If you own a small business, you likely know that keeping track of your expenses is important. And you may also have realized that figuring out how to categorize your business expenses can be confusing.

The good news is that you usually don’t need a complicated accounting system to categorize your expenses correctly. You just need a consistent method and a basic understanding of what each category means. In today’s post, I’ll answer all of the common questions I hear from small business owners who are figuring out how to categorize expenses.

What is a business expense?

For tax purposes, a business expense is basically any purchase that is “ordinary and necessary” for your business. This means that if you’re spending money to keep your business running and the expense is something that other businesses like yours would likely purchase too, then you’re good to classify the purchase as a business expense.

Why do I need to categorize my business expenses? (aka Do I have to categorize my business expenses?)

There are three main reasons that you should categorize your business expenses:

1. To assess your business’ success and quickly determine if you need to make adjustments to spending or pricing
2. To make sure you don’t miss out on any tax deductions
3. To accurately and easily prepare your tax return, which helps you avoid mistakes that could raise red flags with the IRS

I understand that categorizing your business expenses may seem like another tedious task on your long list of to-dos, but it is an important part of “good bookkeeping.” Keeping up on this piece and making sure it’s done right can help you easily answer important questions about your business, such as:

• How much am I spending on supplies?
• How much does it cost me to make each product?
• How much am I spending on advertising?
• How profitable is my business?

In other words, it does not pay off to skip the step of categorizing your expenses.

What are the most common small business expense categories?

The IRS doesn’t provide a list of expense categories that you must use, but there are 4 categories that you should use:

• Meals: Since qualifying food and drink expenses are only 50% deductible and there are strict guidelines for what qualifies, you should keep careful records of the expenses you’re categorizing as meals.
• Entertainment: Typically you can only deduct entertainment expenses if you’re providing the entertainment for things like a workshop you’re hosting or a company-wide event for all of your employees. Since there are strict rules here, it’s important to categorize qualifying entertainment expenses separately.
• Cost of Goods Sold (COGS): This category is used to track the cost of creating or purchasing the goods you sell, such as the raw materials used to make the products. This typically applies to businesses that sell goods rather than a service. Because COGS is used to calculate your gross profit and taxable business income, it’s important to keep track of these expenses separately.
• Car Expenses: This is another category that requires careful receipts and tracking so you can distinguish between business and personal car expenses and mileage, so it makes sense to keep it separate.

If you’re looking for some guidance to get started, here’s a list of common expense categories, along with examples of the types of small business expenses that typically fall under each one:

• Advertising/Marketing: business cards, promotional materials, sponsorships, website and social media ads
• Office Expenses: paper, printer ink, potage/shipping costs, writing utensils, sticky notes, packing materials
• Supplies: items used to create products or provide services (that aren’t included in COGS)
• Digital Downloads: accounting software, design programs, scheduling software, cloud storage, business software, font downloads, photo editing software, monthly software subscription
• Professional Services: payments to your attorney, CPA, and business consultant
• Bank and Payment Processing: bank fees and fees paid to payment processors like PayPal, Stripe, Etsy, and Square

The other categories you use should fit your business and how you think of your purchases. Don’t overcomplicate it, but feel free to make it make sense to you. That way, you’ll be more likely to categorize your expenses consistently, and that’s the important part anyway.

How do I categorize this?!

Many expenses are easy to categorize, but some can be tricky. There are some expenses that seem to regularly trip up business owners working on their books:

How do I categorize business equipment?

Business purchases don’t always become an expense immediately, especially larger purchases that may need to be treated as business assets and depreciated over time. If you’re purchasing big ticket items like a professional camera, computers, or machinery, talk with a CPA about whether it should be expensed or treated as an asset before you categorize it.

How do I categorize software subscriptions?

If you have lots of different software subscriptions and aren’t sure how to categorize them since you pay for some monthly and pay the amount upfront for others, don’t worry about making separate categories for each. Create a category called “Software,“ “Digital Downloads,” or something similar, and you can put all of your digital software, storage, and other related business expenses in that category.

How do I categorize Etsy, Shopify, and Other Online Marketplace Fees?

To decide how to categorize online marketplace fees,, first think about how you’ll use the total amounts in these categories. If you just want to track all of your expenses related to payment processing, then lump all of the fees from the different platforms into a category called “Payment Processing Fees” or something similar.

But if you want to know if selling through one particular marketplace is profitable for you, then use a different category for each marketplace and put all fees for each one in their own category. For instance, you might have an “Etsy” category that includes:

• Etsy listing fees
• Etsy transaction fees
• Etsy payment processing fees
• Etsy advertising fees
• Etsy shipping expenses

Can I deduct an expense if I don’t know what category it belongs in?

Yes, you definitely can, and this is an important bookkeeping tip: Don’t make up a category just because you feel like you have to choose one, and don’t leave an expense off the books or uncategorized.

If you’re not sure where something belongs, put it in a temporary category such as “Ask My CPA” or “Uncategorized,” and make a note explaining what you purchased. Believe me, it’s much better to flag a transaction for review than to miscategorize it or leave it out altogether.

Do I need a receipt for every business expense?

You should keep documentation of your business expenses. A receipt is a form of documentation, but depending on the type of expense, other records can be just as important. For example, a credit card statement showing a $5000 charge doesn’t tell what was purchased or why. A better record for the purchase would include an itemized receipt, and when possible, a note about the business purpose for the purchase.

For meals and travel in particular, good documentation is very important. And digital receipts work too, so just scan or save those online receipts whenever possible.

What if I accidentally categorize an expense incorrectly?

Don’t worry. Bookkeeping mistakes happen. If you’ve categorized an expense incorrectly, you can typically correct the entry. This is why it’s important to reconcile your accounts regularly instead of waiting until the end of the year to look through everything. If you don’t, then when tax time comes and you’re trying to rack your brain to remember why you made a purchase the previous January, you’ll be kicking yourself for not keeping better books.

Abridged by Amy

The best system for categorizing business expenses is the one that you will use consistently. Put a system in place that helps you understand your business without sucking all of the fun out of it.

There’s no reason to make bookkeeping unnecessarily complicated, so when it comes to categorizing expenses, start with a reasonable number of broad categories and adjust as you go. Make sure you keep your receipts and other supporting documentation, and reconcile your accounts regularly. And when you run into an expense that makes you think, “How do I categorize this?” that’s exactly what your CPA is there to help you figure out.

Just remember that good bookkeeping isn’t just about taxes. It should give you useful information about your business that can help you make smarter, more informed business decisions. If you need help coming up with a system that works for you, reach out to a CPA who understands small business owners like you.