To better manage your cash flow and maximize your tax deductions, it's important to carefully track business expenses. Here are the expenses you need to track.
- Business expenses include both the cost of goods sold, as well as the ordinary and necessary operational expenses associated with keeping the business running.
- Separating your business finances from your personal finances helps you more effectively track your business expenses.
- Tracking business expenses is important for maintaining healthy cash flow, as well as 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.
An important element of running a business is keeping tabs on your business finances, including expenses specifically related to your business. Proper accounting not only helps you improve cash flow, the oxygen your business needs to survive, but your company can 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 those expenditures that relate directly to starting and maintaining your business. They include expenses like inventory purchases, for example. Wages and salaries are also considered a business expense. Each of these expenses falls 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," said Jeff Fazio, head of small business specialists at TD Bank.
It's important to separate business expenses from personal expenses because business expenses might help you qualify for tax deductions. Tax deductions are applied to your taxable income, potentially lowering the overall rate you must pay. Tax deductions should not be confused with tax credits, which are applied directly to your tax bill, rather than your taxable income.
"Business expenses are ordinary and necessary costs a business incurs to operate," said Nicholas Holmes, founder of ProductReviewer.com.au. "Businesses need to track and categorize their expenditures because some expenses can count as tax deductions, resulting in significant cost savings."
Key takeaway: Business expenses include the cost of goods sold – which relate to the provision of your products or services – and operating expenses, which cover rent, wages, permits, taxes, and other similar expenses.
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Common categories of business expenses
It helps to classify your business expenses. This can inform how you prioritize them in budgeting, and it's easier to spot areas where you can easily costs if you need to.
Fixed: Fixed expenses are things that do not change from month to month. These are things like mortgages, depreciation, insurance, salaries and rent. While any of these expenses can change over time, they are usually fixed for the duration of a lease, agreement or contract.
Variable: Variable expenses are the opposite of fixed expenses. They are mandatory spending, but their total cost will vary with each billing cycle. Utilities often fall into this category. Inventory, commissions and credit card fees are common examples of variable expenses.
Period: Period expenses can be fixed or variable, and they come at regular intervals, rather than per transaction. Examples of fixed period costs would be the mortgage (or rent), while variable period expenses would include utilities and insurance.
Interest: Interest can be fixed or variable. Many interest costs are tied to period expenses, but 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 are losing to your borrowing portion of the budget.
- 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 types of 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 certain about your business's status under state and federal tax laws, consult with a certified public accountant regarding tax law.
"The IRS defines business expenses as those costs that are ordinary and necessary to carry out business in your industry," said 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 business expenses include:
- Payroll expenses
- Employee benefits
- Home office expenses
- Insurance premiums
- Rent or mortgage payments
- Retirement plans
- Depreciation of equipment
- Interest expense
To make the most of these deductible expenses, it's important to have a complete and accurate accounting of each. When tax time comes, you can itemize these deductible expenses to reduce your overall tax bill. [Read related article: Crazy Tax Deductions Allowed by the IRS]
"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 said. "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."
Key takeaway: Tax-deductible business expenses are those that are considered to be "ordinary and necessary to carry out business" by the IRS.
What types of expenses are not tax-deductible?
It’s easy to assume that all business expenses are tax-deductible, but that's simply not the case. The list below covers the most common non-deductible 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 to track business expenses
Of course, to realize the maximum tax deductions you are eligible for under the law, you must diligently track your business expenses. The first step to doing so is separating your business finances from your personal expenses by establishing a dedicated bank account for your business.
"All business expenses should be paid through a business checking account," Fazio said. "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."
Many small business owners track their business expenses using Microsoft Excel. However, this method is prone to human error and, as your business grows, can be difficult to keep organized. Cloud-based accounting software offers an alternative that 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 said. "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."
"With [accounting] software, the tax records are more secure and auditable. They are better than spreadsheets and paper receipts, as the data stored in the cloud keep all the documents in one place for as long as you want," Holmes added.
Key takeaway: Separate your personal finances and business finances with a dedicated business bank account. You can also use accounting software to track your business expenses more accurately and transparently.
The benefits of tracking business expenses
There are other benefits to tracking business expenses beyond qualifying for tax deductions. Business owners can more easily understand cash flow, one of the most important factors in the survival of a business, when they accurately track their expenses.
"One of the primary reasons why most businesses fail is the mismanagement of the cash flows," Holmes said. "Owners can manage their cash flows through daily expense management so that expenses don't outstrip the income at the end of the month."
Additionally, effectively tracking business expenses allows business owners to gauge how well their business is doing by illuminating the business's profit margin. It 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 said. "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."
Good accounting software can help you further separate unreimbursed expenses from deductible expenses, allowing you to tag specific line items by expense category. This includes tags like personal expense, entertainment expense, meal expense, travel expense, capital expenses and more. Not only does this help for reporting purposes at the end of the tax year, it also helps you examine your business expenses on a granular level and determine where you might be able to find cost savings.
Key takeaway: Tracking business expenses helps business owners keep tabs on tax-deductible expenses, as well as gain insight into specific expenses and cash flow.
Tracking business expenses is crucial to success
If you are just starting your business or if you are looking to grow in the near future, you need to track your business expenses in a meticulous and transparent way. Not only will it help you reduce your taxable income, but it will also help you manage your business.
When cash flow suffers, you can review your business expenses and see where there are opportunities to cut. 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.
Key takeaway: Tracking business expenses is essential to building a healthy business and growing your company wisely.