Any company will have business expenses. Meticulously tracking them ensures you know where your funds are going, and it helps you reduce your tax liability. It’s also crucial to understand what business expenses are and what you can deduct so you're not paying more taxes than necessary.
What Are Business Expenses?
According to the Internal Revenue Service (IRS), business expenses are ordinary and necessary costs incurred to operate your business. Examples include inventory, payroll and rent. Fixed expenses are regular and don’t change much — things like rent and insurance. Variable expenses are expected, but they can change. Some examples include sales commissions, gas for business vehicles and shipping costs. You expect variable expenses each month, but the actual amount will vary. Tracking your business expenses helps you keep an eye on whether you’ll see profits or losses.
- Business expenses need to be considered ordinary and necessary for them to be tax-deductible.
- Business expenses are recorded on an income (profit and loss) statement.
Business Expenses Explained
Also referred to as deductions, business expenses are the costs of operating a business. They’re recorded on the income statement. These expenses will be subtracted from business revenue to show a company's net profit or loss and taxable income.
Guidelines for business expenses can be found in Section 162 of the Internal Revenue Code (IRC). As long as an expense is considered ordinary and necessary, it can be reported to the IRS to help reduce tax liability.
According to the IRS, ordinary refers to expenses common to most business owners in the industry or trade. Necessary means your expenses help with your business operations, and they're appropriate to your organization.
How Do Business Expenses Impact or Reduce Taxes?
Any expense that meets the IRS definition of ordinary and necessary can be deducted. To be written off, an expense needs to be incurred by a business intending to make a profit. Some expenses may be fully deductible, whereas others are partially deductible or won’t be fully deducted the year they’re incurred.
What Are Examples of Deductible Business Expenses?
The following business expenses may be fully or partially deductible:
- Advertising and marketing
- Bank fees and interest
- Business mileage
- Educational expenses for employees
- Employee benefits
- Equipment maintenance and repair
- Home office (you’ll need to meet certain requirements such as that it is your main place of business)
- Membership dues (business-related expenses only)
- Legal fees
- Office supplies and equipment
- Payroll (employees and contractors)
- Rent or office lease
- Mortgage payments
- Some costs of business travel
What Are Examples of Non-Deductible Business Expenses?
Not all business expenses are tax-deductible.
Here are some examples:
- Demolition expenses or losses
- Educational expenses incurred to meet requirements to conduct business
- Government fines and penalties
- Illegal activities
- Lobbying expenses
- Political contributions
Also note that capital expenditures, while deductible, are typically written off over several years through an accounting process known as depreciation.
Income Statement Reporting
Your income statement is the main financial statement used when recording business expenses and determining your taxable income. The income statement shows a picture of your company’s expenses and revenues over a given period of time. The statements are typically broken into different categories.
Costs of Goods Sold (COGS): Also known as cost of sales, COGS refer to the cost of manufactured or purchased goods sold. COGS are a business expense and affect how much profit a company makes on its products. It's deducted from a business's total revenue to determine gross profit and can include factory overhead, storage, cost of raw materials and parts used to make a product, direct labor costs, shipping or freight in costs and indirect costs, such as distribution or sales force costs.
Operating Costs: Operating costs are any expenses associated with the day-to-day maintenance and administration of a business. Operating costs include fixed, variable and semi-variable costs. These expenses are subtracted from gross profit to find operating profit and typically include marketing costs and executive compensation. Gifts and meals would also fall under this category.
Depreciation: Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than over one year. Depreciation has two main components: one is the decrease in the value of an asset over time and when you allocate the price you originally paid for an asset over the period of time you use that asset. Generally Accepted Accounting Principles (GAAP) requires that companies use standard depreciation methods with specific depreciation schedules for various asset categories. Amortization is similar to depreciation, but is a method of spreading the cost of an intangible asset over a specific period of time.
Interest expenses: Interest paid on loans is subtracted from taxable income.
Personal vs. Business Expenses
Business expenses can be deducted to lower your company’s overall taxable income. Personal expenses cannot. So, what are some of the differences and is there ever a gray area?
Personal expenses: It’s vital that you keep your personal expenses separate from business. For example, if you go to the hardware store to buy some lumber for a personal project and throw in some industrial cleaner to scrub the floors of your store, be sure to run two transactions. That way you can keep separate receipts and if you have a business credit or debit card, you can use that for the business purchase.
Business expenses: Are you making a purchase to try and drive more revenue to your business? Is it something that would be considered a normal purchase in your industry? It’s likely a business expense. Record the purchase, store the receipt and record the reason for the purchase. The amount can be deducted from your income and lower your tax liability. Large expenses that increase the long-term value of your business like buying new equipment or investing in a new building are considered capital expenditures and are handled differently than other expenses.
Key differences: Business purchases are things you buy in the normal operations of your business. Personal expenses are items that do not pertain to your business. But what about things like home offices? If you use an office out of your home primarily for business purposes, you may be able to write off that expense. But you won’t be able to deduct the entire price of your home mortgage. There are occasions when you can itemize certain aspects of expenses like utilities, real estate taxes or phones. It’s especially important for you to keep meticulous records that detail why you’re expensing these items, in case you are ever audited.
Top 6 Business Expense Tips
Staying on top of your business expenses can be overwhelming. But it is also one of the easiest ways to reduce your overall tax liability. Here are some tips to make expense management a little easier.
Keep meticulous records.
When in doubt, keep it. Not only will receipts and other documentation of your business expenses come in handy if you’re ever audited, the IRS requires some records be kept for up to 7 years. Things like receipts, tax returns and employment records need to be kept for 3-4 years. And documentation of writing off bad debt should be kept for 7 years. Consider using business accounting software to track your expenses and go paperless for record keeping.
Separate personal and business expenses.
Business expenses can be written off and reduce your overall tax liability. Start separating your business and personal expenses right away. Open a separate business checking account. Get a business credit or debit card. And make sure your business partners know which expenses can be written off, and which can’t.
Brush up on what expenses are considered tax deductible.
Not all expenses are tax deductible. But most expenses you incur while trying to drive revenue to your business can be written off. Some major purchases like large equipment are considered capital expenditures. The initial purchase may not be written off all in one tax year, but the depreciation of value, along with the costs of running it would be.
Save receipts for business travel.
Many business travel expenses are tax deductible. Keep records of costs like transportation, lodging and some of the meals (usually 50% of the cost.) Keep your receipts for these expenses for at least three years, as long as the IRS can audit you.
Record expenses as soon as possible.
Whether you store your records yourself or use a business accounting software program, get in the habit of recording expenses right away. Formalize the process for how you track and store the receipts and record expenses.
Monitor and review expenses regularly.
Business accounting software can display your expense information with charts and dashboards. And if you track your expenses manually, be sure to build regular review into the expense management policies and procedures. Consider double-entry bookkeeping to catch errors and prevent fraud.
How to Track Business Expenses?
Tracking your business expenses should become a habit. By making it part of your regular workflow, you’re less likely to miss expenses that can reduce your overall tax burden. And by keeping an eye on your expenses and revenue through your income statement, you’re able to better monitor the financial health of your company.
Open a business bank account. Make sure this is separate from your personal checking account and only use it for business expenses. This will make it easier to track your business charges. And you may be eligible for business credit or debit cards that come with perks like cash back or no-interest financing for three months.
Formalize how you store receipts. Consider scanning receipts and keeping digital copies. Try and make it part of your regular workflow. If not daily, try to set aside the same time each week to scan and organize receipts. Write the business purpose on the receipt so you can remind yourself later, if needed.
Review and categorize your expenses regularly. Examine each transaction and track your spending by category. By comparing your expenses to revenue, you can see how much it costs to produce an amount of revenue in a given time.
Consider buying business accounting software. Save time and ensure you have the most up-to-date information with an accounting platform. Store and track receipts and easily categorize expenses. You can see charts and dashboards of your financial information, as well as generate important reports, like the income statement.
Tracking Business Expenses With Software
By tracking your expenses, you can reduce your tax liability. But it’s also important to keep detailed records of these expenses in case you’re audited or need to reconcile accounts. Going paperless and using business accounting software can help save time, automate processes and keep more accurate financial records, even if you have a small business or startup. As your business grows, the software will scale with your growth. And top-tier cloud solutions like NetSuite integrate with other business software, such as your CRM, inventory management and ecommerce functions.
Business Expense FAQs
Can business expenses be carried forward?
Your business may be able to take a carryforward if you have a net operating loss (NOL), you're over the amount of deductions allowed and a nonrefundable credit you qualify for is more than the tax you owe in a year.
Business expenses that can be deducted are not taxed. There are a few business expenses like demolition that cannot be written off.
Can I deduct personal expenses for business?
You cannot deduct personal expenses for your business. However, if the expense is for both business and personal use, you may deduct the business portion. For example, let’s say you have a vehicle and drive to consult with on-site clients 25% of the time. You can deduct 25% of your business expenses. You’ll need to keep records such as mileage incurred, maintenance costs and the purpose of each trip.
What are the three types of business expenses?
The three major types are:
- Fixed: These expenses tend not to change and remain the same. Examples include rent or equipment lease payments.
- Variable: These expenses change from month to month. Examples include employee commissions and utilities.
- Periodic: These expenses happen occasionally. Examples include emergency equipment repairs and annual bonuses.