It’s crucial to categorize expenses the right way to keep your business in good financial shape. It helps you avoid IRS audits and penalties, leads to better budgets, and can even lower your taxes. How? It all begins with clear business expense categories.
Business expense categories are the foundation of solid bookkeeping. They make it easier to file taxes in general, and business owners love how categorized expenses help with tax deductions, specifically. These deductions can save you thousands of dollars each year.
Who doesn’t want that?
Below, we list the major business expense categories for small and mid-size companies. We’ll also go over what makes an expense tax-deductible. Finally, we’ve got tips on how to track business expenses.
What is a business expense category?
A business expense category is a way to sort and group your business expenses. The IRS defines a business expense as “the cost of carrying on a trade or business.”
At tax time, you’ll go through your business expense categories and determine which costs you can deduct. You’ll have to show a business expense is “ordinary and necessary” to deduct it on your tax return.
Don’t worry—the IRS defines these terms, too.
“An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
As you can see, there’s some room for interpretation. Business owners are largely given the freedom to make buying decisions to support their operations as they see fit while abiding by the law.
As a normal part of operating your business, you’ve undoubtedly already paid some “ordinary and necessary” business expenses. For example:
- Rent and utilities
- Office supplies
- Vehicle costs
- Employee wages or salaries
- Interest payments
It’s worth pointing out, too, that there are limitations on what you can categorize as a business expense.
Some expenses may seem like a business expense at first glance when they’re actually the purchase of an asset—which is not a business expense. In business, an asset is a resource that has value and can be converted to cash. An asset can be tangible like a computer or intangible like a prepaid insurance policy.
Generally, if you expect an item to last longer than a year, it’s a business asset. Let’s say you buy new furniture for the waiting room in your auto shop. That’s not a business expense. That furniture will hold value, so it’s an asset.
But while you can’t consider that a “business expense” at tax time, you can likely deduct the cost of depreciation, or loss of value over time. (For more, read our article on the difference between business assets, expenses and liabilities.)
Let’s get back to business expense categories.
So, here’s the situation. You’ve made a purchase for business purposes. It’s a reasonable, helpful and appropriate product or service specifically for business use. How do you sort and group this expense in your bookkeeping or accounting system?
Let’s dig into the 23 business expense categories small and mid-size business owners should recognize.
23 need-to-know business expense categories
Below, we’ve rounded up the main business expense categories you’re likely to use. Every industry has different requirements.
If you don’t see the expense category you’re looking for, it’s fine to create the one you need.
- Advertising & Marketing: Your promotional expenses. These vary from business cards and commercial airtime to online ads and out-of-home posters.
- Business Licenses & Permits: A bar’s liquor license, for example, or other required permits for your industry.
- Business Insurance: Broadly, this could include business liability insurance, workers’ compensation insurance, and other forms of insurance that protect your business from loss.
- Charitable Contributions: Do you have a charity collection box near your checkout counter? Maybe you use a company vehicle for volunteering, like holiday meal delivery. You can deduct some of these expenses, but always double-check IRS guidelines.
- Continuing Education: Conferences, education expenses and other employee training or development. Make sure to record travel and meal expenses separately.
- Depreciation Costs: You can deduct depreciable assets like payment equipment, furniture and other machinery in the first year you bought them.
- Entertainment: As of 2018, business entertainment expenses are no longer tax-deductible. You’ll still want to distinguish them from crossover costs like meals and travel.
- Health Insurance: This includes insurance premiums you cover for your employees. You might also have self-employed insurance costs.
- Home Office Deductions: If you work from home as a sole proprietor or LLC, you have some options. You may be able to deduct costs like rent, mortgage interest, repairs or utilities.
- Interest Payments: Ongoing payments on all credit lines. These include small business loan payments and business credit card expenses.
- Meals: The IRS scrutinizes business meal expenses closely. Whether it’s a lunch meeting or travel-related meal, you can deduct only 50% of meal costs.
- Organization Dues: This is important if you’re part of a chamber of commerce or other business association. You can’t deduct fees for hobby groups and social clubs, though.
- Professional Fees: If you take advantage of services from a certified public accountant (CPA), tax advisor, marketing consultant or other professional, use this category.
- Office Supplies: Cleaning supplies, water and other monthly office expenses belong here. Using a business credit card for these ongoing costs helps with tracking, too.
- Rent: Your rental costs for any building you rent for business.
- Retirement Plans: If 401(k) plans or other funds are part of your employee benefits, list them separately for more accurate tax filing.
- Taxes: Business property taxes, payroll taxes (also called employment taxes) and more.
- Technology: It’s worthwhile to separate subscription costs for things like POS software or QuickBooks from office supply costs.
- Travel Expenses: Another closely examined business expense category. Document business travel that takes you outside city or area limits as well as related costs like airfare, hotels and meals.
- Utilities: Along with gas, electric and water, don’t forget internet, phone and other utility bills.
- Vehicle Expenses: Since so many owners use vehicles for business and personal purposes, this is another category to watch. You can handle vehicle deductions two ways. You can calculate the amount using the standard mileage rate option. Or you can use the actual expense option. Actual expenses include all expenses—gas, oil, insurance and more—incurred while using the car for business. To claim depreciation costs for a vehicle, it must be driven for business purposes 50% of the time or more.
- Wages & Salary: This includes gross income, commission and bonuses. Keep payroll taxes separate to monitor costs more easily.
- Website Expenses: Domain fees, web hosting and other costs required to keep your site live.
If you manage bookkeeping and tax filing yourself, it’s even more important to group expenses in a way that’s easy to understand. Feel free to call an accountant to review your setup, too.
Next, we’ll go over deductible expenses—what you can write off on your income tax return. As a reminder, even legitimate tax claims can be rejected if your expenses aren’t supported by solid recordkeeping.
How do you know if a business expense is tax-deductible?
A tax deduction is an expense that you can deduct from your taxable income on your income tax return. The more expenses you write off, the lower your business taxes. What’s great is that all business owners can claim tax deductions, regardless of size or industry.
The best resource for understanding what you can and can’t deduct is IRS Publication 535. This goes over common business expenses, what is and isn’t tax-deductible, and more.
You can write off ordinary and necessary business expenses, with some exceptions. There’s also a wealth of information specifically for small businesses, like this list of small business tax deductions.
Check guidelines regularly on the IRS website or another trusted financial source. The rules change frequently as a result of tax reforms. For example, as we mentioned above, business entertainment expenses are no longer deductible.
Using business categories isn’t just about keeping things tidy. You’ve got to be ready to prove that your business purchases are valid expenses.
Final tips on using business expense categories
Before setting up business expense categories, review how to track business expenses. If you don’t have some of these best practices in place already, we offer step-by-step advice on how to get going.
Using business expense categories the right way is an easy win for small business owners. Clean bookkeeping and expense-tracking have a ripple effect. Beyond simplifying tax time, you’re better prepared to write off expenses.
And that’s money you can put back into your business.
KEEP READING: How to Track Business Expenses (in 9 Steps)