Welch v. Helvering: The Classic Definition of "Ordinary and Necessary" Business Expenses
Case Summary
Welch v. Helvering is one of the most quoted tax cases in history, featuring beautiful judicial language from Justice Benjamin Cardozo. It established the framework for determining whether business expenses are "ordinary and necessary" under what is now IRC § 162(a), the most important business deduction provision in the tax code.
The Facts of the Case
Thomas Welch worked for E.L. Welch Company, a grain business. When the company went bankrupt in 1922, it couldn't pay its creditors. Welch was not personally liable for these business debts—he had no legal obligation to pay them.
However, in 1924-1928, Welch voluntarily paid approximately $20,000 to satisfy the old debts of the bankrupt company. He made these payments to restore his reputation and business standing in the grain industry so he could continue working in the field.
Welch tried to deduct these payments as ordinary and necessary business expenses , arguing they were necessary to maintain his business reputation.deduct these payments as ordinary and necessary business expenses
The IRS disagreed, arguing the payments were not deductible because they were capital expenditures to build his personal reputation and goodwill.not deductible
The Supreme Court's Decision
The Ruling: No Deduction
The Supreme Court sided with the IRS, holding that Welch's payments were NOT ordinary and necessary business expenses. While the payments might have been "necessary" for his business success, they were not "ordinary" in the tax law sense.
Justice Cardozo's Famous Analysis
Justice Benjamin Cardozo wrote one of the most quoted passages in tax law:
"Ordinary in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part.""Ordinary in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part."
The Two-Part Test
The Court established that to be deductible, an expense must be BOTH:
- "Necessary": Appropriate and helpful for the business"Necessary":
- "Ordinary": Normal, common, and accepted in that type of business"Ordinary":
Understanding "Ordinary"
What "Ordinary" DOES Mean:
- Common in the industry: Other businesses in your field incur similar costsCommon in the industry:
- Accepted business practice: The expense is a normal way to conduct that type of businessAccepted business practice:
- Customary: It's the kind of expense people in your business typically haveCustomary:
- Not extraordinary: It's not highly unusual or unexpected in your fieldNot extraordinary:
What "Ordinary" Does NOT Mean:
- Frequent: The expense doesn't have to occur regularly or repeatedlyFrequent:
- Small: Large expenses can still be ordinarySmall:
- Predictable: Unexpected expenses can be ordinary if they're common in the industryPredictable:
- Your personal habit: It doesn't matter if YOU do it often; it matters if others in your business doYour personal habit:
The Cardozo Test: "Life of the Group"
The key question is: Is this expense ordinary in the life of the community/industry, even if it's unique in your individual experience?Is this expense ordinary in the life of the community/industry, even if it's unique in your individual experience?
Examples:Examples:
- Defending a major lawsuit might happen only once to you, but it's ordinary for businesses generally → DEDUCTIBLE
- Paying off your former employer's debts is highly unusual even for your industry → NOT DEDUCTIBLE
Understanding "Necessary"
What "Necessary" DOES Mean:
- Appropriate and helpful: The expense assists your businessAppropriate and helpful:
- Has business purpose: There's a legitimate business reason for the expenseHas business purpose:
- Related to business activities: Connected to your trade or businessRelated to business activities:
What "Necessary" Does NOT Mean:
- Absolutely essential: The business doesn't have to fail without itAbsolutely essential:
- Required by law: You don't have to be legally compelled to pay itRequired by law:
- The only option: There can be other ways to achieve the same goalThe only option:
- Reasonable in amount: Even excessive expenses can be "necessary" (though amounts might be questioned)Reasonable in amount:
Real-World Applications: Is It Deductible?
✅ ORDINARY and NECESSARY (Deductible):
1. Legal Fees to Defend Business Lawsuit
- Necessary? YES - Defending your business is appropriate and helpfulNecessary?
- Ordinary? YES - Businesses commonly face lawsuits and hire attorneysOrdinary?
- Result: DEDUCTIBLEResult:
2. Advertising Costs for New Business
- Necessary? YES - Advertising helps attract customersNecessary?
- Ordinary? YES - All businesses advertiseOrdinary?
- Result: DEDUCTIBLEResult:
3. Professional Liability Insurance
- Necessary? YES - Protects your business from claimsNecessary?
- Ordinary? YES - Common for professionals to carry insuranceOrdinary?
- Result: DEDUCTIBLEResult:
4. Employee Training Programs
- Necessary? YES - Improves employee skills for current jobNecessary?
- Ordinary? YES - Employers commonly train employeesOrdinary?
- Result: DEDUCTIBLEResult:
❌ NOT Ordinary and/or NOT Necessary (Not Deductible):
1. Welch's Situation: Paying Former Employer's Debts
- Necessary? MAYBE - Helped his reputationNecessary?
- Ordinary? NO - Highly unusual; people don't typically pay debts they don't oweOrdinary?
- Result: NOT DEDUCTIBLE (capital expenditure for goodwill)Result:
2. Country Club Dues
- Necessary? MAYBE - Could help network and find clientsNecessary?
- Ordinary? MAYBE - Some businesspeople use clubsOrdinary?
- Result: NOT DEDUCTIBLE (specifically prohibited by IRC § 274)Result:
3. Fines and Penalties
- Necessary? NO - Violating laws isn't appropriate for businessNecessary?
- Ordinary? Doesn't matterOrdinary?
- Result: NOT DEDUCTIBLE (against public policy)Result:
4. Personal Expenses
- Necessary? NO - Personal benefit, not businessNecessary?
- Ordinary? Doesn't matterOrdinary?
- Result: NOT DEDUCTIBLEResult:
The Gray Areas: Borderline Cases
1. Business Suits and Professional Clothing
General Rule: NOT deductible (personal expense)General Rule:
Exception: Uniforms or specialized clothing not suitable for everyday wear (e.g., chef's whites, safety gear) ARE deductibleException:
Why: Regular business clothes serve a personal function (covering your body) even if you wouldn't buy them otherwiseWhy:
2. Home Office Expenses
General Rule: Can be deductible if you meet strict requirementsGeneral Rule:
Test: Must be used regularly and exclusively for business, and either:Test:
- Principal place of business, OR
- Place where you meet clients/customers
Ordinary and Necessary? YES - Many businesses operate from home officesOrdinary and Necessary?
3. Commuting Costs
General Rule: NOT deductible (personal expense)General Rule:
Exception: Travel between job sites, or from home office to client location IS deductibleException:
Why: Commuting to your regular workplace is personal; business travel is differentWhy:
4. Entertainment Expenses
Pre-2018: 50% deductible if directly related to businessPre-2018:
Post-2017 Tax Reform: Generally NOT deductiblePost-2017 Tax Reform:
Exception: Business meals are still 50% deductible (100% for 2021-2022 due to COVID relief)Exception:
Modern Applications of the Welch Standard
1. Cryptocurrency and NFT Businesses
Question: Are crypto transaction fees ordinary and necessary?Question:
Analysis:Analysis:
- Necessary? YES - Required to conduct crypto transactions
- Ordinary? YES - All crypto businesses incur these fees
- Result: DEDUCTIBLE
2. Social Media Influencer Expenses
Question: Are costs for professional makeup/hair styling deductible?Question:
Analysis:Analysis:
- Necessary? MAYBE - Helps create content
- Ordinary? MAYBE - Common for influencers, not for general population
- Result: LIKELY DEDUCTIBLE if exclusively for filming/content creation
3. Cybersecurity Insurance
Question: Is cyber liability insurance deductible?Question:
Analysis:Analysis:
- Necessary? YES - Protects against data breaches
- Ordinary? YES - Increasingly common for all businesses
- Result: DEDUCTIBLE
The Importance of Documentation
To prove an expense is ordinary and necessary, you should document:
- Business Purpose: Why did you incur this expense?Business Purpose:
- Business Benefit: How does it help your business?Business Benefit:
- Industry Practice: Do others in your field have similar expenses?Industry Practice:
- Amount: Receipts and records of what you paidAmount:
- Date: When the expense occurredDate:
Common Documentation Mistakes
Mistake #1: No Business Purpose Written Down
Writing "business expense" on a receipt isn't enough. Note specifically why it was necessary for your business.
Mistake #2: Mixed Personal/Business Use
If an item serves both personal and business purposes, you can only deduct the business portion. Keep detailed logs.
Mistake #3: Excessive Amounts
Even if an expense is ordinary and necessary, the IRS can question whether the amount is reasonable. A $1,000 lunch meeting will raise eyebrows.
Mistake #4: No Contemporaneous Records
Keep records at the time of the expense. Recreating them years later during an audit looks suspicious.
The Relationship to Other Tax Concepts
Ordinary and Necessary vs. Reasonable
The tax code requires expenses to be ordinary and necessary, but the IRS can also question if amounts are "reasonable." All three concepts work together:
- Ordinary: Common in your industryOrdinary:
- Necessary: Appropriate and helpfulNecessary:
- Reasonable: Not excessive in amountReasonable:
Ordinary and Necessary vs. Capitalization
Even if an expense is ordinary and necessary, you might have to capitalize it rather than deduct it currently if it:
- Creates a lasting benefit
- Acquires or improves an asset
- Has benefits extending substantially beyond the current year
Key Takeaways from Welch v. Helvering
- "Ordinary" Doesn't Mean Frequent: An expense can be ordinary even if you incur it only once"Ordinary" Doesn't Mean Frequent:
- Industry Standards Matter: Look at what's common in your field, not just your personal experienceIndustry Standards Matter:
- "Necessary" Is Generous: You don't have to prove the expense was absolutely essential"Necessary" Is Generous:
- Both Tests Must Be Met: The expense must be BOTH ordinary AND necessaryBoth Tests Must Be Met:
- Documentation Is Critical: Be prepared to explain why your expense meets both testsDocumentation Is Critical:
How Tax Help Guy Can Help
At Tax Help Guy, we help business owners maximize legitimate deductions:
- Expense Review: Analyze your expenses to identify deductible itemsExpense Review:
- Documentation Systems: Set up record-keeping to support deductionsDocumentation Systems:
- Audit Defense: Defend your business expenses if the IRS questions themAudit Defense:
- Tax Planning: Structure expenses to maximize deductibilityTax Planning:
- Industry Research: Help prove expenses are ordinary in your fieldIndustry Research:
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