Tax season can make you feel like you’re drowning in a sea of missing documentation and expenses when there’s no structure in place to report them.
As if internally managing the finances of a small business or startup isn’t hard enough, now you have to think about what an external entity requires
Enter business expense categorization to save the day. Topics included in this article:
What is expense categorization?
Expense categorization is the process of grouping expenses for financial control and tax purposes. For example, if your company paid for airfare for a business trip, you may categorize that as a “travel” expense. And, because it is categorized as such, specific transaction details and documentation would then be required so you can write it off come tax time.
Some examples of business expense categories include:
Payroll
Employee benefits
General and administrative expenses
Marketing and advertising spend
Research and development spend
Payments for professional services
Trying to go back and categorize your expenses at the end of the year is a sure way to lose valuable time and money. Instead, categorize and map your expenses in advance. You’ll make it easier to do reporting and save the maximum amount in business tax deductions.
How do you categorize business expenses?
Business expenses can be categorized into various buckets including payroll, employee benefits, general and administrative expenses, marketing and advertising, research and development, and payments for professional services.
The key is to set up categorization that reflects your internal company structure, e.g. by department and spend management needs. Just make sure to include enough detail and documentation to easily pull reports that satisfy IRS compliance.
For example, expenses may be classified by type, like “General and Admin” and “Research and Development” (R&D), and then sorted by department, like “Marketing” and “Engineering.” So, when an engineer in the company buys software for building new products, the expense is categorized as an R&D expense, incurred by the Engineering Department and attributed to that department when sorted.
It’s worth noting that you likely will need more granular categories for internal P&L statements than you will for IRS categorization. To make your life easy, those more granular categories should each fit into one of the IRS categories.
There is no need to overcomplicate classifying different types of expenses. Keep categories general and limit the number of general ledger (GL) accounts you have. Use custom fields to capture the “who, what, where, and why” of each transaction, so they can be easily sorted or reclassified for different reports as needed.
For example, for internal purposes, you may only need to know that an employee made a meal purchase, but if you want to deduct the expense as a business meal come tax time, you will need to know if the employee ate alone, with a team, or with a client, and what was discussed. You may not need an entire category for each of these details, but defining transaction details in your spend management platform can make reporting and increasing tax deductions much easier. Noting how many people were at the meal and what was discussed, for example, can mean the difference between an “individual meal” that is only 50% deductible versus a “team event” that is 100% deductible.
List of common business expense categories
Not sure where to start with creating business expense categories? Here are a few common lists, but again, tailor these to your own company’s structure.
Payroll and employee benefits
These are employee-related expenses that include:
General and admin
This includes regular operating expenses such as:
Office supplies (i.e., computers, printers, pens)
Rent and leases
Cleaning services for the office space
Transportation
Meal stipends
Other office expenses
Marketing and advertising
These are costs that cover the promotion of your business:
Research and development (R&D)
These are expenses incurred in the process of building a product, including:
Professional services
These cover the professional fees of external consultants and contractors:
How to categorize expenses to maximize tax deductions
To optimize your expense categories for business tax deductions, it’s important first to understand what is deductible and what documentation is needed for compliance when claiming expenses on your tax return and filing small business taxes.
Your source of truth for this is IRS publication 535, which dictates what is deductible or not. According to this document, an expenditure is considered deductible if it can be proven “ordinary and necessary” for business purposes.
For example, you can usually count a business luncheon with a prospective client as ordinary and even necessary to cultivating business. However, that embarrassingly large pizza order you placed for just yourself while you ate your feelings over the weekend may not be so necessary or ordinary to your business growth and can't be considered a write-off. Learn more about deductions allowed under IRS Publication 535.
What can I deduct as a business expense?
You can deduct a variety of business expenses such as rent or lease payments, utilities, office supplies, employee salaries, advertising, insurance, professional fees, and the cost of goods sold, as long as they’re necessary in the course of conducting your business.
What counts as deductible business expenses will depend on your particular business structure, but this list includes the major expense categories that are deductible per the IRS:
Deductible expense category
Details
Cost of goods sold: This is deducted from your gross receipts to find your gross profits for the year. Note, you cannot deduct the cost of calculating the cost of goods sold.
Capital expenses
Not-for-profit activities and charitable contributions
Business travel expenses
Awards
Bonuses
Education benefits
Fringe benefits: While fringe benefits are deductible for the employer, they are taxable for the employee, so when categorizing these expenses, make sure to categorize them as “fringe benefits” and map them to the correct GL accounts so the amounts are easily added to W2s.
Loans or advances
Property (such as company stock)
Business expense reimbursements
Sick and vacation pay
If you will receive equity in the property or a title of any kind, the rent is not deductible.
Taxes on leased property
Improvements by lessee
Cost of getting a lease
Each of these categories has precise requirements for deduction and is subject to change at the discretion of the IRS. So it’s a good idea to subscribe to IRS e-News alerts, review the “recent developments” section of the IRS publication 535 regularly, and work closely with a tax advisor to maximize deductions.
Taking the time at the start of each tax year to optimize your expense categories and map to ledgers based on IRS changes will make tax season significantly smoother.
For example, for internal purposes, you may only need to know that an employee made a meal purchase, but if you want to deduct the expense as a business meal come tax time, you will need to know if the employee ate alone, with a team, or with a client, and what was discussed. You may not need an entire category for each of these details, but defining transaction details in your spend management platform can make reporting and increasing tax deductions much easier. Noting how many people were at the meal and what was discussed, for example, can mean the difference between an “individual meal” that is only 50% deductible versus a “team event” that is 100% deductible.
Tip from Edwine Alphonse, our Finance Controller at Ramp: "By being intentional about your naming conventions and the categorizations, you'll make sure you're complying with IRS rules, in terms of documentation. You’re also making your life easier when it’s time to do your tax filing or going through your year-old closing checklist.”
Non-tax-deductible expenses
Some expenses you want to watch out for that are not tax deductible include the following:
How to make sure your business expense categories are correct
So, you’ve determined categories that align with your internal finance needs and IRS compliance, but you’re still faced with actually enforcing categorization. Manually processing expenses has proven unreliable and time-consuming, so how do you ensure expenses are consistently and correctly categorized?
Use expense management software
Startup and small business expense management software automates expense mapping and categorization with customizable fields, prompts for required documentation, and integrates with bookkeeping software.
Gathering all of your expenses in a central software where every expense process can take place provides a clear audit trail and easy reporting.
With every transaction in one platform, it’s easy to pull a report for a single expense category across all departments and GLs and then sync with bookkeeping and tax-filing software.
Automate workflows
Expense management software that's built into modern corporate credit cards and charge cards adds an additional layer of data control by providing customized card controls that inform every step of the transaction.
Custom no-code workflows provide consistent expense documentation by prompting employees throughout the transaction process. When a transaction occurs, employees are immediately prompted via SMS or email to submit documentation.
Once documentation is submitted, automated receipt matching ties it to the corresponding expense and prompts the employee to fill in required details in customizable fields. The expense management software then uses automation and AI to categorize the expense and sync the information with your accounting software.
Get back your time and money during tax season with Ramp
Tax season doesn’t have to be stressful. Saving time and money shouldn’t be complicated, even if you’re a small business owner or startup founder without a big finance department.
With Ramp’s powerful finance automation and AI behind your business expense categorization, tax season is just another day at the office. You can pull comprehensive reports with a single click and then sit back with a cup of coffee and watch your tax return grow. Learn more about how we are saving our customers an average of $100k in their first year using our software.
The information provided in this article does not constitute legal or financial advice and is for general informational purposes only. Please check with an attorney or financial advisor to obtain advice with respect to the content of this article.