What are business expenses?
– Business expenses are costs a company incurs while running its operations. Businesses subtract these expenses from revenue to calculate taxable net income. In tax language, many of these costs are called deductions.
Key categories and definitions
– Direct costs (cost of goods sold, or COGS): Expenses directly tied to producing or purchasing the goods a business sells. Common items: raw materials, direct labor, factory overhead, and the value of inventory used during the period.
– Indirect costs (operating expenses): Overhead and running costs not directly traceable to a product—examples include rent, office salaries, marketing, and general administrative expenses.
– Interest expense: Cost of borrowing; typically shown later in the income statement and deducted after operating profit.
– Capital expenditures vs. operating expenditures: Capital expenditures are payments for long-lived assets (machines, buildings, vehicles) that are usually capitalized and then depreciated or amortized over time. Operating expenditures are recurring costs to run the business day-to-day.
– Depreciation: The process of allocating the cost of a capital asset across several tax years. Depreciation is a deductible expense but spread across the useful life of the asset.
– Mixed-use (personal/business) costs: When an item is used partly for business and partly for personal purposes (e.g., a car or a home office), only the business portion is deductible.
– Ordinary and necessary (tax standard): Under the U.S. tax code (Section 162), deductible business costs must be ordinary (typical in the industry) and necessary (appropriate and helpful for the business). This does not require an expense to be absolutely essential.
– Non-deductible items: Certain payments are not allowed as business deductions—examples include bribes, fines and penalties, political contributions, and some lobbying costs.
How expenses are recorded (high-level)
1. Start with total revenue for the period.
2. Subtract COGS to get gross profit.
– COGS = beginning inventory + purchases during the period − ending inventory.
3. Subtract operating (indirect) expenses from gross profit to get operating profit (often called earnings before interest and taxes, or EBIT).
4. Subtract interest and taxes to arrive at taxable income (or adjusted taxable income for certain rules).
Practical notes on special categories
– Inventory and COGS: Items included in COGS cannot be deducted again as operating expenses. Keep accurate beginning/ending inventory records for tax reporting.
– Depreciation: Instead of expensing the full purchase price of a long-lived asset in one year, depreciation spreads the deduction across multiple years using an accepted method (straight-line, MACRS, etc.).
– Meals, gifts, and entertainment: The tax code limits deductibility for many entertainment and meal expenses. For example, many business meals are only 50% deductible (with exceptions that can make some meals fully deductible).
– Vehicle and home-office use: For mixed-use items you must determine the business-use fraction (miles or square footage) and only deduct that portion. Maintain contemporaneous records—receipts, mileage logs, and a clear allocation method.
Short checklist (to manage business expenses for tax and accounting)
– Separate business and personal accounts and payments.
– Keep receipts, invoices, and digital copies for all expenses.
– Maintain inventory records: beginning balance, purchases, and ending balance.
– Track mileage and keep a timely log if you use a vehicle for business.
– Record purchase dates and costs for capital assets and track depreciation schedules.
– Note the business purpose for travel, meals, and entertainment.
– Review limits and non-deductible categories (fines, political ads, bribes).
– Consult your tax professional on ambiguous items or major transactions.
Small worked example (simple income-statement flow)
Assumptions for the tax year:
– Total revenue: $200,000
– Beginning inventory: $10,000
– Purchases of goods during year: $50,000
– Ending inventory: $8,000
– Operating expenses (rent, salaries, marketing, etc.): $60,000
– Interest expense: $2,000
Step 1 — Calculate COGS:
COGS = beginning inventory + purchases − ending inventory
COGS = $10,000 + $50,000 − $8,000 = $52,000
Step 2 — Compute gross profit:
Gross profit = revenue − COGS = $200,000 − $52,000 = $148,000
Step 3 — Subtract operating expenses to get operating profit:
Operating profit = gross profit − operating expenses = $148,000 − $60,000 = $88,000
Step 4 — Subtract interest to get taxable (pre-tax) income:
Taxable income before taxes = $88,000 − $2,000 = $86,000
Notes on mixed-use vehicle expense (example):
– If a small business owner drives 12,000 total miles in the year and 3,000 miles are for business, business-use percentage = 3,000 / 12,000 = 25%.
– If total vehicle expenses (fuel, insurance, repairs) = $4,000, the deductible portion = 25% × $4,000 = $1,000 (alternatively, a standard mileage rate can be used if elected—check current IRS rules).
Common documentation required
– Receipts and invoices
– Bank and credit-card statements (business accounts)
– Inventory records (counts, cost records)
– Asset
asset purchase records (invoices, serial numbers, warranty information, and depreciation schedules)
– Payroll records (pay stubs, payroll-tax filings, and employee time sheets)
– Sales and use tax filings and receipts
– Contracts and agreements (leases, customer contracts, vendor agreements)
– Licenses and permits
– Insurance policies and claims records
– Loan documents and interest statements
– Reimbursement requests and company expense-policy documentation
– Mileage logs and calendars for travel and business appointments
– Digital records and backups (spreadsheets, accounting software exports, emailed receipts)
Record-retention guidance (practical rules of thumb)
– Keep supporting documents for at least 3 years after the date you file the tax return to which they relate (this is the typical IRS statute of limitations for most audits).
– Keep records for up to 7 years when they support claims for bad-debt deductions or worthless securities.
– Keep property-basis documents (purchase price, improvements, depreciation schedules) for as long as you own the asset plus 3 years after you dispose of it.
– When in doubt, keep receipts and records longer rather than shorter; digital backups make this easier.
How to classify expenses (short decision checklist)
– Ordinary and necessary? If an expense is common in your trade and helpful for running the business, it’s likely deductible.
– Capital vs. current expense? Capital expenditures create or improve a long-lived asset and are capitalized (and then depreciated/amortized). Supplies and routine repairs are current expenses. Use the “less-than-one-year useful life” informal test for small items.
– Personal vs. business? Allocate mixed-use items (e.g., vehicle, cell phone, home office) using a reasonable method (mileage, percentage of use, or square footage). Keep supporting logs.
Worked example — simple equipment depreciation (straight-line)
Assumptions:
– Equipment cost = $10,000
– Estimated salvage value = $0
– Useful life = 5 years
Formula: annual depreciation = (cost − salvage) / useful life
Calculation: annual depreciation = ($10,000 − $0) / 5 = $2,000
Result: You may deduct $2,000 per year as depreciation expense (for accounting/book purposes). Note: tax depreciation rules (MACRS, bonus depreciation, Section 179 expensing) differ from straight-line; check current tax rules before claiming.
Quick step-by-step checklist to prepare records for filing taxes
1. Reconcile bank and credit-card accounts to your accounting ledger.
2. Separate personal and business transactions. Flag nonbusiness items.
3. Compile receipts and sort by category (COGS, payroll, rent, utilities, travel, advertising).
4. Prepare payroll-tax filings and gather W-2/1099 copies.
5. Generate depreciation schedules from fixed-asset records.
6. Calculate business-use percentages for mixed-use assets (record method and assumptions).
7. Run a trial balance and adjust accruals and provisions (bad debts, prepaid expenses).
8. Produce a one-page summary: gross revenue, COGS, operating expenses, interest, and taxable income before tax. Keep supporting schedules attached.
Audit-readiness checklist
– Maintain a contemporaneous mileage log (date, purpose, miles).
– Keep vendor invoices and proof of payment for expenses over a nominal threshold (e.g., $75–$250).
– Support large or unusual transactions with contracts, board minutes, or client correspondence.
– Retain bank reconciliations and adjusted trial balances for 3–7 years.
– Document accounting methods and any changes made mid-year.
Common pitfalls to avoid
– Mixing personal and business expenses without clear allocation.
– Failing to keep receipts or relying solely on memory.
– Misclassifying capital purchases as current repairs (or vice versa).
– Ignoring small recurring expenses (they add up and should be tracked).
– Not confirming current tax rules for depreciation or the standard mileage rate.
Useful authoritative sources
– Investopedia — Business Expenses (overview and examples): https://www.investopedia.com/terms/b/businessexpenses.asp
– IRS — Recordkeeping for Small Businesses and Self-Employed: https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping
– IRS Publication 946 — How To Depreciate Property: https://www.irs.gov/publications/p946
– U.S. Small Business Administration — Keep Records and Accounts: https://www.sba.gov/business-guide/manage-your-business/keep-records-accounts
Educational disclaimer
This information is educational only and not individualized tax or investment advice. Tax rules change; check current IRS guidance or consult a qualified tax professional for advice specific
to your situation.
Quick checklist — track business expenses reliably
– Separate accounts: use dedicated business bank and credit-card accounts to avoid commingling personal and business transactions.
– Capture receipts: scan or photograph receipts immediately; attach them to the related transaction in your accounting system.
– Classify consistently: create a chart of accounts (rent, utilities, meals, travel, repairs, depreciation) and use it every month.
– Reconcile monthly: match bank and card statements to recorded transactions; investigate discrepancies promptly.
– Back up records: keep digital backups and retain originals per local tax rules.
– Review with a pro: have a CPA or tax preparer review year-end classifications, capitalizations, and depreciation choices.
Worked example — straight-line depreciation (illustrative)
Assumptions
– Equipment cost: $12,000.
– Estimated salvage value: $2,000.
– Useful life: 5 years.
Formula
– Annual depreciation (straight-line) = (Cost − Salvage value) ÷ Useful life.
Calculation
– (12,000 − 2,000) ÷ 5 = 2,000 per year.
Interpretation
– Each year you record $2,000 as depreciation expense on the income statement and reduce the asset’s book value by $2,000 on the balance sheet.
Notes
– This is a bookkeeping example. Tax depreciation rules (Section 179, bonus depreciation, or MACRS in the U.S.) may allow different timing and amounts. Always check current tax guidance before applying to returns.
Practical monthly routine (step-by-step)
1. Collect receipts and invoices daily; add photos to your accounting app.
2. Enter or import all bank/card transactions weekly; code them to the chart of accounts.
3. Reconcile accounts at month-end; adjust for bank errors or missed entries.
4. Run a profit-and-loss report and check for unusual categories or spikes.
5. Flag capital purchases for fixed-asset tracking; schedule depreciation entries.
6. Archive verified monthly backups (cloud + local) and prepare notes for tax preparer.
Common tax-related reminders
– Capitalize versus expense: repairs and maintenance are generally expensed; improvements that extend asset life are capitalized and depreciated. The distinction has reporting and tax implications.
– Small businesses sometimes elect Section 179 or bonus depreciation (U.S.) to accelerate deductions — rules change and have limits.
– Keep contemporaneous mileage logs (date, miles, purpose) if claiming vehicle expenses; consider whether the standard mileage rate or actual-expense method is appropriate.
Selected authoritative sources
– Investopedia — Business Expenses: https://www.investopedia.com/terms/b/businessexpenses.asp
– IRS — Recordkeeping for Small Businesses and Self-Employed: https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping
– IRS Publication 946 — How To Depreciate Property: https://www.irs.gov/publications/p946
– U.S. Small Business Administration — Keep Records and Accounts: https://www.sba.gov/business-guide/manage-your-business/keep-records-accounts
Educational disclaimer
This information is educational only and not individualized tax, legal, or investment advice. Tax rules change over time and vary by jurisdiction. Consult current official guidance or a qualified tax professional for advice tailored to your specific facts and circumstances.