Business Expenses: When, What, and How to Deduct

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Every business owner knows that you need to spend money to make money, but spending money is only the beginning.

You also need to know when the expense can be deducted, whether it actually qualifies as a business expense, and how it should be categorized for tax purposes.

In our last three articles, we talked about why recordkeeping matters, what records you should keep, and how long you should keep them. Now, we’re going to build on that foundation by looking at the expenses those records support.

We’ll cover:

  • When expenses are deducted under the cash versus the accrual method

  • What makes an expense ordinary and necessary

  • How to handle expenses that are partly business and partly personal

  • Capital expenses

  • Cost of Goods Sold, or COGS

If the terms capital expenses and Cost of Goods Sold terrify you, don’t panic.

We’re about to dispel some of the mystery behind these categories so you can take advantage of all the legal deductions you’re entitled to and keep more money in your pocket.

So, When Can an Expense Be Deducted?

The timing of when you can deduct an expense depends, in part, on the accounting method your business uses.

Two common accounting methods are the cash method and the accrual method.

Cash Method

Under the cash method of accounting, you generally report income when you receive the money and deduct expenses when you actually pay them.

For example, let’s say you’re a podcaster and you complete sponsored content in December, but the sponsor doesn’t pay you until January.

If you use the cash method, you would generally report that income in January because that’s when you actually received the money.

The same basic idea applies to expenses.

Suppose your podcast editor sends you an invoice in December, but you don’t pay it until January. Under the cash method, you would generally deduct the expense in January because that’s when you actually paid it.

Accrual Method

The accrual method of accounting works differently.

Under the accrual method, you generally report income when it is earned, regardless of when you actually receive the money.

Going back to our sponsorship example, if you complete the sponsored content in December but aren’t paid until January, the income would generally be reported in December because December is when you earned it.

Expenses work similarly too.

Instead of simply looking at when you paid the bill, the accrual method generally looks at when the expense was incurred.

So, if your podcast editor sends you an invoice for completed work in December and you don’t pay the invoice until January, that expense would generally belong to December under the accrual method.

An easy way to remember the difference is:

Cash method: income and expenses are generally recorded when money changes hands.

Accrual method: income and expenses are generally recorded when they are earned or incurred, not simply when the money is received or paid.

What Qualifies as an Ordinary and Necessary Business Expense?

To deduct an expense as a business expense, it generally needs to be both ordinary and necessary for your business.

An ordinary expense is one that is common and expected in your type of business.

A necessary expense is one that is helpful and appropriate for operating your business.

For a podcaster, ordinary and necessary business expenses might include:

  • Podcast hosting fees

  • Editing software

  • Music or sound-effect licenses

  • Website hosting and domain fees

  • Payments to editors, producers, graphic designers, or virtual assistants

  • Transcription services

  • Equipment repairs and routine maintenance

  • Professional fees, such as bookkeeping or tax preparation

Now, I’ve heard some curious advice from interesting content creators who tell you to start a business because you can deduct everything!

Well, friends, that’s not 100% correct.

Just because you spend money while operating a business does not automatically make that expense a business expense or make it deductible.

For example:

  • Everyday clothing that you happen to wear while recording generally isn't deductible if you could also wear it in your everyday life.

  • A vacation doesn't suddenly become a business trip because you call it “research.”

  • Home décor purchased primarily because you wanted it in your home doesn't become deductible simply because your podcast equipment happens to be in the same room.

  • Personal grooming expenses, such as haircuts or manicures, generally remain personal expenses.

The important question isn't simply, “Did I spend this money while running my business?”

It’s whether the expense actually qualifies as a business expense under the tax rules.

What If an Expense Is Both Business and Personal?

Some expenses have both a business and a personal component.

In those situations, you generally separate, or prorate, the expense between the business portion and the personal portion and deduct only the business portion that you can substantiate.

A common example is using your personal cell phone for business purposes when you're first starting out.

Suppose you pay $100 a month for your cell phone and, based on your records, 60% of your usage is for your business.

You wouldn't automatically deduct the entire $100.

You would generally deduct the business portion: 60%, or $60.

The remaining $40 is personal and not deductible.

Capital Expenses

Next, I would normally advise you to hold on to your hats!, but actually, I’m going to have you get comfy and grab some popcorn because we’re going to learn about capital expenses.

A capital expense is money you spend to start your business, buy business assets, or make major improvements to those assets.

Start-Up Costs

For a podcaster, start-up costs might include:

  • Market research conducted before launching the business

  • Pre-launch advertising or promotional expenses

  • Certain professional fees incurred while getting the business established

Business Assets

Business assets are things purchased for the business that are expected to be used in the business for more than one year.

For a podcaster, those might include:

  • A computer

  • Recording gear

  • Cameras

  • Other business equipment

Major Improvements

Capital expenses can also include major improvements to business property.

For example, a podcaster might convert a room into a permanent recording studio by:

  • Adding permanent soundproofing

  • Upgrading the electrical system

  • Installing permanently mounted shelving, cabinetry, or equipment stations

Generally, capital expenditures may need to be recovered over time through rules such as depreciation or amortization.

However, different types of capital expenditures receive different tax treatment.

There are also tax provisions that may allow you to deduct some or all of certain capital expenses sooner, such as Section 179, bonus depreciation, or safe-harbor elections.

The correct treatment depends on the type of expenditure and the tax rules that apply to your particular situation.

Cost of Goods Sold

And now for our final terrifying term, which we’re about to tame: Cost of Goods Sold, or COGS.

COGS is basically what it costs you to create or buy the products you sell.

If you're a podcaster whose business is producing podcast episodes, you generally aren't going to have Cost of Goods Sold associated with producing the podcast itself.

But you might have COGS if your business also sells physical products such as branded T-shirts, mugs, or other merchandise.

For some micro-business owners, however, COGS is a much bigger part of the business.

Let’s say you’re a jewelry maker.

Some of the costs involved in making the jewelry you sell aren't treated simply as ordinary operating expenses. Instead, those costs become part of your Cost of Goods Sold.

That can include things such as the raw materials that go into the product and shipping costs incurred to obtain those materials.

For example, suppose you spend $40 on silver and stones to make a necklace and then sell that necklace for $150.

That $40 in materials is part of the cost associated with producing the necklace and would generally be included in Cost of Goods Sold.

An easy way to think about it is this:

If the cost goes into creating the product you’re selling—like the silver and stones that become part of the necklace—it would generally be included in COGS.

What about the tools or assets you use to make the product?

Depending on the item, they may instead be treated as an ordinary business expense or as a capital expense.

And see?

You already know what those are!

The Bottom Line

Business deductions aren't simply about identifying everything you spent money on during the year.

You also need to determine what kind of expense it is and how the tax rules require you to treat it.

A regular business expense may be deductible as an ordinary and necessary expense.

A mixed-use expense may need to be divided between its business and personal portions.

A long-term asset or improvement may be a capital expense.

And costs associated with producing the products you sell may belong in Cost of Goods Sold.

Understanding those distinctions can help you properly claim and maximize the deductions you're legally entitled to.

Next week, we’re firing up the engines and diving into Car and Truck Expenses, so make sure to subscribe so you don’t miss an opportunity to keep more money in your pocket.

As always, this article is meant for educational purposes only. You should always consult a licensed tax professional, like me! To determine what’s right for you and your business.
Location: United States

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