Someone gave me a great tip on business expenses when I asked him jokingly whether I could deduct my pet food. He said, “Sam, everything is a business expense so long as you can justify it.” Interesting!
I’m no accountant, but I have read hundreds of financial statements and understand the basics of maximizing revenue, minimizing costs, and thereby maximizing profits after tax. A company’s expenses are different, depending on industry. The Cost of Goods Sold (COGS) for an individual blogger might be $0, since the individual is writing all his or her own content. COGS is very straight forward.
It’s the operating expenses which gets a little gray. Operating expenses are essentially all expenses that are necessary for you to make profits happen. There are a whole set of rules of what you can and cannot deduct. What I’d like to do is have a open discussion using an example to understand more.
AN INCOME STATEMENT SNAPSHOT
Hero Media is a small media company set up as an S-Corp owned by Pat. The main source of income is advertising and the main product is written content. What are the line-items that stand out the most? What can you say about this company from just looking at the income statement?
|MONTHLY INCOME STATEMENT|
|GROSS AD REVENUE||$10,000|
|Cost of Goods Sold||$250|
|Net Ad Revenue||$9,750|
|Travel & Accommodation||$2,000|
|TOTAL OPERATING EXPENSES||$5,950|
|Taxes at 30%||$1,140.00|
|Operating Profit Margin||38%|
|Net Profit Margin||27%|
The first thing you notice is how small Cost of Goods Sold is. Pat basically does all of his own writing and pays just $250 for acquisition of content.
The second thing you see is a relatively large Travel & Accommodation expense of $2,000. Clearly, Hero Media must write a lot of travel-rich content, at least for this month.
Finally, you an see that Pat draws a $2,000 salary for all the writing, marketing, and coordinating he does for the company. Pat has to pay normal taxes + all payroll taxes on the $2,000. Meanwhile, Hero Media makes a net profit of $2,660 after paying 20% Federal Tax and 10% state tax. The amount is called “retained earnings” that accrues on the company’s balance sheet.
LET’S DISCUSS BUSINESS EXPENSES AND CURVE BALLS
Hopefully the way I’ve laid out the income statement and the description that follows makes things sound perfectly legitimate and straightforward.
An operating profit margin of 38% and a net profit margin of 27% is relatively healthy and doesn’t raise any red flags in my opinion. Meanwhile, if you are in the media/internet/blogging business and have only a 10% operating margin because you have tons of expenses, that might raise some eyebrows. And if you actually have mega expenses that surpass your $10,000 in monthly revenue, then you might really have a problem.
Travel & Accommodation
The $2,000 Travel & Accommodation expense is a round-trip ticket to Hawaii with three nights stay at the Kahala Resort in Oahu. Pat lives in freezing Michigan and decided to take a trip in January to write about how it would be like to live a location independent lifestyle in Oahu. He entitles the article, “The Best Place For An Online Entrepreneur To Live And Work“.
Some of you may raise your eyebrows and wonder whether this is a legitimate expense, since Hawaii is a vacation destination. Well, how else is Pat going to gain credibility in his article above if he doesn’t go visit the place! That’s like a blogger teaching you how to be a millionaire without being a millionaire himself! Or a relationship guru who still lives at home with his parents. No credibility means poor content, no traffic, and no ad revenue.
Does visiting Des Moines, Iowa for only $300 sound like a more legitimate? If so, why do you think this is more OK? How nice of a place should be irrelevant, so Hawaii is in!
Every year, I have one board meeting up at my vacation rental in Squaw Creek, Lake Tahoe. This is a legitimate business expense as annual board meetings are required.
Somehow, I feel this business expense is harder to justify even if it’s just $50. Pat claims that his pet bunny provides him relaxation during his 5 hours a day writing marathons. Without his pet bunny, he would be more stressed and would therefore write worse content, leading to lower revenue.
At $50 a month, Mr. Rabbit’s expense is minimal, and only 0.5% of gross revenue. Is this a business expense? Maybe, as I’ve seen people/companies expense hundreds of dollars worth of massages to maintain the health of the owner. Is this a red-flag? Maybe if you wrote it as “Pet Bunny” above. But, if you put the $50 into the Miscellaneous category, it would likely go undetected.
As a professional writer, can you write without your right hand? Well, Mr. Bunny is Pat’s right hand fur ball.
This is one of my favorites. Eating great food is heavenly. We all have to eat anyway, so we might as well take clients out for meals on the company to help subsidize our foodie tendencies, and potentially do some business as well.
There’s no IRS law that says you have to say more than once sentence about business during the meal. A simple, “How’s business doing?” can suffice! No matter how wealthy a client they are, everybody loves a free meal. At $500 a month, it looks like Pat is spending a healthy amount of time wining and dining. I believe there is some stipulation that you can only expense the portion of the bill which the client accounts for e.g. $100 bill for two, you can only expense roughly $50. That said, what if all you had was free bread and water?
Relatively speaking, $500 is a large Miscellaneous expense. This line item is a catch-all expense for everything he’s missed. This can include parking tickets, coffees he bought at the airport, magazines and books about travel and Oahu he needed to read for his writing, tips to the valet, and so forth.
Pat has most of the receipts. He’s just too lazy to categorize every single $5 expense, so he puts in Miscellaneous. Is $500 really a business expense? Probably. Is Miscellaneous as a category a red-flag? Hard to say, because even $500 is only 5% of total revenue. There’s a big category called “General & Administration” in the Selling, General & Administration vernacular of operating expenses, which is also a catch-all phrase.
Perhaps all the owner has to do is change the word Miscellaneous to General & Administration!
THE POWER OF JUSTIFICATION
The reason why I no longer have 4-pack abs is because I spend too much time in front of the computer writing. Who has time for exercise? The reason why I’m poor is because of the evil 1% top income earners and marketing companies who peddle consumption. Spending less than I earn is hard, and I have bills to pay.
We can use the power of justification to justify practically anything we want. As we return to the post title’s question of, “What Is A Business Expense?”, share with us whether you think the above examples are indeed business expenses, and bring up several more examples of your own. Accountants and financial gurus, please also feel free to blow holes in my article as well.
Note: Think about categorization, expenses as a percentage of revenue, margins, industry standard, cash flow and profitability. If the industry standard is a 25% operating margin, and you somehow year in and year out show only a 5% operating margin because you load tons of non standard expenses into your income statement, it will seem fishy. As a business, you are also ALLOWED to lose money too once in a while, therefore paying no taxes. We can’t all be winners.
Photo: Drinking a Mythos Beer at the top of Santorini, 2011. I’ve written three posts about my cruise and generated more income than the cost of the trip.
Disclaimer: I am not an accountant, although sometimes I feel like one after staying at the Holiday Inn Express. Please seek a professional accountant for business expense advice. Updated on 2/10/2015.