DEFINITION of Business Expenses
Business expenses are any costs incurred in the ordinary course of business. Business expenses are deductible and are always netted against business income.
BREAKING DOWN Business Expenses
Section 162 of the Internal Revenue Code (IRC) defines a business expense as any expense that is “ordinary and necessary” when running a business or trade. Ordinary means that most business owners in the same line of business or trade commonly pay for these things. Necessary means that the expenses help in doing business, are appropriate, and a business owner might not be able to handle the business if s/he did not make the expenditure. An expense that meets the definition of ordinary and necessary for business purposes is tax deductible under Section 162 of the IRC. While some business expenses are fully deductible, others are partially deductible, that is, only a percentage of the cost can be claimed. Below are some examples of allowable fully deductible expenses:
- Accounting or bank fees
- Membership dues
- Subscriptions to publications
- Marketing and advertising expenses
- Continuing education and training costs
- Wages paid to contract employees
- Employee benefit programs
- Equipment rentals
- Insurance costs
- Interest paid
- Laundry charges
- Office expenses and supplies
- Maintenance and repair costs
- Rent on office space
- Utility expenses
- Printing and copying expenses
- Legal fees
The Internal Revenue Service (IRS) advises that a business expense be separated from expenses used to figure Cost of Goods Sold (COGS); personal expenses and; capital expenses.
Cost of Goods Sold
The value of inventory on-hand at the beginning and the end of each tax year is used to determine the COGS, which is deducted from the entity’s total revenue to find the gross profit for the year. Any expenses included in COGS cannot be deducted again as a business expense. Expenses that are included in calculating COGS include direct labor costs; factory overhead; storage and; costs of products or raw materials.
In many cases, an expense incurred by a business owner is both personal and business related. For example, a small business owner might use his car for both 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, only costs associated with the portion of the home that is exclusively used for business are deductible. The business portion of these expenses would be included in the home office deduction, which involves measuring the square footage of the office space and of the whole house, and finding the percentage.
Capital expenses, which are recognized as business assets, must be capitalized, rather than deducted. These expenses are deducted over a number of years through depreciation, and include costs of computers, furniture, property, equipment, trucks, etc. According to the IRS, the three types of costs that must be capitalized are business start-up costs, business assets, and improvements.
A capital asset that is used for both business and personal purposes is known as a listed property. If a listed property is used primarily for business reasons, then it is subject to the statutory percentage depreciation method, as it will be considered a business asset in this case. Listed property that is used for business only half the time at most can still have depreciation on the business use percentage claimed, but it must be depreciated under the straight-line method.
Gifts, Meals, and Entertainment Costs
A business that made a gift to its client can only deduct the value of this gift up to $25, as gifts are only partially deductible. However, not all "gifts" are considered gifts for tax purposes. Gifts made to employees are usually fully deductible, and money spent on meals and entertainment can be claimed as a gift expense to increase the deduction amount. Meals and entertainment expenses are business costs that are deductible up to 50 percent of the cost.
Some expenses incurred by a business are not tax deductible even though they may be considered an ordinary cost of running a business. These expenses include bribes, lobbying costs, penalties and fines, and contributions made to political parties or candidates.
Although it is not necessary to include receipts for business expenses when you file your tax return, many tax preparers will ask for detailed, itemized copies of your expenses before they will submit the return. Business owners should keep these kinds of records for a minimum of seven to 10 years from the date of filing.