How To Categorize Expenses: A Guide For Freelancers & Agencies

Do you know where all your money went last month? That’s a tough question to answer if you don’t categorize expenses on a regular basis. 

The best way to keep track of small business finances is by being proactive about expense management.

Sure, it sounds like a chore. In a lot of ways, it is.

But it’s a lot less of a chore than desperately trying to get all your receipts together in early April so you can file your taxes. It’s a much better option than hustling to make more money because your bank balance is too low and you don’t know why!

In this post, I’ll talk about how you can categorize your expenses. I’ll discuss why you should do it and how you can get started. Then I’ll dig into the details of business expense categories so you know exactly what you need to do. Finally, I’ll cover expense reports so you know what you can do with this information.

Just a quick note here – I’m assuming that you are running a freelance or small agency operation in the US. That means you are probably a sole proprietor or single-member LLC. The general gist of this article will still be true even if you’re not, though.

Why should a small business owner categorize expenses?

You probably already know that it’s important to track all your business transactions. After all, you need to do this in order to monitor cash flow and make income statements.

But it’s not enough to just track your expenses. You need to categorize them too. There’s a difference.

For one, categorizing expenses will make your life easier during tax time. You’ll be able to tell the difference between tax-deductible expenses like office expenses and non-deductible expenses, many of which are more personal. This process will also help you tell the difference between expenses that are deductible from your business (such as operating expenses) and from your personal taxes (such as health insurance and retirement).

Taxes are important, but that’s not the only reason to do this. Categorizing expenses also helps you understand where money is spent, which will help you make a budget. You can even create sub-categories when the IRS standard ones won’t quite do the trick.

If you proactively go through your accounting system and keep up with expenses, say on a weekly basis, you will be able to run expense reports and other financial statements whenever you like. You can use that to make better business decisions.

1. Start by tracking all your revenues and expenses.

Before you categorize your expenses, you need to have a system for tracking your finances in general. You can read more about this in our guide here.

If you’re in a rush, I’ll save you a click. Here’s the outline of that article, for your convenience:

  1. Start a separate bank account for your freelance or agency business.
  2. Pick accounting software to help track business expenses.
  3. Keep excellent records to improve accuracy and make life easier.
  4. Know what is and isn’t a valid business expense.
  5. Choose cash or accrual accounting.
  6. Regularly view and categorize expenses and revenues.
  7. Plan for taxes.
  8. Find a great accountant.

You can do this with a spreadsheet if you like. But I strongly recommend that you use modern accounting software instead.

QuickBooks is popular and well-accepted by accountants. A lot of people prefer Xero and FreshBooks for lower prices. If you’re really into open source software, GnuCash might be a good option for you.

2. Create expense categories.

Categorizing expenses will help you with budgeting and accounting. But it all starts with the categories. You need to come up with those first before you can put expenses into them.

If you don’t know where to start with expense categories, I suggest looking at the IRS 1040 Schedule C for inspiration. Under Part II, it has a list of expense categories that all your deductible expenses need to fall under.

(This is, perhaps, the only scenario in which anyone has ever looked to the IRS for inspiration.)

Try not to be overwhelmed by its beauty.

2.1. Familiarize yourself with IRS standard categories.

Here is a list pulled straight from the tax forms with quick explanations and examples for each.

  • Advertising: Costs to promote your business. Examples: online ads, flyers, business cards.
  • Car and truck expenses: Costs of using a vehicle for business. Examples: mileage, repairs, insurance.
  • Commissions and fees: Payments to others who help you get business. Examples: sales commissions, transaction fees.
  • Contract labor: Payments to non-employee workers. Examples: freelance designers, temporary help.
  • Depletion: Expense for natural resource extraction. Examples: timber, minerals (not common for most freelancers).
  • Depreciation and Section 179 expense deduction: Cost of business assets spread over their useful life; immediate expense of assets. Examples: computers, machinery.
  • Employee benefit programs: Costs of benefits for employees. Examples: health insurance, education assistance.
  • Insurance: Business insurance costs. Examples: liability insurance, property insurance.
  • Interest: Interest paid on business debts. Examples: interest on business loans, credit cards.
  • Legal and professional services: Fees for professional services. Examples: lawyers, accountants.
  • Office expense: Office-related costs. Examples: stationery, small equipment.
  • Pension and profit-sharing plans: Contributions to retirement plans for employees. Examples: 401(k) plans, SEP IRA.
  • Rent or lease: Payments for renting or leasing business property. Examples: office space rent, equipment lease.
  • Repairs and maintenance: Costs to maintain or repair business property. Examples: building repairs, equipment servicing.
  • Supplies: Costs for items used in business. Examples: cleaning supplies, office supplies.
  • Taxes and licenses: Business-related taxes and licensing fees. Examples: state business taxes, professional licenses.
  • Travel and meals: Costs of traveling for business and meals during travel. Examples: airfare, dining with clients (note only 50% of meals are deductible).
  • Utilities: Utilities for the business location. Examples: electricity, water.
  • Wages: Salaries and wages paid to employees. Examples: employee salaries, bonuses.
  • Other expenses: Any other business expenses not elsewhere classified. Examples: bank fees, business-related education.

This is a pretty complete list on its own, but as I’ll show in a minute, you can break Other Expenses into more categories. This will let you run more complete reports and make a more precise budget.

Note: If you’re a regular reader, you might know that I advocate for using “Other Expenses” to separate personally tax-deductible expenses from tax-deductible business expenses. The IRS uses “Other Expenses” to refer to other tax-deductible business expenses that don’t fall into one of their other standard categories. So if you notice inconsistencies in this blog, that’s the explanation.

2.2. Add custom categories as needed.

Freelancers and small agencies often find themselves spending money on business expenses that don’t fit into a neat category on an IRS Schedule C. That’s completely fine and normal. For situations like this, you can create additional expense categories in your accounting software. Then, when it comes time to file taxes, you can simply tally up the numbers and put that under Other Expenses. (Under the supervision of your certified public accountant, of course!)

Here are a few examples of custom categories you might add.

  • Software subscriptions: Ongoing costs for software needed to run your business, like graphic design programs, accounting tools, or project management software.
  • Bank fees: Charges related to business banking, like monthly service fees or transaction fees.
  • Educational expenses: Costs for business-related courses or workshops that aren’t part of a formal degree program.
  • Professional organization dues: Membership fees for professional associations or chambers of commerce.
  • Website costs: Ongoing costs for maintaining a website, such as hosting fees, domain registration, and web development.

Adding custom categories will help you make budgets and run reports that tell a more complete story about your business. Each expense category you add will be another line on your P&L. Don’t be afraid to add them if you need them!

2.3. Determine which categories are tax deductible.

The vast majority of expenses that you will incur in the course of doing regular business, at least in the US, will be tax-deductible. The biggest exception I personally run into are meals, which are only 50% deductible.

It’s worth noting that if you pay for your own health insurance and retirement out of your business bank account, those expenses will most likely be deducted from your taxes. However, those deductions will show up on your regular old 1040, not necessarily the Schedule C you make for your business.

That is a really specific detail, but it’s a common error for side hustlers, freelancers, and agency owners to make on their finances. Just be aware.

When in doubt, ask a tax professional which expenses are deductible and which are not. 

3. Regularly categorize your expenses.

Once you set up expense categories in your accounting software, the main thing you need to do is regularly go through your expenses and categorize them. Reporting will mostly take care of itself.

If you use QuickBooks, for example, once you set up expense categories and start using them, you’ll see the data show up in your Profit & Loss, Balance Sheet, and other key reports.

Block off some time every week to do the necessary work of categorizing expenses. Then you can run reports whenever you like.

Final Thoughts

When you categorize expenses, you’re doing yourself a huge favor. Consistently categorizing expenses is one of the best things you can do to keep your business finances under control.

Filing taxes will be much easier with clean expense records. You’ll be able to run accurate financial reports whenever you like. Budgeting will be a breeze too.

So if you’re feeling stuck – scroll back up to part 2.1 and make sure all those categories are in your accounting software. That’s a good first step to help you get started!

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