Understanding Business Expenses and Which Are Tax Deductible

What Are Business Expenses?

Business expenses are costs incurred in the ordinary course of business. They are subtracted from revenue to arrive at a company’s taxable net income. Business expenses are also referred to as deductions.

Every business, from the consultant working from home, to the smallest corner store, to the largest corporation, has business expenses and tracks them throughout the year for tax purposes.

Business expenses are generally divided into two broad categories, capital expenditures and operational expenditures. That is, some expenses relate to major purchases made to improve a company’s performance over the long term. Others relate to the spending necessary to run company operations from day to day.

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 refers to expenses that are common in the industry and most business owners in the same line of business or trade would normally incur them. 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
• Processing fees from business and corporate credit cards
• 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

How Expenses Are Recorded

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 Internal Revenue Service (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 details 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 deductible. These expenses include bribes and kickbacks, lobbying costs, penalties, fines, and contributions made to political parties or candidates, among others.

The Bottom Line

The key to business tax reporting and business expense deductibility is that expenses are “ordinary and necessary.” 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.