Whether you’re an entrepreneur running a small business, or a W-2 employee who wants to claim a tax deduction for your side-hustle, understanding the ins and outs of business expenses is an important part of running a business and minimizing your tax burden.
Keep reading to learn all about business expenses, which expenses are deductible and non-deductible (with examples), as well as everything you need to know about tracking and reporting business expenses.
Please note that this article only applies to U.S.-based businesses and that it’s intended only as a guide and does not constitute financial advice. Please consult a tax professional or use an authorized IRS e-file provider to ensure that your financial reporting complies with IRS regulations.
The Internal Revenue Service (IRS) provides detailed guidelines on which expenses can be claimed to reduce a business’s tax liability in Publication 535 (2021), Business Expenses. You can consult the full list of IRS publications for more information.
What Are Business Expenses?
Simply put, business expenses refer to the costs incurred in the process of running a for-profit business. Often referred to as “deductions,” calculating your business expenses and subtracting them from your company’s revenue can significantly reduce your tax burden.
However, not all business expenses are created equal. In order to qualify as tax-deductible, your expenses need to be considered ordinary and necessary costs associated with operating a business in your industry, as outlined in the Internal Revenue Code (IRC).
Keep reading to learn which business expenses are deductible and nondeductible, with examples of each.
Deductible Business Expenses
As we’ve mentioned above, a business expense needs to be considered “ordinary and necessary” to be tax deductible—but what does this mean exactly?
- According to the IRS, an ordinary expense is an expense that is considered “common and accepted” (i.e. not unusual) in your trade or industry. Essentially, this means that this is an expense that would be incurred by most businesses in your industry.
- The IRS defines a necessary expense as one that is “helpful and appropriate” in conducting business in your industry.
While not restricted to indispensable expenses (without which it wouldn’t be possible to do business), most business expenses you might consider unavoidable in the course of normal business are likely to qualify as necessary expenses. (Note that expenses like fines are considered avoidable, and thus not “necessary” or deductible).
When writing off expenses, it’s worth keeping in mind that while some expenses are fully deductible, others are only partially deductible, and others can’t be deducted in the same year as they were incurred.
Additionally, certain expenses (e.g. capitalized business assets) must be written off over several years using depreciation (or amortization for intangible assets).
It’s also important to keep in mind that which expenses are deductible depends on the structure of the business. This means that the allowable deductibles and financial reporting requirements will vary between sole proprietorships, partnerships, limited liability companies (LLCs), and corporations (s-corporations, and c-corporations).
Understanding the relative tax benefits and the administrative burden — and associated costs — of each of these business structures can be instrumental to setting up your business in a way that balances tax efficiency with your available resources.
Examples of Deductible Business Expenses
The most common business expenses you can write off as deductions include payroll expenses, employee benefits programs, utilities, property and equipment leases, asset depreciation, and other operational expenses.
Below are more examples of permissible deductible expenses:
- Advertising and marketing costs
- Bank fees (e.g. credit card processing fees)
- Charitable contributions
- Commissions (supplemental wages)
- Employee education expenses
- Employee benefit programs (retirement plans, education plans, etc.)
- Employee training expenses
- Entertainment expenses (subject to rules)
- Equipment maintenance and repair
- Equipment rental
- Gifts (subject to rules)
- Home office expenses (subject to rules)
- Insurance premiums
- Interest paid on certain business loans, business credit cards, and mortgages on properties bought by the business (or sole proprietor).
- Legal and professional services fees
- Licences, permits, and other regulatory fees
- Office supplies and equipment
- Payroll or wages
- Rent or lease on office space or place of business
- Maintenance and repair
- Membership dues (business-related dues only, e.g. union and other professional organizations)
- Mileage (business-related)
- Business-related software and subscriptions
- Taxes (Certain federal, state, local, and foreign taxes, including real estate taxes, taxes on leased property, state- and locally-imposed income taxes, foreign income tax withholdings, employment taxes, self-employment taxes, excise taxes, sales taxes, franchise taxes, fuel taxes, occupational taxes, and state or local taxes paid on personal property used in your trade or business.)
- Business travel expenses
- Supplies and materials
- Utilities like water and electricity
- Wages paid to independent contractors
Non-deductable Business Expenses
Unfortunately for business owners, not all of a company’s expenses are tax deductible.
Examples of Non-deductable Expenses
Below are examples of business expenses that are not tax-deductible:
- Anticipated liabilities (or reserves for anticipated liabilities)
- Certain legal fees (e.g. those incurred in the process of acquiring an asset)
- Club dues and membership fees (with certain exceptions)
- Demolition costs or losses
- Educational costs incurred in meeting the minimum regulatory requirements to conduct business
- Government fines (e.g. late filing fees)
- Illegal activities (e.g. bribes and kickbacks)
- Lobbying expenses
- Personal expenses (unless the expense is partly for business purposes)
- Political donations.
Why You Should Keep On Top Of Business Expenses
While writing off your business expenses is the best way to reduce your tax liability, it’s crucial that you keep meticulous records of all your transactions. The IRS may decide to audit your records to check whether your reported deductions match your actual expenditures.
Tracking business expenses for tax purposes can be a challenge even for established businesses with full-time accountants — or even whole accounts payable teams, let alone small businesses.
But even if you’re a one-person team, don’t fall into the trap of waiting for tax season to balance your books. Trying to catch up on all your accounting when it’s time to file your tax return is a nightmare — avoid this at all costs.
Aside from saving you a lot of time and stress, there are several other reasons it’s a good idea to review your business’s income and expenses on a regular basis:
- When too much time passes between making a transaction and recording it, it can be easy to forget the exact details and circumstances of the transaction, not to mention lose important evidence like paper-based receipts.
- Having accurate data about your revenue and operating expenses to date allows you to plan for your future expenses, stay within budget, maintain positive cash flow, and build a reserve to cushion any nasty surprises.
- Continuously tracking your business expenses makes it easier to project your business’s profitability (or lack thereof) and make strategic adjustments to stay the course or drive growth. Plus it makes it easier to raise funds if you want to obtain a loan or attract investors.
In addition to reducing your administrative burden come tax season, timely record-keeping can do wonders for employee morale.
Running a tight ship when it comes to business finances means faster turnaround times for reimbursements of expenses like travel costs—not to mention this makes it easier to ensure that your expense claim policies and procedures are being followed before non-compliance can cause problems.
How To Report Business Expenses
Business expenses are reported in your business’s income statement, which should record all of your revenue and expenditure. You’ll typically record your expenses by category in your income statement. These categories include direct costs, indirect costs, depreciation, and interest.
Direct costs or cost of goods sold (COGS) such as labor costs, cost of materials, the overhead of business premises, storage, etc. These are deducted from your business’s total revenue to determine your gross income or gross profit.
Indirect costs such as marketing expenses, executive compensation, and general expenses are deducted from your gross profit to determine your operating profit (also known as net profit).
Depreciation and amortization are used to expense tangible and intangible business assets, respectively, over the course of several years. These assets include property, furniture, computers, equipment, machinery, vehicles, etc. (tangible) as well as patents, trademarks, intellectual property licenses, software, etc. (intangible).
Interest is the final expense deducted from a company’s income to calculate its taxable income.
For starters, you’ll need to decide on an accounting method to use when reporting your income and expenses. The two basic accounting methods are cash and accrual:
- Under the cash accounting method, you’ll report income in the same tax year that you received it and usually deduct and/or capitalize expenses in the same tax year.
- Under the accrual accounting method, you’ll usually report income in the tax year you earn it, even if you only receive actual payment in a later year. Similarly, you’ll generally deduct and/or capitalize expenses in the tax year that you incurred them, regardless of whether you paid for them that year or not.
For detailed information about the different accounting methods (and periods) recognized by the IRS, consult this PDF of Publication 583 (revised January 2022). To see recent updates, check out About Publication 583, Starting a Business and Keeping Records.
How to Track Business Expenses
Tracking and reporting business expenses is a bit more complex than claiming deductibles from your personal income. This means that businesses and self-employed individuals need to keep detailed records of all their income and expenses to calculate and report their profits accurately.
Here are some tips and best practices for tracking your business expenses:
- Keep your business finances separate from your personal expenses. Having a separate business bank account makes tracking your business expenses so much easier.
- If an expense is partially for business purposes and partially for personal use (e.g. your home office or the bill from your cellphone service provider) you can calculate the usage split and claim the business-use portion.
(Keep in mind that claiming home office expenses may impact your home sale tax exclusion down the line).
- Keep all your receipts and digitize them. To make it easier to not lose them, take photos and store them online as soon as possible after paying for them. Categorize them by types of expense. Most modern accounting software lets you snap a photograph and upload it directly. If you’re using Excel or Google Sheets to track your expenses, you can simply upload these photos to a cloud storage folder (e.g. iCloud, Google Drive, or Dropbox).
- Keep your invoices and receipts organized. Ideally, sort them into folders first by month and then by expense category. This makes it easy to find the details and evidence of each transaction later.
- Keep detailed notes. Even if you think you’ll remember all the details of each transaction, make notes that include the date, expense category, and what the expense was for, e.g. entertaining a client, gas for the company car, etc.
If you’re claiming business mileage on a personal vehicle (or an employee’s personal vehicle), you should keep a detailed log of business mileage.
- Review your records as frequently as possible. Even if you’re using software that automates much of the process, it’s a good idea to check in on your records frequently, verify that they’re accurate, and re-categorize any transactions that have been mislabelled.
- Create a formal workflow for tracking expenses and reconciling your records. Map out which tasks need to occur daily/immediately (e.g. uploading receipts), weekly, monthly, quarterly, bi-annually, and annually.
- If you haven’t already, think about investing in expense reporting software. In addition to making it easy to record expenditures, store receipts, and automatically categorize transactions, this software lets you view your finances in dashboards and charts and makes it easier to generate reports
For more information about tracking business expenses, check out IRS Publication 583 (01/2021), Starting a Business, and Keeping Records.
Subscribe to the People Managing People newsletter for expert-written content on all things organizational development.
Related read: Best Business Management Software