Think of the supplies you buy for your business and the bills you pay. If you have employees, you have their salaries to pay and employer tax deposits to make. Some of your expenses could be daily, others weekly, and still others monthly. You also have quarterly bills like tax deposits, and annual expenses, which can include business insurance and bonding.
How do you decide how to set up small business expense categories? Most of us know how to balance a checkbook, but far fewer people know how to prepare a financial statement. Deciding how to categorize expenses for small business operations will help you understand how much you'll owe in business taxes at the end of the year. It can also help you manage your business and plan for the future.
First, you should categorize your business expenses based on what you actually spend and what you spend it on. Then, you should decide which ones fit in your small business tax expense categories. You can use small business accounting programs to do this, and most of them help you to determine how to decide when you set the programs up.
Categorizing business expenses will help you at tax time. It will also help you to manage your business, especially determining performance metrics. If you've ever seen a restaurant makeover or business rescue show, you've witnessed business owners who often don't know important financial performance metrics for their business, like how much it costs to put a meal on the table for customers.
How can categorizing business expenses help my small business?
Sometimes small businesses that get in financial trouble don't know the basics they need to make day-to-day or longer term financial choices. Restaurant owners may not know how much it costs them to open the doors of their restaurant each day. A business that manufactures cosmetics might not know how much it costs them to make and ship various products.
One way managers refer to these basic cost figures is "financial performance metrics." Categorizing business expenses in a way that makes sense to you will let you identify the performance metrics that are important for your business. Once you've identified the expense categories that contribute most to your performance metrics, you can make changes to achieve and improve your financial performance.
One business metric that every business that sells things should know is Cost of Goods Sold (COGS). Businesses that provide services have a Cost of Service (COS) metric. Another key metric is profit margin. No matter whether your business sells goods or provides services, you should also know your gross and net profit margins.
Your gross profit margin is the basic amount of profit you make after you pay all of your expenses. The net profit margin is the amount of money you have left over after you pay taxes.
Categorizing expenses helps you understand how your business operates
Every business has some expenses that are the same every month, while others vary. These are called "fixed" and "variable" expenses.
Fixed expenses often include:
- Rent or business mortgage payments
- Equipment leases
- Business insurance
- Employee benefits, including insurance premiums
- General liability insurance
- Salaries (for monthly, qualified employees)
Variable expenses include:
- Transportation and fuel
- Phone and internet
- Hourly wages for employees
- Inventory (items purchased for resale)
- Employee bonuses and incentives
The majority of business expenses are tax deductible. However, some, like some types of meals and entertainment, are non deductible expenses, or are only partially deductible. For example, if you take employees or clients out to lunch for a business meeting, 50% of the lunch expense is deductible. If you eat out with your family, none of the meal will be a deductible expense. If you provide a "promotional meal," which is intended to advertise your business — for example, serving hot dogs at a community event — then you can deduct the cost of the promotion. Advertising and marketing expenses are 100% tax deductible.
What about capital expenses?
You will also have one-time or occasional expenses, also called capital expenses.
If you need to buy equipment or vehicles, these are capital expenses. You record capital expenses when you make them. You can depreciate these expenses over time, or you can take a one-time tax deduction based on your capital purchases. You should categorize these separately when accounting for your business expenses. For example, if you buy a delivery van and include it under regular, ongoing "transportation expenses," it could throw off your budgeting of monthly gasoline and vehicle insurance costs.
How do you calculate cost of goods sold if you don't sell products?
Does your business provide a service instead of selling retail items, food, or wholesale goods? You still have a cost of goods sold (COGS) or cost of services (COS).
Everything you must spend to keep your business running fits in the COGS or COS category. You'll find that bookkeeping and accounting software helps you to categorize your expenses as COS or COGS. Any expense that you must make to stay in business and sell your goods or services is considered either COGS or COS and is tax-deductible — within IRS guidelines.
How can we tell how to categorize expenses for tax purposes?
IRS Publication 535 explains the business expense categories for taxes for incorporated businesses. IRS Publication 334 gives self-employed people instructions on which expenses can be deducted on Schedule C. Self employed expenses have similar tax rules to the rules that apply to larger businesses with employees.
The primary difference between the two tax filing categories lies in the area of multi-year tax rules and types of accounting. For example, many larger businesses use the accrual method of accounting. Federal law specifies that if your business has more than $5 million in annual revenue, you must use the accrual method of accounting. With less than $5 million, cash accounting is acceptable and most common among smaller businesses. Cash accounting means you categorize your expenses and account for the money and inventory you have on a cash basis, while accrual accounting recognizes future income like unpaid invoices and future expenses, like multi-year leases.
What are common small business tax deductions?
No matter which accounting method you choose, some expenses are always tax deductible. For example, almost all businesses need to buy supplies, which are among the most common small business tax deductions. If you purchase supplies or equipment, the sales tax you pay is also deductible.
Premiums for Insurance that you need to protect your business are tax deductible, including general business insurance, general liability insurance, and bonding. Going without insurance not only puts your business at risk, you can be certain you'll reduce your tax liability by obtaining the insurance coverage you need and categorizing it as part of your cost of goods sold (COGS) or cost of services (COS) when it comes time to file your taxes.