'Ordinary and necessary' expenses for your business are generally tax-deductible
Every business incurs expenses. Independent contractors, consultants, and freelancers pay for software, computers, or travel out of their own pocket to make their jobs easier. For incorporated businesses, being able to deduct expenses will reduce their business taxes. For sole proprietors, being able to deduct expenses reduces both the regular income tax and the self-employment tax. The bottom line?
Keeping track of all your business expenses will go a long way to reducing your tax liabilities.
What's a Legitimate Business Expense?
The basic definition is that an expense must be "ordinary and necessary" for your trade or profession. That definition comes straight out of the tax code (Internal Revenue Code section 162; see also the Treasury Regulations section 1.162-1). "An ordinary expense," the IRS says in Publication 535, Business Expenses, "is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business."
We make five distinctions when analyzing expenses. We separate personal expenses from business expenses. We separate business expenses into three broad types: cost of goods sold, capital expenditures, and deductible expenditures. Some expenses might be only partially deductible or not deductible at all. Thus, the five distinctions are:
- Personal expenses
- Business expenses
- Cost of goods sold
- Capital expenses
- Deductible expenses
Separating Personal from Business Expenses
Problems arise when an expense might be partly personal and partly business-related. A common example: a freelancer might use one room in her house as an office. In this situation, we would measure the square footage of the office and of the whole house, and find the percentage.
This percentage would then be used to measure the business portion of shared expenses such as rent, insurance, and utilities. The business portion of these expenses would become part of the home office deduction, while the rest of the expenses would be personal in nature.
The general rule: "Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part" (IRS, Publication 535, Business Expenses, section on personal versus business expenses).
Bookkeeping tip: keep track of all your expenses. That way you can review your expenses and ask your accountant if any of them might be tax-deductible.
Cost of Goods Sold
Cost of goods sold are expenses for inventory and things related to inventory. Manufacturers, wholesalers, and retailers track the cost of the products they produce or purchase for resale.
The general rule: "If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold.
Some of your business expenses may be included in figuring cost of goods sold" (IRS, Publication 535, Business Expenses, section on cost of goods sold).
For detailed explanations, see Publication 334, Tax Guide for Small Business, chapter 6, How to Figure Cost of Goods Sold. See also the inventories section of Publication 538, Accounting Periods and Methods.
Some expenses are recorded as assets and their costs recovered over time through depreciation. Such expenses are called capital assets because their costs are capitalized as assets of the business and the cost is deducted over a period of time through depreciation. Examples of capital expenses include computers, furniture, equipment, and real estate.
The general rule: "you must capitalize three types of costs: business start-up costs, business assets, and improvements." (Publication 535).
Keeping Track of Business Expenses
Personally, I use a full-featured accounting software to track my income and expenses. But then again I'm an accountant and feel comfortable using software such as Quickbooks, Sage Peachtree, and Microsoft Office Accounting. I highly recommend these programs to small businesses. Using a full-featured accounting software will help you monitor the health of your company.
Full-featured accounting programs can take a while to get used to. And it's easy to get frustrated with all the features and utilities. So for freelance professionals, I recommend using personal finance software. The top choices here are Intuit's Quicken or Microsoft Money. Both programs are very easy to get used to and can track all of your finances, not just your business expenses.
As an added bonus, the better tax software programs allows you to import data from Quicken or Money. To make your tax preparation process as smooth as possible, I suggest spending some time making sure your expense categories are set up properly. You can add, delete, and modify categories in all personal finance and accounting software. By having intuitive, easy to remember categories, you'll be able to generate meaningful reports. And most programs will let you link the categories to particular line items on the tax forms. Setting this up can go a long way to reducing the amount of time you spend preparing your taxes.
All the accounting programs I mentioned can generate profit and loss reports (called income statements by accountants). These reports help you analyze how your freelance business is doing, whether you are profitable, and how you are spending your money. If you decide to hire a tax accountant, having these reports to greatly expedite the preparation of your tax returns.