What Are Business Expenses?

What Are Business Expenses?

Let me explain business expenses directly: they are the costs you incur while running your business in the usual way. You subtract these from your revenue to figure out your taxable net income. People also call them deductions.

No matter if you're a solo consultant at home, a small shop owner, or part of a huge corporation, you deal with business expenses and track them all year for taxes.

You can divide business expenses into two main types: capital expenditures and operational expenditures. Capital ones are big purchases that boost your company's long-term performance. Operational ones cover the daily spending to keep things running.

Key Takeaways

You can deduct business expenses, which lowers your taxable income. Subtract the total from revenue to get the business's taxable income amount. The IRS says allowable deductions must be 'ordinary and necessary' for your industry. Main categories for deductions include direct expenses, indirect expenses, and interest on debt. On the flip side, you can't deduct things like bribes, kickbacks, fines, or political contributions.

Understanding Business Expenses

Section 162 of the Internal Revenue Code lays out the rules for business expenses. It lets you report any expense that's ordinary and necessary. These don't have to be required; ordinary means they're common in your industry, something most owners in your field would spend on. Necessary means they're appropriate, and you probably couldn't run your business without them.

If an expense fits as ordinary and necessary for business, you can expense it and deduct it from taxes. Some are fully deductible, others only partly.

Here are examples of fully deductible expenses: advertising and marketing, processing fees from business credit cards, employee education and training, certain legal fees, license and regulatory fees, wages to contract employees, employee benefits, equipment rentals, insurance, interest paid, office expenses and supplies, maintenance and repairs, office leases, and utilities.

How Expenses Are Recorded

You record expenses mainly on the income statement, which helps determine taxes. Most statements break expenses into direct costs, indirect costs, and interest.

Direct Costs

To find the cost of goods sold (COGS), you use the inventory value at the start and end of the tax year—it's a big direct expense for many companies. Deduct COGS from total revenue to get gross profit. Once in COGS, you can't deduct those expenses again. COGS can include direct labor, factory overhead, storage, product costs, and raw materials.

Indirect Costs

Subtract indirect costs from gross profit to get operating profit. These include executive pay, general expenses, depreciation, and marketing. Operating profit is also earnings before interest and tax.

Depreciation

You expense business assets through depreciation, a tax-deductible indirect expense on the income statement. Deduct it over several years for things like computers, furniture, property, equipment, trucks, and more.

Gifts, Meals, and Entertainment Costs

The IRS limits deductions for gifts, meals, and entertainment. For instance, you can usually deduct 50% of employee meal costs, but some meals are fully deductible.

Interest Expenses

Interest and tax expenses come last on the income statement. Interest is the final subtraction before taxable income, sometimes called adjusted taxable income.

Personal Expenses

Sometimes your expenses mix personal and business, like using the same car for both. Deduct the business portion of miles. For home offices, deduct costs for the part used only for business.

Non-Deductible Expenses

You can't deduct some business expenses, like bribes, kickbacks, lobbying, penalties, fines, or political contributions.

What Is an Ordinary and Necessary Business Expense?

The IRS defines it as normal and widespread in the industry for 'ordinary,' and appropriate and useful—though not essential—for 'necessary.'

What Is Not a Deductible Business Expense?

Any expense with personal benefit over business benefit isn't deductible. It's a gray area: if you go to LA for business but spend a day at Disneyland, park tickets aren't deductible, but your flight is, if you prove most time was business.

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

If the car is solely for business, deduct all related expenses. For mixed use, deduct only business-related costs, so keep receipts and a mileage log.

The Bottom Line

For tax reporting, remember expenses must be 'ordinary and necessary'—that's the IRS phrase for costs of doing business. Deduct them from income to find taxable income for the period.