What Is a Business Expenses and Which Are Tax Deductible?

Restaurant owner recording receipts for deductible business expenses
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Running a business means incurring expenses. Independent contractors, consultants, and freelancers pay for office supplies, tools, software, computers, or travel out of their own pockets to keep their enterprises up and running. Deducting these expenses reduces an unincorporated business's taxes, and the IRS is okay with that.

Being able to deduct expenses reduces both regular income tax and the self-employment tax for sole proprietors. Keeping track of all your business expenses will go a long way to reducing your tax liabilities, but some things are deductible while others are not.

What's a Legitimate Business Expense?

An expense must be "ordinary and necessary" for your trade or profession to qualify as deductible. This definition comes from Internal Revenue Code Section 162. The IRS defines an ordinary expense as one that's "common and accepted in your industry." A necessary expense is one that's "helpful and appropriate for your trade or business."

Beyond this blanket definition, you must make five distinctions when you're analyzing expenses. First, separate your personal expenses from business expenses, then separate your business expenses into three broad categories: cost of goods sold, capital expenditures, and deductible expenditures.

Some expenses might be only partially deductible or not deductible at all.

The five distinctions are:

  1. Personal expenses
  2. Business expenses
  3. Cost of goods sold
  4. Capital expenses
  5. Deductible expenses

Separating Personal Expenses

Problems can arise when an expense is partly personal and partly business-related. A common example would be if a freelancer used one room in their house as an office, or occasionally used their personal vehicle for driving for business purposes.

This taxpayer would measure the square footage of their office and of their whole house to find find the percentage of space the home office or workspace comprises. This percentage would then be used to measure the business portion of shared expenses such as rent, insurance, and utilities. You would deduct 15% of your shared expenses if your workspace takes up 15% of the entire square footage of your home.

The same equation can be applied to use of your personal vehicle for business purposes. In this case, you would determine the percentage of business miles to overall miles.

The business portion of these home expenses would become part of the home office deduction, while the balance of the overall expenses would be personal in nature.

According to the IRS, the general rule is that you can't deduct personal, living, or family expenses. But you can divide the total cost between business and personal usage if you have an expense for something that's used partly for business and partly for personal purposes.

Keep track of all your expenses so you can review them with a tax profession to determine if any of them might or might not be tax deductible.

Other Deductible Expenses

Don't just look to obvious expenses like office supplies and equipment after you separate out office and vehicle expenses. Interest on business loans is deductible, as are insurance premiums and advertising costs. You might be able to deduct state and local taxes as well, so check with a tax professional to make sure you don't overlook anything.

Cost of Goods Sold

Cost of goods sold are expenses for inventory and things related to inventory. Manufacturers, wholesalers, and retailers track the cost of the products they produce or purchase for resale.

The IRS says, "If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring the cost of goods sold."

Capital Expenses

Some expenses are recorded as assets and their costs are recovered over time through depreciation. These expenses are referred to as capital assets because their costs are capitalized as assets of the business. Thhttps://www.thebalancesmb.com/business-mileage-deductions-397630e cost is deducted over a period of time through depreciation rather than claimed as a deduction all at once.

Examples of capital expenses include equipment, computers, furniture, equipment, and real estate. You're investing in your business for the long term when you spend money on these things. You expect them to last and be serviceable for a while.

You're required to capitalize on three types of costs: business start-up costs, business assets, and improvements.

The QBI Deduction

The Qualified Business Income (QBI) deduction is one you definitely won't want to overlook if you qualify to claim it. First introduced for tax year 2018, the QBI allows sole proprietors, partnerships, and S corporations to shave 20% off their business incomes for tax purposes. Some limitations apply based on income, so check with a tax professional to determine if you qualify and how much of a deduction you can claim.

Keeping Track of Business Expenses

Reputable tax software programs allow you to import data from programs like Quicken or Money. Consider spending some time making sure your expense categories are set up properly to make your tax preparation process as smooth as possible.

You can add, delete, and modify categories in all personal finance and accounting software. Intuitive, easy-to-remember categories will allow you to generate meaningful reports. And most programs will let you link the categories to particular line items on the tax forms. Setting this up can go a long way to reducing the amount of time you spend preparing your taxes.

Full-featured accounting software such as Quickbooks is best to track your income and expenses, and it will help you monitor the health of your company.

Accounting programs can additionally can generate profit and loss reports, also referred to as income statements. These reports can help you analyze how your freelance business is doing, whether you're profitable, and how you're spending your money. Having these reports can expedite the preparation of your tax return if you decide to hire a tax accountant.

Article Sources

  1. IRS. "Publication 535 Business Expenses." Page 3. Accessed Aug. 5, 2020.

  2. IRS. "Deducting Business Expenses." Accessed Aug. 5, 2020.

  3. IRS. "Publication 535 Business Expenses." Page 5. Accessed Aug. 5, 2020.

  4. IRS. "Qualified Business Income Deduction." Accessed Aug. 5, 2020.