Stay Organized: Set Up Business Expense Categories to Keep Your Ducks in a Row

June 6, 2017

When you spend money for your business, do you ever wonder if the expense is tax deductible?

And when tax season comes around each year, do you spend hours sorting through receipts or organizing your expenses into useful categories because they’ve been lumped into one catch-all category?

Business expenses can be confusing for freelancers and new small business owners because many tax resources are rather vague with their definitions. They might even use obscure examples not relevant to your business. To avoid confusion, you should set up expense categories for your business based on categories offered by your local tax body or ones that are common to others in your industry. Expense categories allow you to easily sort and classify expenses as you spend money, saving you a lot of time by avoiding the hours of sorting boxes of receipts.

In today’s post, we’ll discuss the basics of deductible expenses and how you can use FreshBooks to make categorization much easier.

Business expenses can be confusing for freelancers and new small business owners because many tax resources are rather vague with their definitions.

What is a Deductible Expense?

If the expenses can be attributed to a business with the intention of making a profit (as opposed to a hobby), the expense is most likely at least partially deductible. In the U.S., the IRS specifies that to be deductible, expenses must “be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.”

Jargon aside, this simply means ordinary expenses are things other business owners in your industry typically purchase. For instance, a bookkeeper would normally buy computer software, office supplies and advertising. You’re probably already counting these things as expenses.

Necessary expenses would be better defined as costs required for your business to succeed. This includes things like business travel or tools for work. A bookkeeper might be able to pay millions of dollars to advertise during the Super Bowl and categorize it as a normal expense, but is such an expensive ad necessary? Chances are an IRS auditor would say no.

Sample Expense Categories to Keep in Mind

The IRS does not provide a comprehensive list of deductible expense categories, although they do provide some advice on deducting business expenses in Publication 535. The Canada Revenue Agency (CRA) provides a list of commonly used expense categories to get you started. This list can be helpful in other countries as well. If your expense easily falls into one of these categories, they’re likely ordinary expenses and necessary so you should be able to deduct them.

Here is a list of commonly used expense categories. These may not all be directly applicable to your business, and you may have some of your own specific categories, but this list is fairly exhaustive.

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  • Advertising
  • Allowance on eligible capital property
  • Bad debts
  • Business start-up costs
  • Business taxes, fees, licenses, dues, memberships, and subscriptions
  • Business-use-of-home expenses
  • Capital cost allowance
  • Current or capital expenses
  • Delivery, freight, and express
  • Fuel costs
  • Insurance
  • Interest
  • Legal, accounting, and other professional fees
  • Maintenance and repairs
  • Management and administration fees
  • Meals and entertainment
  • Motor vehicle expenses (automobile)
  • Office expenses
  • Prepaid expenses
  • Property taxes
  • Rent
  • Salaries, wages, and benefits
  • Supplies
  • Telephone and utilities
  • Travel
  • Other expenses

Sometimes, an expense might be part personal and part business. Travel is a common area where people mix business and pleasure. In those cases, you’ll have to separate the business portion from the personal portion and deduct only the business side of the expense.

However, Understand There Are Also Non-Deductible Expenses

There are a few expenses that are never deductible:

  • Government-imposed fines and penalties. Even though you can’t deduct government-imposed fines and penalties, you can claim the cost of fighting the fines if they are directly related to your business.
  • Bribes and kickbacks
  • Business clothing (except uniforms). The cost of clothing you wear to work is not deductible unless the clothing is not suitable for wear outside of work. For example, hard hats and other safety gear are deductible. Business suits and even logo apparel are not deductible as you could wear the items on other occasions that don’t relate to work.
  • Political contributions. That includes lobbying costs and the cost of attending campaign events.
  • The value of donated time or services
  • Illegal activities
  • Hobby losses
  • Business gifts over $25
  • Federal income, gift, and estate taxes
  • Club dues. If you belong to a golf or country club, fitness facility, or another social club, your dues are not deductible, even if you entertain clients there. You can deduct dues for professional business or trade organizations.

Drawing the Line Between Assets vs. Deductible Expenses

Sometimes, you might spend money in your business that seems like an expense, but you’re actually purchasing an asset.

Furniture and Equipment

You may buy computers, furniture, printers, or other types of equipment for your business. These items are expected to last longer than one year, so they are assets, not expenses. Instead of expensing the cost of the furniture and equipment, you would “capitalize” the purchase as an asset on your balance sheet, then write off the cost as depreciation expense over the asset’s useful life. Capitalization and depreciation are complex. You can check out IRS Publication 946 for more information, but you may want to consult with an accountant or bookkeeper to make sure you’re following the rules.

Bonus: Setup Expense Categories in FreshBooks

Setting up expense categories in FreshBooks can help you quickly identify and organize business expense throughout the year. This will also make tax time reporting a breeze. Not to mention the peace of mind that comes from knowing where all your cash and profits are going – great for going deeper into your business’ financial health.

In FreshBooks, categories can easily be set whenever you log a new expense. So how do you set up these categories?

  1. In your FreshBooks account, go to the Expenses tab
  2. Click on New Expense
  3. When the Expense form pops up, click on Choose a Category
  4. Choose the appropriate Category from the dropdown, (your receipts will appear color-coded based on chosen category)
  5. Log the rest of your expense

Set Up Expense Categories in an Organized Fashion

While it’s a good idea to break up your expenses into separate accounts, be careful about setting up too many categories. If something is a small, one-time cost that doesn’t seem to fit the other categories, you are better off putting it into a catchall like Miscellaneous Expense or Other Expense rather than setting up more categories. Too many classes can make your Profit and Loss Report unwieldy. I once worked with a business owner who created separate expense subcategories for every vendor he paid, no matter how small the payment. His profit and loss statement was four pages long! Remember, if you really need that level of detail, you can always run a report by vendor.

Remember, to keep documentation for all of your business expenses, regardless of the amount. If you are ever audited, it is your responsibility to substantiate all of the entries and deductions on your tax return. Entries in your small business bookkeeping software and even bank statements are not enough. You should maintain receipts and other records to document your business’ purchases and sales

Generally, the IRS requires that you keep records to support your income and deductions for three years from the date you filed your return. However, they can extend the statute of limitations to seven years if they believe you did not report all of the income you should have reported and your unreported income is more than 25% of the gross income shown on your return.

This is from the FreshBooks archive and was originally published in March 2016.

about the author

Freelance Contributor Janet Berry-Johnson is a CPA and a freelance writer with a background in accounting and insurance. Her writing has appeared in Forbes, Parachute by Mapquest, Capitalist Review, Guyvorce, BonBon Break and Kard Talk. Janet lives in Arizona with her husband and son and their rescue dog, Dexter. Outside of work and family time, she enjoys cooking, reading historical fiction and binge-watching Real Housewives.