Understanding Business Expenses and Which Are Tax Deductible

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.

Vikki Velasquez is a researcher and writer who has managed, coordinated, and directed various community and nonprofit organizations. She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area.

What Are Business Expenses?

Business expenses are costs incurred in the ordinary course of business. They are subtracted from revenue to arrive at a company’s taxable net income. Business expenses are also referred to as deductions.

Every business, from the consultant working from home, to the smallest corner store, to the largest corporation, has business expenses and tracks them throughout the year for tax purposes.

Business expenses are generally divided into two broad categories, capital expenditures and operational expenditures. That is, some expenses relate to major purchases made to improve a company's performance over the long term. Others relate to the spending necessary to run company operations from day to day.

Key Takeaways

• Business expenses are deductible and lower the amount of taxable income.
• The total of business expenses is subtracted from revenue to arrive at a business' total amount of taxable income.
• The IRS defines allowable business deductions as costs that are "ordinary and necessary" for the industry in which the business operates.
• The main deductible categories are direct expenses, indirect expenses, and interest on debt.
• Non-deductible expenses include bribes, kickbacks, fines, and political contributions.

Understanding Business Expenses

Section 162 of the Internal Revenue Code (IRC) details the guidelines for business expenses. The IRC allows businesses to report any expense that may be ordinary and necessary.

Business expenses need not be required to be considered ordinary or necessary. Generally, ordinary means that the expense is common in the industry and most business owners in the same line of business or trade would normally incur them. Necessary means that the expenses are appropriate and a business owner might not be able to manage without making the expenditure.

An expense that meets the definition of ordinary and necessary for business purposes can be expensed and, therefore, is tax-deductible.

Some business expenses may be fully deductible while others are only partially deductible.

Below are some examples of fully deductible expenses:

• Advertising and marketing expenses
• Processing fees from business and corporate credit cards
• Education and training expenses for employees
• Certain legal fees
• License and regulatory fees
• Wages paid to contract employees
• Employee benefits programs
• Equipment rentals
• Insurance costs
• Interest paid
• Office expenses and supplies
• Maintenance and repair costs
• Office lease costs
• Utility expenses

How Expenses Are Recorded

The income statement is the primary financial statement used by businesses to record their expenses and determine their taxes. Most have three categories of expenses, broken down by direct costs, indirect costs, and interest.

Direct Costs

The value of inventory on hand at the beginning and the end of each tax year is used in determining the cost of goods sold (COGS), which is a large direct expense for many companies.

COGS is deducted from an entity’s total revenue to determine gross profit for the year. Any expenses included in COGS cannot be deducted again. Expenses that are included in calculating COGS may include direct labor costs, factory overhead, storage, costs of products, and costs of raw materials.

Indirect Costs

Indirect costs are subtracted from gross profit to identify operating profit. Typical indirect costs include executive compensation, general expenses, depreciation, and marketing costs.

Subtracting indirect costs from gross profit results in operating profit, which is also known as earnings before interest and tax.

Depreciation

Expensing of business assets is usually done by depreciation. Depreciation is a tax-deductible expense on the income statement and is classified as an indirect expense.

Depreciation expenses can be deducted over a number of years. They typically include the costs of computers, furniture, property, equipment, trucks, and more.

Gifts, Meals, and Entertainment Costs

The IRS places limits on costs associated with gifts, meals, and entertainment. For example, you can usually deduct 50% of the cost of providing meals to employees, although certain meals may be fully deducted.

Interest Expenses

The last section of the income statement details expenses for interest and tax. Interest is the last expense a company subtracts to arrive at its taxable income, sometimes called adjusted taxable income.

Personal Expenses

In some cases, expenses incurred by a business owner may be both personal and business-related. For example, a small business owner might use the same car for personal purposes and business-related activities.

In this case, the portion of miles used for business purposes can be deducted. In the case of home offices, costs associated with the portion of the home that is exclusively used for business are generally deductible.

Non-Deductible Expenses

Some expenses incurred by a business are not deductible. These expenses include bribes and kickbacks, lobbying costs, penalties, fines, and contributions made to political parties or candidates, among others.

What Is an Ordinary and Necessary Business Expense?

This is how the IRS describes the type of expense that a business can properly deduct. Generally, "ordinary" means normal and widespread in the industry. "Necessary" means appropriate and useful, while falling short of absolutely essential.

What Is Not a Deductible Business Expense?

Any expense that has a personal benefit rather than a business benefit is non-deductible.

Granted, this can be a gray area. If you go to Los Angeles for business purposes and spend a day at Disneyland while there, your tickets to the park are not deductible. Your flight to and from L.A. should be deductible, as long as you're ready to prove that you spent most of your time there doing business.

Can I Deduct My Car if I Use It for My LLC?

If you use a car entirely for business purposes, you can deduct the related expenses.

If you use a car for both business and personal trips, only the costs related to its business use are deductible. That means keeping receipts and a careful log of mileage and other costs associated with the vehicle.

The Bottom Line

The key to business tax reporting and business expense deductibility is that expenses are "ordinary and necessary." That's the phrase the IRS uses to describe the costs of doing business. Those costs are deducted from income in order to arrive at taxable income for the period being reported.

1. Office of the Law Revision Counsel, United States Code. "26 USC 162: Trade or Business Expenses."
2. Internal Revenue Service. "Tax Guide for Small Business: Chapter 8 Business Expenses," Page 30.
3. Internal Revenue Service. "Tax Guide for Small Business: Chapter 8 Business Expenses," Page 38.
4. Internal Revenue Service. "Tax Guide for Small Business: Chapter 6 How To Figure the Cost of Goods Sold," Pages 27-29.
5. Accounting Tools. "Operating Profit Definition."
6. Internal Revenue Service. "Topic No. 704, Depreciation."
7. Internal Revenue Service. "Publication 463, Travel, Gift, and Car Expenses," Pages 10-12.
8. Internal Revenue Service. "Tax Guide for Small Business: Chapter 8 Business Expenses," Pages 37-38.
9. Internal Revenue Service. "Tax Guide for Small Business: Chapter 8 Business Expenses," Pages 31-32.
10. Internal Revenue Service. "Tax Guide for Small Business: Chapter 8 Business Expenses," Pages 38-39.

The Smith Maneuver is a Canadian tax strategy that makes interest on a residential mortgage tax-deductible. Borrowers need a readvanceable mortgage to use it.

The general business credit is the total value of the separate business tax credits a business claims on its tax return for a specific year.

Section 1031 of the U.S. tax code permits a business to postpone taxes on gains from the sale of business property when the proceeds are invested in other property.

A qualified higher education expense is a tax credit for the parents of students attending a college or other post-secondary institution.

A tax deduction reduces your taxable income and how much tax you owe. You can itemize your deductions or take a fixed amount with the standard deduction.

For tax purposes, a deductible is an expense that can be subtracted from adjusted gross income in order to reduce the total amount of taxes owed.

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