- Business expenses include the cost of goods sold along with the ordinary and necessary operational expenses associated with keeping a business running.
- Separating business finances from personal finances helps you track your business expenses more effectively.
- Tracking business expenses is essential for maintaining healthy cash flow and qualifying for tax deductions that could reduce your taxable income.
- This article is for aspiring entrepreneurs and new small business owners who want to improve their accounting practices with careful expense tracking.
Keeping tabs on business finances – including tracking specific business-related expenses – is crucial to running a business. Proper accounting improves cash flow, the oxygen your business needs to survive. Additionally, careful expense tracking helps your company qualify for valuable tax deductions that reduce your adjusted gross income. Here’s what you need to know about business expenses and how to track them.
What are business expenses?
Business expenses are expenditures directly related to starting a business and maintaining operations. Business expense examples include inventory purchases, payroll, salaries and office rent.
Business expenses fall into one of two categories:
“There are two types of business expenses: cost of goods sold, which are costs associated with making your product; and operating expenses, which include rent, salaries, business licenses and permits, and self-employment taxes,” explained Jeff Fazio, head of small business specialists at TD Bank.
Separating business expenses from personal expenses is crucial for proper small business tax management because business expenses can help you qualify for tax deductions. Tax deductions are applied to your taxable income, potentially lowering the overall rate you’ll pay.
“Business expenses are ordinary and necessary costs a business incurs to operate,” noted Nicholas Holmes, founder of Product Reviewer. “Businesses need to track and categorize their expenditures because some expenses can count as tax deductions, resulting in significant cost savings.”
Tax deductions should not be confused with tax credits, such as research and development tax credits, which are applied directly to your tax bill, not your taxable income.
What are common business expense categories?
Classifying your business expenses is helpful. Categorizing can inform how you prioritize expenses in your small business budget, making it easier to spot areas where you can cut business expenses.
Here are some common business expense categories:
- Fixed: Fixed expenses don’t change from month to month. Fixed expenses include mortgages, depreciation, insurance, salaries and rent. While these expenses can change over time, they are usually fixed for a specific duration.
- Variable: Variable expenses are mandatory expenses. However, their total costs will vary with each billing cycle. Variable expense examples include utilities, inventory, commissions and credit card processing fees.
- Period: Period expenses can be fixed or variable; they come at regular intervals instead of per transaction. Your mortgage or rent would be a fixed period cost, while utilities and insurance are variable period expenses.
- Interest: Interest can be fixed or variable. Many interest costs are tied to period expenses. However, something like credit card purchases for traveling employees can be per transaction. Interest is worthy of its own category because it informs how much money you lose from your budget’s borrowing portion.
- Depreciation: Depreciation is typically a fixed variable expense. But it too is worth a closer look. Depreciation is necessary to help calculate the ROI on replacing major items. It is also typically tax-deductible and thus should always be calculated.
What types of business expenses are tax-deductible?
Many business expenses are eligible for a tax deduction. In some cases, special rules might apply to your business and what you could consider a deductible expense. For example, legal cannabis businesses in compliance with state law cannot deduct the cost of goods sold from their federal tax bill under Section 280E of the Internal Revenue Code. To be sure about your business’s status under state and federal tax laws, consult with a certified public accountant (CPA) regarding tax law.
“The IRS defines business expenses as those costs that are ordinary and necessary to carry out business in your industry,” explained David McKeegan, co-founder of Greenback Expat Tax Services. “Typically, expenses that meet these criteria are tax-deductible by for-profit companies.”
Some of the most common tax-deductible business expenses include:
It’s essential to have a complete and accurate accounting of each deductible expense. When tax time comes, you can itemize these deductible expenses to reduce your overall tax bill.
“Tax season is a dreaded time of the year for those who aren’t prepared. One can get ready for it by keeping meticulous records,” Holmes advised. “Many … expenses are tax-deductible, like business lunches and meetings, mobile data cost, travel, office supplies, rent, etc. That means the owners will surely get money back. However, the owners can get cash back only if they track, categorize and fully disclose all the expenses.”
Check with your accountant about crazy but legal tax deductions. For example, limos, gym memberships, pets and even hair dye may qualify – under the right circumstances.
What types of expenses are not tax-deductible?
It’s easy to assume that all business expenses are tax-deductible, but that’s false. The list below covers the most common nondeductible items. For a comprehensive list, you’ll want to defer to the IRS.
- Political contributions
- Government fines or penalties
- Demolition losses or expenses
- Certain education expenses
- Legal fees
- Capital expenses
How do you track business expenses?
To realize the maximum tax deductions you’re eligible for under the law, you must diligently track your business expenses. Here’s how to do it.
1. Set up a business bank account.
When tracking business expenses, your first step is establishing a dedicated business bank account to separate your business finances from your personal finances. Business accounts can easily generate income statements, helping with taxes.
“All business expenses should be paid through a business checking account,” Fazio advised. “Business accounts … allow businesses to get an accurate view of cash flow to produce income statements needed to obtain financing and can ease the tax return process and help mitigate financial liability.”
2. Use cloud-based accounting software.
Many small business owners track their business expenses using Microsoft Excel. However, this method is prone to human error. As your business grows, it’s hard to stay organized with spreadsheets.
Using the best business accounting software via the cloud automates several elements of business expense tracking and helps keep your financials organized.
“Tracking business expenses will be less painful if the right tool is used,” Holmes explained. “Many small businesses are using cloud accounting software to access their accounting data on their cell phones. Cloud software lets small companies add expenses on the go and connect to [their] bank account or credit card so the expenses update automatically.”
Connecting accounting software with your financial institutions can help you better organize your expenses, identify possible tax deductions and record digital receipts for your expenses.
“With [accounting] software, the tax records are more secure and auditable,” Holmes added. “They are better than spreadsheets and paper receipts, as the data stored in the cloud keeps all the documents in one place for as long as you want.”
Check out our review of Zoho Books if you need an accounting solution for a very small business. If you need a more robust solution, read our in-depth review of QuickBooks Online – our choice as the best accounting software for small businesses.
3. Manage your receipts.
In addition to digitally tracking expenses, take photos of physical receipts for cash payments or payments made on a personal credit card. For example, if an employee takes a client out for lunch and pays with their card, ask them to record the transaction by taking a photo of the receipt and sending it to you for your records.
Other physical receipts to track include car mileage, train tickets for commutes, internet bills and other reimbursement expenses.
Consider using receipt-tracking tools for your business. For example, the Expensify app can automatically read a photo of a receipt and convert it to a logged expense.
What are the benefits of tracking business expenses?
Tracking business expenses has benefits beyond qualifying for tax deductions. Here are a few notable ones.
1. Tracking business expenses helps you understand your business’s cash flow.
Business owners can more easily understand cash flow – an essential business survival factor – when they accurately track expenses.
“One of the primary reasons why most businesses fail is the mismanagement of the cash flows,” Holmes warned. “Owners can manage their cash flows through daily expense management so that expenses don’t outstrip the income at the end of the month.”
2. Tracking business expenses demonstrates your business’s profitability.
Effectively tracking business expenses allows business owners to gauge how well their business is doing by illuminating its profit margin. Tracking can also provide a clear financial record to lenders, improving the chances that a business can secure the funding it needs to grow.
“The percentage of profit tells how much a company is generating money and helps attract the investors, funds the day-to-day activities and aids in getting financing,” Holmes explained. “Every business wants to be profitable at a glance, but many struggle to calculate it, as they don’t keep accurate records of their income and expenses.”
3. Tracking business expenses identifies potential cost savings.
Good accounting software can help you separate unreimbursed expenses from deductible expenses, allowing you to tag specific line items by expense category. This includes tags like personal expenses, entertainment expenses, meal expenses, travel expenses and capital expenses. Separating expenses is helpful for reporting purposes at the end of the tax year and allows you to examine your business expenses on a granular level and determine where you might find cost savings.
4. Tracking business expenses keeps you within your budget.
As a business owner, understanding your budget is crucial to making the right financial decisions. Tracking your expenses will give you further insight into how much money you’re spending, what you’re spending money on and whether your current budget needs adjusting.
For instance, perhaps your expenses are higher than anticipated. You might need to increase your budget or cut back on spending to ensure you stay within your budget. Either way, this knowledge helps keep you financially aware.
5. Tracking business expenses improves employee satisfaction.
By tracking your business expenses, you can more quickly reimburse employees for out-of-pocket expenses like travel, commuting, meals, business supplies and training materials. Offering this reimbursement perk to employees can act as a recruitment and retention incentive. Employees will feel more valued and satisfied if their business expenses are covered.
Other ways to boost employee happiness include setting up a generous paid time off (PTO) policy, promoting a positive work environment and encouraging professional development.
Tracking business expenses is crucial to success
If you are starting a business or looking to grow in the near future, you must track your business expenses meticulously and transparently. You’ll be able to reduce your taxable income and better manage your business.
When cash flow suffers, review your business expenses and find areas where you can cut expenses. Conversely, when your business is doing well, you can examine where you have opportunities to invest in growth.
Tracking business expenses can also help you demonstrate to lenders that your business is fiscally responsible and can be a trusted borrower when you need financing.
Sammi Caramela contributed to this article. Source interviews were conducted for a previous version of this article.
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