Definition of Business Expenses
Business expenses are costs incurred in the ordinary course of business. They can apply to small entities or large corporations. Business expenses are part of the income statement. On the income statement, business expenses are subtracted from revenue to arrive at a company’s taxable net income. Business expenses may also be referred to as deductions. In general, companies have some limitations and special considerations for business expense deductions. They are generally divided into capital expenditures and operational expenditures.
Breaking Down Business Expenses
Section 162 of the Internal Revenue Code (IRC) discusses 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 potentially expense 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 expensable and therefore tax deductible. Some business expenses may be fully deductible while others are only partially deductible. Below are some examples of allowable, fully deductible expenses:
- Advertising and marketing expenses
- Credit card processing fees
- 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
- Utility expenses
Income Statement Reporting
The income statement is the primary financial statement used by entities to record their expenses and determine their taxes. Entities will typically have three categories of expenses which are broken down by direct costs, indirect costs, and interest on the income statement.
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 find the 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 are subtracted from gross profit to identify operating profit. Indirect costs typically include things like 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.
Expensing of business assets is usually done by deprecation. Depreciation is a tax deductible expense on the income statement that is classified as an indirect expense. Depreciation expenses can be deducted over a number of years and include costs of computers, furniture, property, equipment, trucks, and more.
Gifts, Meals, and Entertainment Costs
There are several costs that the IRS has some restrictions on, primarily costs associated with gifts, meals, and entertainment. Generally, you can deduct only 50% of the cost of providing meals to employees, although certain means may be fully deducted.
The last section of the income statement involves expenses for interest and tax. Interest is the last expense a company subtracts to arrive at its taxable income, sometimes called adjusted taxable income.
In some cases, expenses incurred by a business owner may be 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, costs associated with the portion of the home that is exclusively used for business are generally deductible.
Some expenses incurred by a business are not reportable. These expenses include bribes, lobbying costs, penalties, fines, and contributions made to political parties or candidates.