Updated: Aug 27, 2020
When it comes to deciding on your business expense categories, it is not always that clear. It can be one of the most frustrating parts of being a freelancer, especially if you are not working with a bookkeeper.
The categorization of expenses should depend on what you use the subject of the expense in your business. The same items may be categorized differently for different types of businesses. For example, a jewelry maker may buy a case of beads to make and sell bracelets. In that case, they should categorize the beads as "Inventory." If a babysitter purchased a case of beads to make crafts with the kids, "Materials & Supplies" would be the correct category.
The same applies when you are purchasing subscriptions for an online service. Determine what the service is providing to your business, and categorize the expense based on that. If you are purchasing a music subscription that you also use in your yoga classes you are teaching, then you would expense the service as "Dues & subscriptions." However, if you are purchasing a subscription to online courses to enhance your skills in your profession, then you are using that for “Professional Education” – and should categorize the expense as "Training." Lastly, if the service you are purchasing is specific to your business, you can categorize it as "Professional Services," no matter if it is purchased online or offline.
An expense for “Materials & Supplies” would typically include any tangible items that you use to produce your products. An example of “Materials & Supplies” would be the pens and pencils purchased by a tutor or paintbrushes for an artist. “Materials & Supplies” may also include raw materials used to make products you sell, such as wax to make candles or fabric to make clothes. However, if you are purchasing some illustrations, fonts, or stock images, for example, the correct category for them would be "Media Purchases."
Paying for workers is another category that may be confusing. If your worker is your employee, and you withhold payroll taxes and file quarterly payroll tax returns, then your payments will be put in the “Payroll or Wages” category. If you are paying an independent contractor for their services, the expense category would be "Contractors."
When you categorize a purchase for equipment or furniture, the correct category depends on the cost and how long you will be using them. The general accounting rule is that any item purchased that has a useful life of longer than one year is a "Fixed Asset." The business gets a deduction for these “Fixed Assets” over their useful life, called Depreciation. The IRS has specific useful life categories depending on the type of Fixed Asset and particular methods for calculating the depreciation deduction each year. However, if the cost of your purchase is relatively low, you can record the equipment or furniture as an Expense. For freelancers or small businesses, one may claim that any purchase under $1000 can be an Expense instead of a Fixed Asset. For example, buying a $300 filing cabinet that you will probably use for longer than one year would fit the definition of a Fixed Asset and could be depreciated over several years. But since the cost is so low, it is more practical to record it as an expense, such as Office Expense.
"Other Business Deductions" or "Miscellaneous" expense categories should be used infrequently. These categories don't provide enough of a description to let you know as a business owner where your money is going, and whether it is a deductible expense for taxes. If a large percentage of your business expenses are in these categories, then this will result in your accountant (or the IRS) making inquiries to get more details.
Lunafi helps you categorize your business expenses automatically.