Understanding Business Expenses and Which Are Tax Deductible

What Are Business Expenses?

Business expenses are costs incurred in the ordinary course of business. Every business, from the smallest corner store to the largest corporation, tracks these expenses throughout the year for tax purposes. Business expenses are subtracted from revenue to arrive at a company’s taxable net income.

Business expenses are also referred to as deductions. These are generally divided into two major categories, capital expenditures and operational expenditures.

Understanding Business Expenses

Section 162 of the Internal Revenue Code (IRC) details the guidelines for business expenses. The IRC allows businesses to report any expense that may be ordinary and necessary.

Business expenses need not be required to be considered ordinary or necessary. Generally, ordinary means that the expense is common in the industry and most business owners in the same line of business or trade would normally expense these things. Necessary means that the expenses are appropriate and a business owner might not be able to manage without making the expenditure.

An expense that meets the definition of ordinary and necessary for business purposes can be expensed and, therefore, is tax-deductible.

Some business expenses may be fully deductible while others are only partially deductible. Below are some examples of fully deductible expenses:

• Advertising and marketing expenses
• Credit card processing fees
• Education and training expenses for employees
• Certain legal fees
• License and regulatory fees
• Wages paid to contract employees
• Employee benefits programs
• Equipment rentals
• Insurance costs
• Interest paid
• Office expenses and supplies
• Maintenance and repair costs
• Office lease costs
• Utility expenses

Income Statement Reporting

The income statement is the primary financial statement used by businesses to record their expenses and determine their taxes. Most have three categories of expenses, broken down by direct costs, indirect costs, and interest.

Direct Costs

The value of inventory on hand at the beginning and the end of each tax year is used in determining the cost of goods sold (COGS), which is a large direct expense for many companies.

COGS is deducted from an entity’s total revenue to determine gross profit for the year. Any expenses included in COGS cannot be deducted again. Expenses that are included in calculating COGS may include direct labor costs, factory overhead, storage, costs of products, and costs of raw materials.

Indirect Costs

Indirect costs are subtracted from gross profit to identify operating profit.

Typical indirect costs include executive compensation, general expenses, depreciation, and marketing costs.

Subtracting indirect costs from gross profit results in operating profit, which is also known as earnings before interest and tax.

Depreciation

Expensing of business assets is usually done by depreciation. Depreciation is a tax-deductible expense on the income statement and is classified as an indirect expense.

Depreciation expenses can be deducted over a number of years. They typically include the costs of computers, furniture, property, equipment, trucks, and more.

Gifts, Meals, and Entertainment Costs

The IRS places limits on costs associated with gifts, meals, and entertainment. For example, you can usually deduct 50% of the cost of providing meals to employees, although certain meals may be fully deducted.

Interest Expenses

The last section of the income statement involves expenses for interest and tax. Interest is the last expense a company subtracts to arrive at its taxable income, sometimes called adjusted taxable income.

Personal Expenses

In some cases, expenses incurred by a business owner may be both personal and business-related. For example, a small business owner might use the same car for personal purposes and business-related activities.

In this case, the portion of miles used for business purposes can be deducted. In the case of home offices, costs associated with the portion of the home that is exclusively used for business are generally deductible.

Non-Deductible Expenses

Some expenses incurred by a business are not reportable. These expenses include bribes, lobbying costs, penalties, fines, and contributions made to political parties or candidates.

What Is an ‘Ordinary and Necessary’ Business Expense?

This is IRS-speak for the type of expense that a business can properly deduct. Generally, “ordinary” means normal and widespread in the industry. “Necessary” means appropriate and useful, while falling short of absolutely essential.

What Is Not a Deductible Business Expense?

Any expense that has a personal benefit rather than a business benefit is non-deductible.

Granted, this can be a gray area. If you go to Los Angeles for business purposes, and spend a day at Disneyland while there, your tickets to the park are not deductible. Your flight to and from L.A. should be deductible, as long as you’re ready to prove that you spent most of your time there doing business.

Can I Deduct My Car If I Use It for My LLC?

If you use a car entirely for business purposes, you can deduct the related expenses.

If you have a car that you use for both business and personal trips, only the costs related to its business use are deductible. That means keeping receipts and a careful log of mileage and other costs associated with the vehicle.

The Bottom Line

The key to business tax reporting is “ordinary and necessary” expenses. That’s the phrase the IRS uses to describe the costs of doing business. Those costs are deducted from income in order to arrive at taxable income for the period being reported.