Everything You Should Know About Deductible Business Expenses

Major Takeaways

Before we dive in fully, if you’re new to running a business and need a quick overview of income and expenses, here are a few major takeaways: 

• Almost any expense that is ordinary and necessary for generating business income can be deducted.
• The IRS is committed to and constantly looking out for personal expenses included in business expense deductions (most commonly vehicle and travel expenses).
• Some expenses may be fully deductible in the current year while others must be spread out (depreciated) over future years given their useful life.
• Costs of going into business have special rules regarding limits and deductions. 
• Keep in mind that some things are not considered income including loans, gifts, inheritances, returned capital, and certain fringe benefits.
• Working with a tax advisor or accountant can dramatically help ensure your business is not overpaying in taxes.

Deductible Business Expenses

Keeping track of all business expenses is crucial for maintaining financial health and ensuring long-term success. Accurate expense tracking provides a clear picture of where your money is going, helps identify areas where you can cut costs, and ensures you stay within budget. It also simplifies tax preparation by providing detailed records that can support deductions and reduce the risk of costly errors or audits. Moreover, monitoring expenses helps in making informed decisions, setting realistic financial goals, and assessing the profitability of your business. In essence, diligent expense tracking is a cornerstone of sound financial management and strategic planning.

Maximizing business expenses can be advantageous for several reasons, primarily related to tax efficiency and cash flow management. By strategically increasing expenses, a business can reduce its taxable income, thereby lowering the amount of taxes owed. This is particularly beneficial in high-revenue periods where managing tax liability becomes crucial. Additionally, reinvesting in the business through expenses such as upgrades, marketing, or research can foster growth and enhance competitiveness. Properly managed, these expenses can lead to improved operations and increased revenue, ultimately benefiting the company’s long-term profitability. However, it’s essential to ensure that all expenses are legitimate and directly contribute to the business’s goals to avoid financial mismanagement or potential legal issues. That’s why we’ve created this guide to help you understand the most common tax deductible business expenses and even consider often overlooked deductible expenses that can lower your business and related, individual taxes.

So what is a deductible business expense?

A deductible business expense is an expense that can be subtracted from a business’s gross income to reduce its taxable income, thereby lowering the amount of income tax owed. These expenses must be both ordinary and necessary for the operation of the business to qualify as deductible. Examples include rent for office space, salaries and wages, utilities, office supplies, professional services (such as legal or accounting fees), and business-related travel expenses. Deductible expenses must be documented with proper receipts and records to ensure compliance with tax regulations and to substantiate the deductions claimed on tax returns.

Rules for an Expense to be Deductible 

To qualify as a deductible business expense, an expense must meet the following criteria:

1. Ordinary and Necessary: The expense should be common and accepted in your industry (ordinary) and essential for running your business (necessary). For instance, office supplies or rent would be considered ordinary and necessary expenses for most businesses. Because the IRS doesn’t define these terms, there have been thousands of court rulings about how to interpret ordinary and necessary. One judge said it means “appropriate and helpful”. Another judge defined it as “normal, common, and accepted under the circumstances by the business community.” We suggest starting with a common sense approach to justify whether an expense is reasonable under the expectation of ordinary and necessary for your business. 
2. Not Extravagant: The expense must be reasonable in amount and not excessive or lavish. For example, purchasing a high-end luxury vehicle for business use might be deemed extravagant unless it’s justified by the nature of the business.
3. Primarily for the Business: The expense must be directly related to your business operations rather than personal use. For instance, a business meal is deductible only if it’s directly related to business activities and not for personal enjoyment. 

Meeting these criteria ensures that the expenses you claim are legitimate and align with tax regulations, helping to avoid issues during tax audits and maximizing tax benefits. Ultimately, you as the business owner will need to answer any questions by an auditor and be able to substantiate your claims. In the event your potential expense is disallowed, you will need to pay taxes on the amount of net income variance as well as any penalty and interest accrued.

Expenses That Cannot Be Deducted

Certain expenses cannot be deducted for business purposes due to tax regulations and definitions of what constitutes a legitimate business expense. Common examples include:

1. Personal Expenses: Costs that are personal in nature rather than related to business operations, such as personal groceries or personal travel, are not deductible.
2. Fines and Penalties: Payments made for breaking laws or regulations, such as traffic tickets, tax penalties for late payment, or regulatory fines, cannot be deducted.
3. Capital Expenses: Expenses related to purchasing or improving long-term assets like buildings or machinery are not deductible as current expenses but may be depreciated or amortized over time.
4. Political Contributions: Donations made to political campaigns or parties as well as lobbying expenses are not deductible.
5. Luxury Expenses: Excessively high costs for items or services, which are deemed extravagant or lavish, are generally not deductible. For example, a high-end sports car purchased for personal use.
6. Commuting Costs: Expenses for traveling between your home and your primary place of business are considered personal commuting costs and are not deductible.
7. Business Gifts (over $25): Business gifts that exceed a value of $25 per recipient (per year) cannot be deducted above the $25 limit. However, some costs of delivery and personalization can be tracked separately. 
8. Entertainment Expenses: While meals directly related to business are deductible under specific conditions, general entertainment expenses, such as tickets to concerts or sporting events, are generally not deductible.
9. Federal & Personal Income Taxes: Federal Income Taxes you pay on your business income or personal income and property tax.
10. Value of Donated Services: You cannot calculate the value of pro-bono (free) services donated to another individual or organization. Only the out-of-pocket costs associated with providing this service could potentially qualify as advertising or promotional expense. 

Understanding these restrictions helps ensure that only valid, business-related expenses are claimed, maintaining compliance with tax laws and avoiding potential issues during audits.

Current vs Future Expenses

Current Year Expenses and Future Year Expenses refer to how business expenses are recorded and managed within accounting periods, influencing financial statements and tax filings.

1. Current Year Expenses: These are costs incurred within the current fiscal year. They are deducted from the business’s income for that year, impacting the profit and loss statement directly. Examples include office supplies purchased, utility bills paid, or salaries disbursed within the year. These expenses are recognized and recorded in the year they are incurred, directly reducing taxable income for that year.
2. Future Year Expenses: These are costs that will be incurred in future periods but may be prepaid or recognized in the current year. For instance, if you pay for a one-year insurance policy upfront, the expense is spread over the policy period, impacting multiple years. In accounting, such prepayments are recorded as assets initially (e.g., prepaid expenses) and then expensed over time as the benefit is realized. This approach ensures that expenses are matched with the periods in which they generate revenue, adhering to the matching principle in accounting.

Understanding the distinction helps businesses manage their cash flow, accurately report financial performance, and optimize tax strategies.

Top Business Expense Deductions for Small Business

When it comes to managing a small business, maximizing deductions can significantly reduce taxable income. Here are some of the top business expense deductions to consider:

1. Office Supplies and Equipment: This includes items like computers, printers, office furniture, and supplies such as paper, pens, and software. Note that some items such as furniture and computers may also fall under a category of capital expenses that should be depreciated over their useful life. Oftentimes, depreciating capital expenditures can spread out the benefit of the tax savings in future years that can be helpful in periods of growth. Talk to your accountant about the structure that may benefit you the most.
2. Rent and Utilities: Costs associated with renting office space or other facilities, along with utilities such as electricity, water, and internet, are deductible.
3. Home Office: This often overlooked expense has a potential for large tax savings! Expenses for the use of your home for business purposes including office space or storage can be calculated at the percentage of square footage occupied versus the total square footage of your home. This will be covered in more detail later. 
4. Salaries and Wages: Payments made to employees, including wages, salaries, paid time off, and bonuses, are deductible. 
5. Employee Benefits: Expenses for certain employee benefits like health insurance and retirement plan contributions are deductible. Even the costs to administer the plan can be a deductible business expense.
6. Vehicle and Auto Expenses: There are specific rules and limits for auto and vehicle related expenses. Mileage reimbursement at the IRS designated rate is most common but also tracking specific costs related to gas/fuel, repairs and maintenance, licensing and registration are all deductible if following IRS guidelines.
7. Business Meals and Entertainment: Meals with clients or for business purposes are partially deductible. Keep in mind that there are specific rules regarding how much you can deduct.
8. Travel Expenses: Costs for business travel, including airfare, lodging, and meals, are deductible. Ensure the travel is directly related to your business.
9. Advertising and Marketing: Expenses for advertising, marketing, and promotions, including digital ads, brochures, and social media campaigns, can be deducted.
10. Professional Services: Fees paid to accountants, consultants, attorneys, and other professionals are deductible.
11. Insurance: Premiums for business insurance, such as liability insurance, property insurance, and workers’ compensation, are deductible.
12. Education and Training: Costs for courses, seminars, or training directly related to your business or industry can be deducted.
13. Depreciation: If you purchase large assets like machinery or vehicles, you can deduct their cost over several years through depreciation.
14. Bank Fees and Interest: Fees charged by banks or other financial institutions for business accounts and interest on business loans can be deducted.
15. Dues and Subscriptions: Subscriptions to industry journals, memberships in professional organizations, and other related dues are deductible.
16. Repairs and Maintenance: Costs for repairing and maintaining business property or equipment are deductible.
17. Shipping and Delivery: Expenses related to shipping products or delivering services are deductible.
18. Inventory Purchases: There are specific methods to calculate Costs of Goods Sold which are expenses related to the sale of inventory. A Simple Inventory calculation might be easiest but you might also benefit from other GAAP appropriate inventory valuation and costing methods including LIFO, FIFO, Average or Specific Costing. 

It’s essential to keep thorough records and consult with a tax professional to ensure you’re taking full advantage of available deductions and staying compliant with tax laws.

Most Common Overlooked Business Expenses

Many small business owners overlook various deductions that can significantly reduce their taxable income. The list below might help you identify some deductible business expenses you might be missing. Even with diligent bookkeeping records and financial reporting, some business owners might overlook qualified expenses without knowing about their specific rules and limits, or perhaps not list a deduction because they might not know which category to report. Here’s a comprehensive list of commonly overlooked business deductions: 

• Home office expenses
• Startup costs
• Business vehicle expenses
• Gifts in the form of sample giveaways or promotional items
• Client entertainment
• Charitable contributions
• Bank fees, service charges, and interest
• Professional development
• Business association dues/memberships
• Business journals, publications, and books
• Casual labor/independent contractors
• Commissions
• Bad debts, casualty losses, and theft
• Credit monitoring or credit bureau fees
• Research and development
• Environmental regulations or cleanup costs
• Internet costs or other utilities (including home office)
• Postage and shipping fees
• Website expenses including development and maintenance
• Photography and brand shoots
• Travel expenses
• Taxi/ridesharing costs
• Tolls and parking
• Petty cash funds used on small items