How to Categorize Expenses for a Small Business

Running a small business can be an extremely exciting and rewarding experience. However, small business owners are often required to wear many hats, including bookkeeping and accounting . To anyone new to managing business expenses, the process can seem complicated and intimidating, making it tempting to ignore. At the end of the day, taking the extra time to understand your business expenses and learning how to categorize them can have a massive positive impact on the way you run your business. In this article, we’ll explore why it’s so important to categorize your business expenses and how you can do so efficiently and effectively.

What Are Business Expenses?

Business expenses are the cost of, you guessed it, doing business. While this may seem fairly straightforward, there are specific criteria that expenses have to meet in order to be considered a business expense. Essentially, business expenses have to fall under two main categories laid out by the IRS. The IRS requires that business expenses are incurred in a trade or business and deemed ordinary and necessary. Let’s dig a little further into what these terms mean.

Incurred In a Trade Or Business

To be qualified as a business expense, the expense must be profit-motivated . This means that whatever you spent money on, whether it be paper clips or a new website, must contribute towards your company's profit. Even if there was no actual profit, it could still be considered a business expense as long as the IRS recognizes there was a clear intention for profit. While this description is pretty loose, it’s safe to say that cost of buying yourself ice cream on your way home from work every day in order to “boost morale” would not be considered incurred in a trade or business by the IRS.

Ordinary and Necessary

This one is a little easier to guess, as it simply means that the expenses must be ordinary and necessary to your business. Of course, there are hundreds of different industries, each with needs specific to their own. Because of this, business expenses are deemed ordinary and necessary to what is typical and appropriate for each specific trade or business. For instance, if you run a pet store, you could file that large order of rabbit food as a business expense. However, if you run a law firm and try to do the same, you may raise some eyebrows at the IRS.

Be Honest With Your Expenses

While it is always encouraged to write off as much as legally possible on your tax return, trying to pass non-business expenses as business expenses can have serious consequences. If something you’ve written off as a business expense appears too lavish, the IRS can disallow it , meaning that it deems it invalid. If this happens, your tax liability (meaning the amount you have to pay the government) will be increased. Since disallowance often happens months after the initial filing, you will be charged interest on however long after your filing the disallowance occurs. If you significantly underestimate your tax liability by more than 10 percent or are negligent with your return (meaning your financial records are incomplete), you will be charged a 20 percent penalty. Furthermore, if your tax return is found to be fraudulent, you can face serious criminal charges. Like most things in life, with business expenses, honesty is the best policy.

What Is The Difference Between a Deductible and Non-Deductible Expense

It can be tricky determining what can be considered a deductible business expense versus a non-deductible business expense. Although we’ve already gone over what the IRS accepts as a business expense, let’s review what qualifies as a non-deductible expense in order to avoid any confusion between the two. Basically, a nondeductible expense is anything that can be considered a personal expense. So although you may be the owner of the business, if the purchase is for personal gain without any intended effect on the company's profits, it is not deductible. For instance, buying yourself that new sports car cannot be written off. However, you can deduct vehicle-related expenses, such as gas, tolls, and milage, as long as they are incurred while driving between business locations. There are also several expenses that are partially deductible. One example of this is client meals, which are only 50% deductible. Meals among employees, however, are not deductible at all.

What Are The Different Categories of Business Expenses

While the IRS provides an extensive list of all deductible business expenses, here is a simplified list of some of the most common ones so that you can begin to categorize your business expenses more easily:

Advertising

Advertising is an essential part of growing your business. Because of this, you can deduct the cost of anything used to promote your business, from direct marketing campaigns to television commercials.

Credit and Collection Fees

Chances are you have a company credit card . If so, credit card processing fees and even overdraft fees can be written off.

Employee Wages

Everything that you pay your employees is tax-deductible. This is also applicable for contracted workers.

Insurance

Worker’s liability, product liability, and disability insurance. To be clear, this is different than employee health insurance, which should be categorized under employee benefit programs.

Employee Benefits

You are able to write off employee accident and health plans, including health insurance, life insurance, adoption assistance, cafeteria plans, and dependant care assistance.

Office Expenses and Supplies

This includes everyday items you may find around your office, including pens, pencils, paper, and printer ink. Of course, the nature of these supplies varies depending on the nature of your business’s industry.

Rent

Whether you are renting an office or a retail space, any rent payments towards your place of work are tax-deductible. Additionally, if you work from home, you can write off the percentage of your home that is used as your office.

Utilities

This includes the electricity, gas, and water used to keep your office up and running.

Legal and Professional Services

This can be used to cover the cost of services provided by professionals such as attorneys and tax professionals. Again, these are only examples of some of the categories and not a comprehensive list. If you are having trouble finding a category for a certain expense, you can always file it under miscellaneous, and write a description of how the purchase is intended to increase profits for your company.

Why You Should Categorize Your Business Expenses

The most obvious reason to take the time to categorize your business expenses is to make tax filing easier. Completing your tax return can be a long and tedious process. However, categorizing your transactions can make it significantly easier for you to determine what is deductible and what is not. Additionally, categorizing your business expenses can save you money. Keep in mind, accountants are paid by the hour, so if you are hiring one to handle your taxes, having your finances sorted out will save their time and your money. Outside of tax-related business, keeping your finances categorized is a great way to keep track of how your business is spending and how you can potentially cut back or expand in certain areas. Besides, the better organized your finances are, the more time you’ll have to focus on other things, like growing your business.

How To Keep Your Expenses Organized

There are many ways to keep your expenses organized , whether it be through physical folders, spreadsheets, or accounting software. However, depending on your business, accounting software, in particular, can be a huge time saver. If you’ve never used accounting software, it can seem hard to navigate, but taking the time to learn how to use a digital service can help you in the end. With accounting software, you can link your bank and credit card information directly to your account. This way, whenever you make a translation, it will be immediately logged. Afterward, you can go into the software and mark each transaction as either personal or business-related. You can even further categorize business expenses based on the nature of the expense. Additionally, you can often transfer your tax information directly to your accountant from your accounting software when it comes time to file. This way, you don’t have to worry about sifting through receipts or printing off spreadsheets. Instead, all of your business expenses will be readily available and organized right at your fingertips.

The Payoff

As an owner of a small business, anything that you can do to save you and your business money is worth doing. Even though it may not sound particularly glamorous, categorizing your business expenses is a great place to start. When maximizing the benefits of organizing your business expenses, it’s best to start early. Rather than waiting until tax season to begin sorting, try to categorize your expenses as they come in. Taking time to examine your expenses thoroughly will help you identify and maximize your deductions, saving you and your company money. Once you understand what is able to be written off as a business expense, the hard part is over. Now’s the time to start categorizing your expenses and saving money for both yourself and your business. Sources: IRS | Business Expenses IRS | Avoiding Penalties and the Tax Gap Forbes | Eight Tips To Keep Your Business Finances In Order For Tax Purposes