It takes money to run a business. Throughout the year, businesses spend on a variety of goods and services that help keep their operations running smoothly and hitting their growth goals.
These costs are recorded in an income statement (or profit & loss statement), indicating whether the business is profitable.
But beyond that, these costs can save you money on your tax bill. That is, they will be if they fall under the definition of allowable expenses.
Read on for what you need to know to tack your costs with confidence.
What are allowable expenses?
Allowable expenses refer to any costs incurred purely for business purposes.
Typically, these costs are tax deductible. This means that, as part of the tax filing process, you can claim tax deductions on allowable expenses and reduce your reported taxable income.
For a business expense to be classified as an allowable expense, it needs to be used “wholly and exclusively” for business purposes. If an expense isn’t solely for business purposes, an adjustment must be made such that you’re only reporting the business portion.
A prime example of split expenses is home office expenses. Based on the home office adjustment, only a portion of expenses like internet and electricity bills can be allocated to the business as an allowable expense.
What makes an expense “allowable”?
The IRS has strict regulations on what can be considered an allowable business expense. To be reported as a business expense, the transaction must meet the following criteria.
The expense must be ordinary
Ordinary is defined as appropriate for the industry the business participates in.
What’s appropriate for one industry isn’t necessarily appropriate for another. Kitchen equipment makes sense for a bakery, but it wouldn’t make sense for an accountant.
When thinking about whether an expense is ordinary, think about whether your competitors are also spending money on this good or service. Consider reaching out to connections in the industry for clarification if needed.
The expense must be necessary
Expenses are necessary if they contribute to the development or continuation of the business’s operations.
Necessary expenses can be further broken down into direct and indirect costs:
- Direct costs are expenses that are directly related to selling the good or service
- Indirect costs are the supporting expenses (like rent and utilities) that keep the business operating or contributing to growth
The naming of “necessary” may give the notion that it’s something the business can’t go without, but it’s broader than that. For example, your business may not need a new marketing campaign. However, that marketing campaign contributes to revenue growth, thus meeting the criteria.
The expense must be wholly and exclusively for business
For an expense to qualify as allowable, it must be used solely for business purposes.
Many business owners use things like cell phone plans or a vehicle for both business and personal purposes. If that’s the case, then only the business portion can be reported as an allowable expense.
Calculating the business portion of a shared expense requires an adjustment or calculation. Take, for example, a personal vehicle. To report the business portion of its use, you’d need to track the mileage of business trips and adjust each cost incurred based on the percentage of usage that was for business purposes (alternatively, there’s the simplified standard mileage rate).
If the expense is solely for business purposes, no adjustments are necessary.
Examples of allowable expenses
To help define what’s considered an allowable expense, below is a list of common allowable expenses that are universal across industries:
- Staff costs: Any salaries, wages, or benefits paid to employees
- Office costs: Anything from paper clips to home office expenses (when adjusted) are acceptable
- Marketing and advertising: Costs pertaining to the promotion of a business, including anything from a billboard advertisement to providing free samples at a local event
- Professional fees: Amounts paid for professional services, like a lawyer or accountant
- Insurance premiums: Business-related insurance, like general liability or professional liability insurance
- Business use of a vehicle: The costs of operating a vehicle for business purposes, using either the actual cost or standard mileage method
- Training and education: Any classes, seminars, or workshops that relate to an aspect of the business, such as a sales workshop
- Staff uniforms: Branded apparel that is considered mandatory to wear on the job
- Payment processing fees: Fees charged to the business for the use of a payment processor
- Bank fees: Fees incurred on a business account, including account fees, overdraft fees, or transaction fees
- Interest on business debt: Any interest accrued on a business-owned credit account like a loan, line of credit, or credit card
Remember that allowable expenses vary by industry. While the above is a general overview, many more industry-specific allowable expenses will be unique to your business. When in doubt, talk to an accountant or financial professional for clarification.
Allowable expenses vs unallowable expenses
Allowable expenses are solely for business use (or adjusted for the business portion),, ordinary for the industry, a necessary part of the operations, and typically tax deductible. So what makes something unallowable?
So long as a transaction doesn’t meet one of those criteria, the expense is unallowable. Common examples of unallowable expenses include:
- Personal expenses
- Unadjusted expenses that have a personal and business benefit
- Purchases that are outside of a business’s industry-specific needs
- Purchases that do not contribute to the operations or revenue generation of the business
- Expenses that do not meet IRS standards for that category, like travel or education
Understanding allowable and unallowable expenses is a balancing act: you don’t want to leave tax deductions on the table, but you also don’t want to risk the costs of an audit. As always, consider working with an accountant, tax filing service, or financial professional to understand what’s best for your business.
Criteria for allowable expenses
For an expense to be allowable, it must pass the ordinary and necessary test. Let’s break this down into two separate parts.
Ordinary expenses are those that are common and accepted in your industry. What’s integral in this definition is that “ordinary” will vary business-by-business. Building supplies would be ordinary for a construction company, but the IRS would take another look if they showed up on the tax return of a law firm.
Necessary expenses are those that are conducive to the operations or growth of the business. Keep in mind, this doesn’t mean an expense has to be “needed” in order to be necessary.
Your sales team might not need a session with a sales coach, but the business benefits in the form of higher conversion rates and more sales. This meets the criteria of being necessary.
The additional criteria for allowable expenses is whether the expense is wholly for business purposes. If an expense has both a personal and professional use, it needs to be adjusted such that only the business portion is reported.
Clean record keeping and supporting documentation are essential in proving each of these criteria.
When reviewing your transactions, what you paid for or the purpose of the expense may not be immediately clear. But with an itemized receipt or invoice, you prove the purchase was an allowable expense based on what was purchased.
It’s also worthwhile to document the purpose on the receipt or invoice itself. In the prior example of the law firm purchasing building supplies, it’s possible that it was to repair damages to their property. Writing down that detail on the receipt or in the journal entry supports the expense as allowable.
Allowable expenses for different business structures
The types of allowable expenses are generally the same across different business structures. However, there are a few key details you should know before you start reporting your costs.
Allowable expenses for sole proprietorships and partnerships
Sole proprietorships are unique as the individual and the business are seen as the same, singular entity in the eyes of the IRS.
There isn’t a separate tax filing for the business. Instead, the owner reports their business income and expenses on Schedule C, which is attached to their tax return.
It’s similar for partnerships that report their share of the business’s income and expenses on a Schedule K-1.
This setup leads to some ambiguity about what’s an allowable expense. If the business owner and the business are one in the same, then what’s a business expense? And how should you separate the two?
The three criteria of ordinary, necessary, and wholly for business are of the utmost importance to sole proprietorships. Only report expenses that meet those three criteria, and adjust for purchases that have a personal and professional purpose.
It’s also best practice for sole proprietorships to open up a separate bank account for business transactions. And for each expense run through the account, keep the physical receipt and a digitized version for safekeeping and ease of access.
Allowable expenses for LLCs and corporations
When a business is formalized as a corporation, the rules under which it operates become stricter.
While the criteria for allowable expenses remain the same (ordinary, necessary, and wholly for business purposes), personal and business funds and activity must be clearly separated. Typically, this means separate bank accounts, credit cards, or online accounts for personal and business purposes.
An expense would not be allowable if it’s run through a personal account. Instead, that individual would need to be reimbursed by the business to legitimize the expense.
This creates one additional consideration for allowable expenses for LLCs and corporations: has the expense been properly run through the business? If not, it can’t be reported as an allowable expense.
Tax implications of allowable expenses across business types
Allowable expenses serve the same purpose across business types: reduce taxable income with tax deductions or tax credits.
Where there’s a difference is how the tax deductions or credits impact the entity.
Sole proprietorships and partnerships report their income and expenses directly on their personal tax return. Every tax deduction accrued on allowable expenses reduces the amount they pay in self-employment taxes.
Meanwhile, corporations have their business activity reported separately on their tax return. Deductions reduce the corporate income taxes paid, and savings are kept within the business.
In both cases, being attentive about allowable expenses and recordkeeping is essential. You must keep receipts, invoices, and transaction records to prove expenses meet the three criteria and claim the tax deduction.
How to automate approval for allowable expenses
The larger a business’s operations grow, the harder it is to stay on top of its expenses. On top of reconciliation and review, you need to collect documents and keep purchases organized.
But what if you had total confidence that every expense was allowable?
Enter BILL Spend & Expense, a combination of expense management software and virtual cards that make tracking expenses a breeze. By assigning virtual cards with controls on vendors and amounts, you’ll know every transaction that comes through is allowable and aligned with your policy.
And with real-time reporting, you can stay up-to-date on how the business is spending to make savvy, strategic decisions.
Reach out to schedule a demo and see how BILL can save you time and effort on your expense management.
