the money moved. The adjustment comes entirely from the word reasonable, and the taxpayer’s defense is comparable-compensation data and a written job description, prepared before the audit rather than during it.
The common mistake: arguing business purpose when the problem is category. Taxpayers spend enormous energy proving that a client golf outing genuinely generated revenue. It does not matter. Section 274(a) disallows entertainment whether or not it worked. The corresponding mistake in the other direction is assuming an unusual expense fails the ordinary test just because it is rare in your own experience. A one-time expense can be entirely ordinary if the industry commonly faces it.
Two smaller doctrines sit alongside the main tests and decide more cases than their profile suggests. The first is the origin of the claim rule: whether a legal fee is a deductible business expense or a nondeductible personal or capital cost depends on the transaction that gave rise to the claim, not on the consequences of losing. Fees to defend title to property get capitalized into basis; fees to defend the way you ran the business get deducted. The second is the requirement that the expense belong to your business rather than someone else’s. A shareholder who personally pays a corporation’s bills is generally making a capital contribution or a loan, not incurring a deduction, which is the modern echo of Welch. The IRS guidance on deducting business expenses restates both principles in plainer language than the cases do.
Practical guardrails: write a one-line business purpose on anything unusual at the time you incur it. Get comparable-compensation support for family members on the payroll. And treat any expense that produces a benefit lasting beyond the year as a capitalization question first and a deduction question second, because that is the order the examiner will use. Our guide to contractor versus employee classification covers the adjacent problem of who is on the payroll in the first place.
Looking ahead, expect the reasonableness question to keep growing in closely held businesses, particularly for S corporations, where the incentive runs the other way and owners understate salary to reduce payroll tax. Both directions are examined. This page is general information and not advice about your facts; a licensed CPA should review compensation levels and unusual expense categories before the return is filed.
Are fines and penalties deductible under IRC 162(f)?
Generally no, and the rule got broader in 2017. Section 162(f) now denies a deduction for any amount paid or incurred, whether by suit, agreement, or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such entity into the potential violation of any law.
Read that carefully, because two phrases do a lot of work. Or at the direction of means a payment routed to a third party at the government’s instruction is caught. And investigation or inquiry into the potential violation means the disallowance applies even when nobody was ever charged, nobody admitted anything, and the matter closed with a settlement that recites no liability. The pre-2018 rule reached fines and similar penalties; the current rule reaches settlements of investigations.
Three exceptions survive, and the first is the one that matters commercially. Under 162(f)(2), amounts constituting restitution, remediation of property, or amounts paid to come into compliance with a law remain deductible, but only if two conditions are met. The order or settlement agreement has to identify the payment as restitution, remediation, or an amount paid to come into compliance. And the taxpayer has to establish that the amount actually was that. Both. An agreement that identifies the amount but cannot be substantiated fails, and an amount that plainly was restitution but sits in a silent agreement also fails. Treasury Regulation 1.162-21, finalized in early 2021, is unforgiving on this point.
The second exception covers amounts paid or incurred under an order in a suit in which no government or governmental entity is a party. The third covers amounts paid as taxes due. And two carve-outs cut back the exceptions: reimbursement of the government’s own investigation or litigation costs is never deductible, and amounts a taxpayer pays to satisfy a legal obligation it had anyway are tested on their own terms.
There is now third-party reporting. Section 6050X requires the governmental entity to file Form 1098-F and furnish a copy to the payer when a covered settlement meets the reporting threshold in the regulations. Box 2 reports the total amount required to be paid, Box 3 the portion identified as restitution or remediation, and Box 4 the portion identified as an amount paid to come into compliance. The IRS receives that form. When your return claims a deduction larger than what Box 3 and Box 4 support, the mismatch is mechanical.
Work a settlement. A specialty pharmacy in Manhattan settles a state attorney general investigation into billing practices for $2,400,000. The agreement, as first drafted, says only that the company will pay $2,400,000 to resolve all claims. Under 162(f) as written, none of it is deductible. The entire amount was paid to a governmental entity in relation to an investigation into a potential violation of law, and nothing is identified as restitution or compliance. Now suppose tax counsel gets involved before signing and the agreement is revised to state that $1,500,000 represents restitution to the state health program for overbilled claims, $300,000 represents amounts to be spent implementing a new claims review system to come into compliance, $450,000 is a civil penalty, and $150,000 reimburses the state’s investigative costs. The deductible portion is $1,800,000, assuming the company can also establish the character of those amounts with its own records. At a 21 percent federal rate that identification is worth $378,000, plus the state effect. Same settlement, same cash, one paragraph of drafting.
The common mistake: treating the tax characterization as something to sort out at filing time. By then the agreement is signed and the Form 1098-F is issued. The allocation has to be negotiated into the document, and government lawyers will often agree to accurate labels because accuracy costs them nothing, but only if somebody asks while the document is open. The second mistake is assuming a payment to a private plaintiff is safe. It usually is, since 162(f) requires a governmental entity, but a qui tam settlement under the False Claims Act involves the government even when a relator brought the case, and the treble damages structure raises separate questions about which portion is compensatory.
Related provisions travel with this one. Section 162(c) disallows illegal bribes and kickbacks, including payments to foreign officials that would violate the Foreign Corrupt Practices Act and kickbacks under federal health care programs, and no identification language rescues those. Section 162(g) disallows two-thirds of treble damages paid under the antitrust laws when there has been a criminal conviction or a plea. Section 162(q) disallows settlements and related attorney fees for sexual harassment or abuse claims when the settlement carries a nondisclosure agreement, which effectively forces a choice between confidentiality and deductibility.
State and local enforcement is where mid-sized businesses meet this rule most often, and the analysis is the same. A payment to a state department of labor to resolve a wage-and-hour investigation, a penalty from a city agency over a licensing violation, a settlement with a state environmental regulator. Each is paid to a governmental entity in relation to a potential violation of law, so each needs the identification language to preserve any deduction. The back wages themselves are usually deductible as compensation, since paying employees what they were owed is restitution in substance, but that conclusion is far safer when the consent order says so. Amounts a business pays to satisfy ordinary tax obligations stay deductible or nondeductible on their own terms, with federal income tax never deductible and most state and local business taxes allowed.
Legal fees are the bright spot. The costs of defending the matter generally remain deductible under the ordinary and necessary standard, following Commissioner v. Tellier, even where the underlying penalty is not. Accounting for the two separately from the first invoice keeps the deductible portion clean.
Going forward, build a habit: any time a settlement with a regulator, a state agency, or a federal enforcement office is on the table, get the tax allocation language drafted before signature and keep the substantiation file that proves the character of each bucket. Our tax strategy team works with counsel on that language. This page is general information and not tax or legal advice about your matter; have a licensed CPA and your attorney review the agreement before it is executed.
How does the IRC 162(m) million-dollar limit on executive compensation work?
Section 162(m) is a deduction rule, not a pay cap. A publicly held corporation can pay an executive whatever the board approves. It simply cannot deduct more than $1,000,000 of that pay for any covered employee in any taxable year. The company writes the check, the executive pays tax on the full amount, and the corporation eats the excess with after-tax dollars.
The $1,000,000 threshold has been in the statute since 1993 and has never been indexed for inflation. In 1994 it applied to a narrow group of very large companies. Today it reaches ordinary compensation at mid-cap public companies, and that erosion is entirely by design of not doing anything.
Three definitions decide whether the section bites. Publicly held corporation originally meant a company with equity registered under Section 12 of the Securities Exchange Act. The 2017 tax act expanded it to include any corporation required to file reports under Section 15(d), which sweeps in companies with registered public debt and no publicly traded stock. A private company that issued high-yield bonds through a registered offering can be subject to 162(m) without a single share trading anywhere.
Covered employee means the principal executive officer at any time during the year, the principal financial officer at any time during the year, and the three other highest compensated officers whose compensation is required to be reported to shareholders. Then the rule that changed the planning entirely: once someone is a covered employee for a taxable year beginning after December 31, 2016, they remain a covered employee for all future years. Permanently. That reaches deferred compensation paid a decade after retirement, severance, and payments to a beneficiary after death. Legislation enacted in 2021 adds the five highest compensated employees who are not otherwise covered, effective for taxable years beginning after December 31, 2026, and that group is redetermined each year rather than carried forward, so a company can have a shifting population of five on top of a permanent population of officers.
Applicable employee remuneration is broad: salary, bonus, the value of stock options and restricted stock when included in income, and most other compensation, reduced by amounts the executive elected to defer and by commissions and performance pay only for arrangements still protected by the grandfather. The 2017 act repealed the qualified performance-based compensation exception and the commission exception for taxable years beginning after December 31, 2017, subject to a grandfather for compensation payable under a written binding contract in effect on November 2, 2017 that has not been materially modified since.
Numbers make the cost visible. A public company pays its chief executive $1,300,000 in salary, a $2,200,000 annual incentive, and $4,500,000 of restricted stock units that vest and are included in income this year. Total applicable remuneration is $8,000,000. The deduction is limited to $1,000,000, so $7,000,000 is nondeductible. At a 21 percent federal corporate rate that is $1,470,000 of additional federal tax, before state effects. Under the pre-2018 rules, if the incentive and the equity had qualified as performance-based, roughly $6,700,000 would have been deductible and the additional tax would have been near zero. That is the size of what the repeal did, and it is why deferred compensation programs designed in 2015 no longer work as intended.
The mechanics run through the return. Compensation over the limit is added back as a permanent book-to-tax difference on the Schedule M-1 or M-3 filed with Form 1120, which means the disallowance is visible on the face of the return and easy for an examiner to test against the proxy statement. Public company compensation tables and the tax return are built from the same underlying data, and the IRS reads both. Companies that compute the addback from a payroll summary rather than from the proxy figures routinely miss items the tables include, the value of restricted stock at vesting, dividend equivalents, and amounts paid to a former officer who remains a covered employee for life. Building the calculation off the same schedule the proxy uses removes an argument nobody wants to have.
The financial reporting side matters too. Nondeductible compensation is a permanent difference under ASC 740, so it raises the effective tax rate rather than creating a deferred tax asset. Analysts notice. Companies with heavy equity compensation for a small executive group often see a rate reconciliation line that has grown steadily since 2018.
The common mistake: assuming deferral helps. Before the permanent covered-employee rule, a company could defer a bonus until after an executive left the top five and deduct it then. That door is closed for anyone covered in 2017 or later, the status follows them out of the building. A second mistake is amending a grandfathered contract without checking. Increasing an award, extending a term, or accelerating vesting can be a material modification that destroys the grandfather for the entire arrangement going forward. A third is forgetting that the limit applies to the aggregated group in some circumstances, so compensation paid by a subsidiary to an officer of the parent still counts.
Structure is where the remaining planning lives, and the general deduction rules still apply to everything under the cap. Partnerships and S corporations are not publicly held corporations, so operating partnerships in an umbrella structure have different exposure than the public parent, and the regulations address payments made by a partnership in which the corporation holds an interest. Companies expecting to go public should model 162(m) before the offering, because the transition rule for newly public companies is narrower than it was.
Looking ahead, the 2027 expansion to the five highest compensated employees is the item to model now. It captures people who are not officers at all, a top salesperson, a portfolio manager, a division head, and it requires a data process to identify them annually. Our corporate return team works through these permanent differences with public and bond-registered filers. This page is general information and not advice about your compensation arrangements; have a licensed CPA and compensation counsel review the specifics before you sign anything.
What records do you need to support an IRC 162 deduction in an audit?
Enough to answer three questions for every dollar: what did you buy, what did it cost, and why did the business need it. The first two live on the receipt. The third almost never does, and the third is what examiners test.
The general standard comes from Section 6001, which requires every person liable for tax to keep records sufficient to establish the amount of gross income, deductions, credits, and other matters. The regulation adds that records must be kept as long as their contents may become material, which for a return is generally at least three years from filing, six years where more than 25 percent of gross income was omitted, and indefinitely for a return never filed or a fraudulent one. For depreciable property, keep the purchase records for as long as you own the asset plus the statute period after you dispose of it. Publication 583 lays out the baseline expectations for a new business.
Where the ordinary standard applies, the Cohan rule provides a safety net. In Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), the court accepted that the Broadway producer George M. Cohan had incurred substantial travel and entertainment expense despite keeping no records, and held that the Board of Tax Appeals should make an approximation rather than disallow everything, bearing heavily against the taxpayer whose own carelessness created the uncertainty. Courts still apply Cohan to categories like supplies or repairs where the evidence shows an expense was certainly incurred.
Congress removed that safety net for the categories most prone to abuse. Section 274(d) provides that no deduction is allowed for traveling expenses, for gifts, or for listed property unless the taxpayer substantiates by adequate records, or by sufficient evidence corroborating the taxpayer’s own statement, four elements: the amount, the time and place, the business purpose, and, for gifts and formerly for entertainment, the business relationship of the person involved. There is no estimating. A missing mileage log means a disallowed vehicle deduction even when nobody doubts the car was driven for work. Publication 463 works through what qualifies as an adequate record.
What that looks like in practice, by category. Vehicle: a contemporaneous log, an app is fine, showing date, destination, business purpose, and miles, plus total annual mileage and the odometer readings that let you compute the business percentage. Travel: the itinerary, lodging receipts regardless of amount, receipts for any other expense of $75 or more, and a note of what business was conducted each day. Meals: the receipt, who attended, and the business discussed, with the 50 percent limit applied at entry so the return does not require a reconstruction. Home office: a floor plan or measurement, the mortgage or rent and utility records, and evidence of regular and exclusive use. Payments to contractors: the signed Form W-9 before the first payment and the Form 1099-NEC after year end, because a payment to an unidentified vendor invites both a disallowance and a backup withholding assessment.
Run a realistic exam. A consulting S corporation in Brooklyn claims $34,000 of travel, $9,800 of meals, $16,500 of vehicle expense on a leased SUV, and $12,000 paid to three subcontractors. On audit the owner produces credit card statements for everything, hotel folios for six of eleven trips, no mileage log, and no W-9s. The result is predictable. Travel is reduced to the six documented trips, roughly $19,000, and the remaining $15,000 is disallowed under 274(d) with no Cohan estimate available. The vehicle deduction is disallowed in full for the same reason, $16,500 gone. The meals survive at 50 percent for the amounts where the owner can name attendees, perhaps $3,000 of the $4,900 otherwise allowable. The subcontractor payments are allowed because the work is documented by invoices, but penalties for failure to file information returns apply. Total adjustment near $33,000, an accuracy-related penalty of 20 percent under Section 6662 on the resulting underpayment, and interest from the original due date. The owner spent every one of those dollars. He simply could not prove why.
The common mistake: relying on bank and credit card statements. A statement proves payment. It says nothing about purpose, and purpose is the contested element. The second mistake is reconstructing records after the notice arrives. Reconstructions are permitted in limited circumstances, records destroyed by fire or flood, for example, but a log created from calendar entries the week before the appointment is transparent and damages credibility on every other issue in the exam. The third is commingling: a single account used for both personal and business spending guarantees a longer audit, because the examiner has to test every line rather than sample.
Digital records count, and they count fully. The IRS accepts electronic images of receipts and machine-generated logs as long as the system reproduces a legible copy and the data cannot be silently altered. What auditors dislike is a system nobody can explain, an expense app that a former office manager set up, with no export, no backup, and no one who remembers the password. Ownership of the records is the taxpayer’s responsibility, not the vendor’s, so download an annual archive each January and store it with the return.
A few habits eliminate most of this. Keep a dedicated business account and card. Photograph receipts at the point of sale into whatever expense app you already have, and write the purpose in the note field while you still remember it. Run mileage through an automatic tracker rather than a notebook. Reconcile monthly rather than annually, so that an unexplained charge gets resolved while the vendor and the reason are still fresh. And keep the year’s substantiation together with the filed return rather than scattered across three systems.
Going forward, treat documentation as part of the deduction rather than as backup for it. An IRC 162 deduction without records is not a deduction with a paperwork problem, for travel, vehicles, and gifts it is not a deduction at all. Our guide to tax advice covers what to expect from a professional relationship, including what your CPA can and cannot do for you once an examination has started. This page is general information rather than advice about your records; have a licensed CPA review your substantiation before you file, and again if you receive a notice.