There are several types of expenses relevant to small businesses, and it’s important for any business owner to fully understand the distinctions between them. Almost all types of expenses reduce your overall profit, but if your business is taxed as an S-Corp or C-Corp, some may also be deductible from business income taxes. If you’re self-employed (or own an LLC with pass-through tax status), many of these expenses can be deducted from your personal income taxes on Schedule C.
Business expenses can be deducted from your taxes. Cost of goods sold (COGS) expenses are not deductible, but directly reduce gross receipts to gross profit. You also cannot deduct capital expenditures; they are costs that become the assets of your business. Personal expenses generally cannot be deducted unless a portion of the expense is used for business purposes. There are also several other categories of business expenses, most of which can be deducted from corporate or business taxes.
Business expenses that can be deducted must be both ordinary and necessary, according to the IRS. Ordinary expenses are defined as those that are common and accepted in your particular business. Necessary expenses are those considered useful and appropriate for your particular business. Therefore, the IRS offers a fairly wide margin for what is considered an acceptable business expense. If you’re ever unsure about a specific expense, find a legitimate business purpose for spending the money. If you can make a convincing case that the expense is “ordinary and necessary,” write it on the receipt or on file in case you are ever asked about it years later.
Any company that buys products for resale or manufactures them will need to calculate an accurate Cost of Goods Sold (COGS). COGS are deducted from gross receipts to find gross profit. That is, gross profit (before business expenses are deducted) equals your total sales minus the total cost of goods sold. It is important to keep COGS expenses and business expenses separate. COGS generally include four categories:
- Cost of raw materials or inventory, including freight charges
- storage cost
- Direct labor cost, including pension contributions for any employees working to produce the product…not sales staff
- Manufacturing/Factory Overhead Running Costs
These expenses are related to gross profit only and cannot be deducted again with business expenses. Make sure your accounting system is set up to correctly classify COGS expenses and business expenses.
Capital expenditures include startup costs, asset costs, and any improvement costs. Instead of deducting these expenses, they are capitalized, thus becoming business assets. Some upfront costs can be deducted or written off, but those details are for another day. Personal expenses, such as household or family expenses, are generally not deductible unless the expense is used in part for business. In these cases, the expenses are divided into personal and business percentages, and the amount equal to the business percentage can be deducted. The same method applies to deductions for using your home or car for business purposes: the percentage of use for each must be calculated, and only the amount used specifically for business can be deducted.
Other common expenses that may be deductible from your business taxes include employee wages, the cost of rented space for the business, interest on loans, insurance costs, and any taxes paid at the local, state, or federal level. . In general, all of these are included in the basic definition of business expenses. Of course, there are other legitimate, deductible business expenses…remember, anything that is an ordinary cost necessary for doing business! Understanding the different types of expenses is important. As a business owner, you need to know the numbers inside and out, how to keep your accounting system accurate, and how each type of expense affects your bottom line.