Business expenses are costs incurred in the ordinary course of business. From the smallest retail store to the largest multinational corporation, every business tracks these expenses throughout the year for tax purposes. These expenditures are subtracted from revenue to determine the taxable net income, often referred to as deductions.
Key Takeaways
- Tax Deductions: Business expenses are deductions from taxable income.
- Revenue Reduction: These expenses reduce the total revenue to calculate the company’s taxable income.
- IRS Guidelines: The IRS defines allowable business deductions as costs that are “ordinary and necessary” for the specific industry.
- Deduction Categories: The main categories include direct expenses, indirect expenses, and interest on debt.
Understanding Business Expenses
IRS Guidelines
Section 162 of the Internal Revenue Code (IRC) provides guidelines for business expenses, allowing businesses to report any expense that is ordinary and necessary. The term “ordinary” means common in the industry, while “necessary” implies that expenses are appropriate and that a business owner might struggle to manage without them.
An expense deemed ordinary and necessary for business purposes is tax-deductible. Some business expenses may be fully deductible, while others might only be partially deductible.
Examples of Fully Deductible Expenses
- Advertising and marketing expenses
- Processing fees from business credit cards
- Education and training for employees
- Certain legal fees
- Licenses and regulatory fees
- Wages paid to contract employees
- Employee benefits programs
- Equipment rentals
- Insurance costs
- Paid interest
- Office supplies and expenses
- Maintenance and repairs
- Office lease costs
- Utility expenses
Income Statement Reporting
The income statement is the primary financial document businesses use to record expenses and determine tax obligations. Expenses are generally classified into direct costs, indirect costs, and interest.
Direct Costs
The inventory value at the beginning and end of each tax year determines the cost of goods sold (COGS), a significant direct expense.
- COGS: Deducted from total revenue to find the year’s gross profit. These expenses include direct labor costs, factory overhead, storage costs, product costs, and raw materials.
Indirect Costs
Indirect costs are subtracted from gross profit to identify operating profit.
- Examples: Executive compensation, general expenses, depreciation, marketing costs. Subtracting these from gross profit leads to operating profit or earnings before interest and tax.
Depreciation
Depreciation allocates the cost of business assets over several years, including items like computers, furniture, property, equipment, and vehicles.
Gifts, Meals, and Entertainment Costs
The IRS limits deductions for these expenses, typically allowing a 50% deduction for employee meals, though some meals may be fully deductible.
Interest Expenses
The final section involves interest costs, subtracted last to determine taxable income, sometimes called adjusted taxable income.
Personal Expenses
Some expenses might be both personal and business-related. For instance, a small business owner’s car used for both purposes can have business-related miles deducted. Similarly, home office expenses exclusive to business use are generally deductible.
Non-Deductible Expenses
Certain expenses cannot be deducted, such as bribes, lobbying costs, penalties, fines, and political contributions.
Defining ‘Ordinary and Necessary’ Business Expense
This IRS term refers to commonly deductible expenses within the industry that are appropriate and useful.
Non-Deductible Business Expenses
Any expense with personal benefits rather than business purposes is non-deductible. While in a business trip to L.A., a day at Disneyland isn’t deductible, but flight expenses should be, provided the primary purpose of the trip was business.
Deducting Car Use for Business
If a car is used entirely for business, related expenses are deductible. If it’s mixed use, only business-related costs are deductible, necessitating meticulous record-keeping.
The Bottom Line
Efficiently managing “ordinary and necessary” business expenses is crucial for accurate tax reporting and maximizing savings. The IRS requires these costs to be deducted from income to determine taxable income for the financial period being reported.
Related Terms: capital expenditures, operational expenditures, gross profit, tax-deductible, depreciation.
References
- Office of the Law Revision Counsel, United States Code. “26 USC 162: Trade or Business Expenses”.
- Internal Revenue Service. “Publication 535, Business Expenses”, Page 3.
- Internal Revenue Service. “Publication 535, Business Expenses”.
- Accounting Tools. “Operating Profit Definition”.
- Internal Revenue Service. “Topic No. 704, Depreciation”.
- Internal Revenue Service. “Publication 463, Travel, Gift, and Car Expenses”, Pages 10-12.
- Internal Revenue Service. “Publication 535, Business Expenses”, Pages 5-6.
- Internal Revenue Service. “Publication 535, Business Expenses”, Pages 47-49.
- Internal Revenue Service. “Publication 535, Business Expenses”, Page 6.
