How to Handle Business Expenses Correctly (and Stay IRS-Compliant)

How to Handle Business Expenses Correctly (and Stay IRS-Compliant)

Tracking business expenses the right way is essential for tax deductions and financial organization. However, mixing personal and business expenses or claiming the wrong deductions can raise red flags with the IRS. Here’s how to properly manage business expenses and avoid costly mistakes.

1. What Qualifies as a Business Expense?

According to the IRS, a deductible business expense must be:

✅ Ordinary – Common in your industry (e.g., a photographer buying a camera).

✅ Necessary – Helpful and appropriate for your business (e.g., marketing software for a digital agency).

Common deductible business expenses include:

📌 Office supplies & equipment

📌 Business meals (50% deductible, but must include business purpose and attendees).

For IRS compliance, record the date, amount, location, attendees, and business purpose.

📌 Travel expenses (transportation, lodging, per diem).

Ensure expenses are necessary and properly documented.

📌 Software & subscriptions (QuickBooks, Canva, Zoom)

📌 Home office deduction (used exclusively and regularly for business; choose between simplified or actual expenses method). Simplified method allows $5 per square foot (up to $1,500), while actual expenses deduct a portion of rent, mortgage, and utilities.

📌 Marketing & advertising

📌 Business vehicle expenses (mileage or actual expenses; must maintain a contemporaneous mileage log). Personal commuting does not qualify; only business-related miles count. Consider using apps like MileIQ or Everlance for tracking.

2. Keeping Business & Personal Expenses Separate

One of the biggest mistakes small business owners make is mixing business and personal finances.

Here’s how to avoid that:

✅ Open a separate business bank account & credit card.

✅ Use accounting software (QuickBooks, Wave, or Xero) to track expenses.

✅ Label transactions clearly and categorize expenses properly.

✅ Save receipts and maintain digital records for at least three years (six years if substantial income is underreported; four years for employment tax records).

3. Common IRS Red Flags for Business Expenses

🚨 Claiming 100% Business Use of a Vehicle – If you drive for personal reasons too, you must track mileage properly and choose either the standard mileage rate or actual expenses. Keep a mileage log with date, destination, purpose, and miles driven.

🚨 Excessive Business Meals & Entertainment – The IRS requires documentation, including who was present and the business purpose.

🚨 High Home Office Deductions – Your home office must be exclusively and regularly used for business. Be prepared to justify the square footage and how it's used.

🚨 Unusually Large or Uncommon Deductions – Deductions should align with industry norms and income levels; if claiming large deductions, maintain proper documentation such as receipts, contracts, and justifications.

📖 Want to learn more about IRS audit red flags? Read our blog on How to Reduce Your IRS Audit Risk here: https://wix.to/X4gNoGA

4. Tracking Expenses the Right Way

To avoid issues at tax time, stay organized year-round:

✅ Use receipt-tracking apps like Expensify or Shoeboxed.

✅ Keep a digital filing system for tax documents.

✅ Review profit & loss reports regularly to spot discrepancies.

✅ Consult a bookkeeper or tax professional for proper categorization.

✅ Consider Section 179 deductions for immediate expensing of qualifying equipment.

✅ If you're a pass-through entity, explore the Qualified Business Income (QBI) deduction to maximize tax savings.

✅ For large deductions, maintain additional documentation (receipts, invoices, written justifications).

Final Thoughts

Properly handling business expenses not only reduces your tax liability but also lowers your IRS audit risk. Need help setting up a system for tracking expenses? Schedule a free consultation with KB2 Bookkeeping & Tax to ensure your expense tracking is IRS-compliant and optimized for tax savings. 🚀