Every business incurs expenses. Even independent contractors, consultants, and freelancers pay for software, computers, or travel out of their own pocket to make their jobs easier. For incorporated businesses, being able to deduct expenses will reduce their business taxes. For sole proprietors, being able to deduct expenses has an even bigger impact: business expenses will reduce both the regular income tax and the self-employment tax.

The bottom line? Keeping track of all your business expenses will go a long way to reducing your tax liabilities.

What's a Legitimate Business Expense?

That's a question I hear all the time from clients and readers. There's no hard and fast rule. The basic definition is that an expense must be "ordinary and necessary" for your trade or profession. That definition comes straight out of the tax law, so don't blame me for being vague. This topic is so huge, the IRS has devoted an entire publication to the topic of business expenses (Pub 535).
Generally speaking, a business expense has a legitimate business purpose. Buying a copy of TurboTax so I can review it for taxes.D106 is a legitimate expense. Even an IRS auditor can see how having a copy of this tax software directly relates to my job. Taking my friends out for dinner, however, is not a business expense. Even though my friends might ask me tax questions or discuss how my business is going, the dinner really isn't about closing a deal or negotiating a contract.

IRS auditors are on the look out for personal expenses that are masquerading as business expenses.

Problems arise when an expense might be partly personal and partly business related. A common example I encounter are freelance professionals who have a personal project that turns into a published article. A freelance writer, just to give one example, might be repairing her house, and end up writing some tips that gets published in a magazine. Would her home repair expenses be legitimate business expenses? Or would they be entirely disallowed in an IRS audit? Or is this a middle of the road answer? As a general rule, the IRS will allow you to allocate the expense to personal and business use, and deduct the business portion on your tax return. (See Publication 535, Personal versus Business Expenses.)

So here's a useful tip. Always keep track of all your expenses, even if you have doubts about being able to deduct them. It will be easier for you to ask your accountant about expenses if you keep track of everything.

Keeping Track of Business Expenses

Personally, I use a full-featured accounting software to track my income and expenses. But then again I'm an accountant and feel comfortable using software such as Quickbooks, Peachtree, and Microsoft Office Accounting. I highly recommend these programs to small businesses. Using a full-featured accounting software will help you monitor the health of your company.

Full-featured accounting programs can take a while to get used to. And it's easy to get frustrated with all the features and utilities. So for freelance professionals, I recommend using personal finance software. The top choices here are Intuit's Quicken or Microsoft Money. Both programs are very easy to get used to and can track all of your finances, not just your business expenses.

As an added bonus, the better tax software programs allows you to import data from Quicken or Money. To make your tax preparation process as smooth as possible, I suggest spending some time making sure your expense categories are set up properly. You can add, delete, and modify categories in all personal finance and accounting software. By having intuitive, easy to remember categories, you'll be able to generate meaningful reports. And most programs will let you link the categories to particular line items on the tax forms. Setting this up can go a long way to reducing the amount of time you spend preparing your taxes.

All the accounting programs I mentioned can generate profit and loss reports (called income statements by accountants). These reports help you analyze how your freelance business is doing, whether you are profitable, and how you are spending your money. If you decide to hire a tax accountant, having these reports to greatly expedite the preparation of your tax returns.

For more information, see a list of common deductible business expenses.