What are Allowable Business Expenses?

Today, we’re going back to the basics—back to defining simple accounting terms, in this case. Why? Because capable business owners should be able to talk about accounting, tax, and finance with a high degree of precision. That means knowing what words mean—exactly what they mean. When you do; people notice. So, what are allowable business expenses? 

Take a few minutes with me today, and we’ll cut out that lag time.

First, let’s define a tax-deductible business expense.

Tax deductions reduce tax liability because they reduce your business’s gross taxable income: you keep income that otherwise would have been taxed.

Allowable expenses are a class of tax-deductible business expenses. They are directly related to business operations. Now, does that mean all operational costs are tax-deductible? No, of course not.

So, we have a definition: Allowable business expenses are a defined set of operational costs that the Internal Revenue Service (IRS) has allowed businesses to deduct from their gross taxable income.

Now, let’s look at the two magic words that turn an operational cost into an allowable business expense.

Allowable business expenses must be “ordinary and necessary.”

According to the Internal Revenue Service (IRS), deductible business expenses are divided into two main categories: “ordinary” and “necessary.”¹

Ordinary? Necessary? Let’s get specific.

An ordinary expense is common and accepted in your industry.

Industry-specific business expenses can vary widely, and what’s appropriate for one company isn’t for another. For example:

• Software subscriptions and online tools would be appropriate for a digital marketing firm.
• Food and kitchen equipment would be typical for a restaurant.
• Heavy machinery and building materials would be expected for a construction company.

A necessary expense is helpful and appropriate for your trade or business.

However, “necessary” does not mean “indispensable.” That marketing consultant you’re thinking of hiring? If they’re going to boost your business’s reach, they’re considered a necessary expense, even if your business could survive without them.

And here is where the confusion lies for a lot of people:

Any business expense that plays a role in keeping your business afloat and bringing in revenue should be at least partially deductible. That said, a lot of individuals who run businesses miss out on the tax breaks because the complexity is overwhelming.

Let’s delve into the specifics of deductible expenses so that you don’t become a statistic.

The three umbrella tax deduction categories are direct expenses, indirect expenses, and interest on debt.

Direct expenses are the costs that go directly into the product or service you’re selling.

For direct expenses, the clearer and more specific you are about these expenses, the more tax deductions you can claim.

• Direct expenses are costs directly related to providing a service or product.
• Materials like wood, nails, and paint are direct expenses.
• Software, materials, and contract labor are also direct expenses.

Remember that the IRS classifies these costs under “Cost of Goods Sold.”²

Indirect expenses are your overhead costs.

Costs not directly associated with the production of goods or services include payroll and tax preparation fees, office space costs such as office expenses, mortgage interest, property taxes, utilities, insurance, and other costs related to day-to-day business activities.

Interest on debt is tax deductible.

Whether it’s a loan to kickstart your venture, the mortgage for the property, or a credit card for unforeseen expenses, the interest paid on these borrowed funds used for business purposes can be subtracted from your business income.

What’s in Your Deductible Toolbox?

Armed with knowledge, let’s explore the essentials you need to track for tax time:

• Advertising and marketing expenses.
• Business property expenses such as mortgage interest, taxes, and maintenance costs.
• Business travel expenses like flights and hotel stays.³
• Employee salaries and benefits, including perks like business meals and holiday parties.⁴
• Office supplies from computers to paper clips.⁵
• Home office expenses may be deductible if it’s the primary place of your business.⁶
• Professional services include accountants, lawyers, and consultants.⁷
• Tools of the trade include the essential equipment and resources necessary for a particular profession.
• Utilities and services such as internet expenses, water, and power.

This list just scratches the surface. Understanding these categories and keeping meticulous records can streamline business tax filing and strategic financial planning.

Not all business-related expenses are fully deductible.

Some expenses are only partially deductible.

• Business meals can only be deducted 50%.⁸
• Home office deductions are based on the percentage of your home used exclusively for business.⁹
• Business use of your vehicle is deducted from the mileage and expenses associated with using the car for business purposes.¹⁰
• Capital expenses must be capitalized and depreciated over the life of the asset.
• Entertainment expense deductions are frequently abused, so post-2018 tax law changes have eliminated most of them, even if they’re business-related.¹¹ However, there are nuances and exceptions, such as events for employees’ benefit, that may still offer partial deductions.

Other expenses are non-deductible.

Childcare is not an allowable expense, even if you work from home. Entertainment expenses that are not directly linked to company culture or leadership activities don’t make the cut. Even many commuting expenses, outside of mileage accumulated for standard business activities, fall outside the realm of allowable business expenses.

Professional and social clubs present lucrative opportunities for networking and lead generation, but club dues are not allowable business expenses.

Now, are there gray areas? Absolutely. That’s where I come in.

Yes, even the simple stuff is complicated.

Schedule a discovery call today, and let’s get a plan together to save you taxes and grow your business.

Talk soon,
Jeremy A. Johnson, CPA

References

1. Guide to Business Expense Resources | Internal Revenue Service [Internet]. www.irs.gov. Available from: https://www.irs.gov/forms-pubs/guide-to-business-expense-resources.
2. Department of the Treasury Internal Revenue Service Get forms and other information faster and easier at: Tax Guide for Small Business For use in preparing 2016 Returns [Internet]. 2017. Available from: https://www.irs.gov/pub/irs-pdf/p334.pdf. 
3. Topic No. 511 Business Travel Expenses | Internal Revenue Service [Internet]. Irs.gov. 2019. Available from: https://www.irs.gov/taxtopics/tc511 
4. Publication 15-A Employer’s Supplemental Tax Guide [Internet]. 2017. Available from: https://www.irs.gov/pub/irs-pdf/p15a.pdf 
5. Publication 535 [Internet]. https://www.irs.gov/. 2023 [cited 2024 Jan 8]. Available from: https://www.irs.gov/pub/irs-prior/p535–2022.pdf. 
6. Topic No. 509 Business Use of Home | Internal Revenue Service [Internet]. www.irs.gov. Available from: https://www.irs.gov/taxtopics/tc509.
7. Publication 15-A Employer’s Supplemental Tax Guide [Internet]. 2017. Available from: https://www.irs.gov/pub/irs-pdf/p15a.pdf 
8. Publication 463 Travel, Gift, and Car Expenses [Internet]. Available from: https://www.irs.gov/pub/irs-pdf/p463.pdf.
9. Publication 587 Business Use of Your Home (Including Use by Daycare Providers) [Internet]. Available from: https://www.irs.gov/pub/irs-pdf/p587.pdf 
10. Publication 463 Travel, Gift, and Car Expenses [Internet]. 2024 Feb. Available from: https://www.irs.gov/pub/irs-pdf/p463.pdf. 
11. Federal Register: Request Access [Internet]. unblock.federalregister.gov. Available from: https://www.federalregister.gov/documents/2020/10/09/2020-21990/meals-and-entertainment-expenses-under-section-274