How to categorize expenses for small business
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Key takeaways
- You can maximize your tax deductions and reduce tax time stress by categorizing expenses for small business
- Understanding the tax deductions you qualify for will help you identify the types of expenses to track
- Accounting software can automate the most time-consuming parts of the categorization process
Every small business owner knows you need to spend money to make money. Especially on a tight budget, using your funds strategically can help maximize your returns.
To truly make the most of every purchase, it’s crucial to categorize each expense for your small business. This involves grouping similar business costs together in your accounting software and financial documents. Keeping your records organized helps you prepare for tax season. Discover the benefits of categorizing your small business expenses and five tips to put it into practice.
Why categorize your small business expenses?
Every small business owner is familiar with the process of tracking expenses—a basic bookkeeping task. While recording every expense is helpful, categorizing them can make your books even more efficient and cost-effective.
More tax deductions
As a small business owner, you can write off relevant business expenses when filing your personal or business tax return. Depending on your business structure—e.g., sole proprietorship or LLC—the IRS allows you to deduct most business expenses considered “ordinary and necessary” for your business and industry, such as rent, advertising costs, or home office expenses like office furniture and printer ink.
This process can be complicated, so it pays to stay organized. If you’re claiming tax-deductible expenses, the IRS might require you to fill out separate forms. On a Schedule C—which many small business owners use for most deductions—expenses must also be separated into categories like advertising and wages.
If you categorize as you spend, you can get as many write-offs as possible and save time when tax time rolls around.
Faster tax filing
Filing taxes as a small business owner can be time consuming and expensive. But when you categorize expenses for small business regularly, filing taxes takes far less time and money. Whether you’re filing yourself or outsourcing to a tax prep business, categorizing expenses beforehand allows you or your accountant to simply plug in the numbers, reducing the amount of time it takes to complete the proper tax forms.
Plus, your records will clearly match your actual expenses. This provides even more peace of mind: If the IRS audits your business, you can use your records to back up your claims.
Better insight into your financial health
The benefits of categorization extend beyond tax season. Organizing your expenses also helps you stay on top of your small business’ financial health.
For example, noting details about expenses on your profit and loss statements helps you keep track of your cash flow. By breaking down your expenses into categories, you can quickly identify unnecessary costs or expenses that aren’t meeting ideal returns. As you review your statements throughout the year, this system can help you make more informed budgeting decisions.
How to categorize expenses for small business
Learning how to categorize expenses for small business can help you during tax time and year round. Here are five steps that make the process as easy as possible.
1. Separate business and personal expenses
When you make a purchase or payment for your business, you should use separate payment and record-keeping methods if possible. This saves you the step of sorting out purchases for business use and personal use. Not only will this reduce time and effort in tax season, but it will also help maintain accuracy when you’re claiming deductions on your tax forms.
If you operate as an LLC or corporation, you’re legally required to keep your personal and business bank accounts or credit cards separate. While sole proprietors are not required to do so, it’s a good practice anyway.
2. Identify your tax-deductible expenses
For certain business structures, the IRS allows you to deduct “ordinary and necessary” business expenses from your taxes—but this category varies greatly between businesses. For example, airfare is a common business travel expense for luxury travel bloggers, while local HVAC businesses are more likely to take gas deductions using the standard mileage rate.
Chat with a tax professional to identify the deductible expense categories you qualify for and should use to organize your expenses throughout the year. Many business owners qualify for the following small business tax deduction categories:
- Advertising, such as Yelp Ads and social media ads
- Contract labor
- Legal and professional services, such as CPA fees
- Business loan interest
- Taxes and licenses, such as payroll taxes and state income taxes
- Home office costs, such as including mortgage interest and repairs
- Office expenses, such as including office supplies and postage
- Utilities, such as business phone expenses
- Health insurance premiums for employees
3. Group your key business expense categories
Once you’ve identified the deductions you qualify for, start sorting your most common expenses into deductible categories.
However, not all your purchases will fit into tax-deductible categories. For example, if you pay for membership dues for a social or recreational club—such as a hotel or airline club for frequent travelers—you cannot deduct these dues, even if you joined for a clear business purpose.
Once you’ve sorted out your deductible expenses into categories of their own, take a look at what’s left and see if you can bundle any common costs together into new categories. Just avoid making categories that only contain one or two types of expenses. A general “memberships” category will tidy up your books without being redundant (as creating separate categories for each social club you’re involved in would be). Categorizing your non-deductible expenses will help you identify where you’re spending the most money so you can make smarter business decisions.
4. Sort expenses faster with accounting software
Once you finalize your expense categories, consider investing in small business accounting software to simplify the sorting process.
Platforms like QuickBooks, Wave, Xero, or Zoho Books can connect directly to your business bank and credit card accounts to instantly log your expenses. Once you plug your categories into the platform, you can also sort each purchase as you’re reviewing your expenses every week or month. For recurring expenses, some platforms can even sort for you.
What’s more, once your purchases are categorized, some accounting software can automatically generate financial reports, including your profit and loss statements.
5. Categorize your receipts
As you start categorizing your expenses, don’t forget to sort your receipts into the same categories—particularly the tax-deductible ones. When you write off business expenses, the IRS requires you to keep the receipts, contracts, bills, and other relevant records for at least three years in case of an audit.
Before you panic about paperwork, small business owners can use receipt scanner apps to avoid keeping years’ worth of paper records. Select an app that integrates with your accounting software and cell phone—for example, Minute7 and Neat integrate with QuickBooks.
Keep your expenses organized
Categorizing expenses for small business can help you fly through every tax season and make better decisions for your brand’s financial health. Once you identify the tax-deductible categories you qualify for—as well as buckets for any remaining costs—you can use accounting software to automate most of the process.
Want to continue managing your finances with ease? Read our nine tips for successful small business accounting.
The information above is provided for educational and informational purposes only. It is not intended to be a substitute for professional advice and may not be suitable for your circumstances. Unless stated otherwise, references to third-party links, services, or products do not constitute endorsement by Yelp.
