As a small business owner, you may run on a tight budget. Your business expenses might add up fast between equipment, inventory, overhead, and payroll. Luckily, many of your business expenses are tax-deductible. But, what constitutes an allowable business expense?
What are allowable business expenses?
Business expenses refer to costs incurred or money spent while operating a business. There are hidden costs of running a business, as well as the traditional expenses that you incur. To deduct an expense, the Internal Revenue Service (IRS) says the item bought must be ordinary to your industry. The expense must also be necessary to run your business.
Let’s say you own a hair salon. At your salon, you offer washes, cuts, and colors. You dry your customers’ hair as a part of these services, but one of your hair dryers breaks.
You buy a new hair dryer. You could consider the new hair dryer a deductible business expense. This is because a hair dryer is an ordinary tool in a salon. Having a hair dryer is also a necessary part of your services.
The IRS allows 100% small business tax deductions for many general business expenses. General business expenses could include:
- supplies
- employee wages
- rent paid for office space
- lease payments on warehouse space
- fuel cost
- utility payments
- equipment maintenance
Some expenses are not tax deductible. These expenses are either not ordinary and necessary to running your business, or are already claimed in another tax filing.
Non-deductible expenses include:
- Cost of Goods Sold (COGS) – You deduct COGS from your gross receipts to find your gross profit for the year. You cannot deduct COGS again as a business expense.
- Capital assets – You have to pay some large expenses over a long period of time. A business expense is entirely used up within one year.
- Personal expenses – You do not make personal expenses to run your business. Personal expenses are unrelated to your business expenses and cannot be deducted.
Dividing expenses
Sometimes you buy something that you use for both your business and your personal life. When this occurs, you may divide the expenses.
You might consider costs of entertaining a client ordinary and necessary for your business. But, for bookkeeping purposes, these expenses are only 50% deductible.
Here is an example of dividing your expenses. You might buy a cell phone to use for your business. Half of your calls are made to clients. The other half of your calls are personal.
In this case, you consider 50% of the cost of the cell phone a business expense. The cell phone is ordinary and necessary for your business. You consider the other 50% of the cost of the cell phone a personal expense. Personal expenses are not deductible.
Direct and indirect business expenses
You can categorize expenses by direct and indirect expenses. Both direct and indirect expenses have to be necessary and ordinary for you to deduct them.
Direct expenses are specifically related to producing the good or service you sell. Direct expenses are usually 100% deductible. Examples of direct expenses include raw materials and wages.
Indirect expenses help you operate your business. Examples of indirect expenses include rent and utilities. Indirect expenses are deductible based on a percentage.
Indirect expenses are a large factor when you run your business from home. For this reason, accounting for small business may include these types of expenses frequently. You find the percentage to deduct by comparing your home’s total square footage to the space you use for business in your home.
You will need to record your expenses to get a tax deduction. Be sure to document your expenses and keep your receipts throughout the year. Are you uncertain if you can claim an expense? IRS Publication 535 can help you determine if a business expense is deductible. There are even special deduction rules that allow you to deduct depreciable property instead of capitalizing it if it is below the safe harbor threshold. Make sure you do your research!
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This article has been updated from its original publication date of October 19, 2012.
This is not intended as legal advice; for more information, please click here.
