Understanding Business Expenses
Understanding the core difference between Personal and Business Expenses
There is often confusion around what is considered an allowable business expense in the context of people that are self-employed or small company owners. This confusion can arise as a result of the proximity of operation between the owner and the business. In other words, small business owners or sole traders often use personal spaces e.g. their home, car etc. to conduct business activities. As a result, the distinction between business expenses and personal expenses can be blurred.
It is important to understand that there are Generally Accepted Accountancy Principles (GAAP) that guide the process or the manner in which we account for business transactions. Not everything charged in the profit and loss account of a trade, profession or vocation is an allowable deduction for tax purposes. For example, we normally add back depreciation when computing your taxable profits because it is not an allowable expense (Private and Personal Expenditure Toolkit).
Therefore, in accounting terms – you cannot deduct expenses that have not been wholly and exclusively incurred for the purposes of trade. This means that you can only claim an expense when it has occurred directly as a result of the business’s trading activities. This means that you cannot claim travel to go see a friend as a business expense unless the friend is a client, supplier and you are there to exclusively discuss matters that relate to the business.
There are 5 problematic areas for HMRC when it comes to business expenses:
• Record Keeping
• Personal Bills
• Travel and Subsistence
• Entertaining, gifts, subscriptions and sponsorship
• Drawings and Capital Account
Good record keeping is extremely important for the accuracy of the information you provide. We cannot emphasize enough the importance of good record keeping as a tool to identify a clear separation between personal and business expenses. The impact of poor record keeping is that non-business expenses may be incorrectly recorded or mis-posted as allowable business expenses, or the opposite may occur e.g. justifiable business expenses not being claimed accurately.
As mentioned above, there is often a close link between the finances of small business owners and the business. This can result in personal expenses being paid by the business and/or business expenses being paid by the business owner. It is therefore relevant, once again, to emphasize the importance of good record keeping. It is also important to consider whether the expense has been incurred wholly and exclusively for the purposes of the business. For instances where it is not e.g. using your home for the business purposes – it is important to apportion the cost so that only the business element of the total expense is recorded in the accounts. This means that if your rent is £1000 per month. This expense as a whole cannot be claimed as a business expense and thus you may decide to apportion 30% (£300) of the cost to the business. This applies to other expenses such as utility bills.
Travel and Subsistence
This can be a more complex area involving special rules. Once again, travel and subsistence expenses can only be claimed if they are for business purposes. However there are circumstances when the expense may appear to have a business purpose yet is not wholly allowable, particularly where there is a business and personal purpose (a mixed purpose). It is important to establish all of the facts when considering whether such an expenses allowable (Private and Personal Expenditure Toolkit).
Entertaining, gifts, subscriptions and sponsorship
The general principle is that entertaining and gifts are specifically disallowed from been claimed as expenses. There are a few exceptions to the general principle. For example entertaining employees (within certain limits) and small gifts that include advertising will normally be allowed. If the facts are not established this can lead to entertaining and gifts being incorrectly claimed as allowable.
For subscriptions and sponsorship the general principle is whether the wholly and exclusively test is satisfied. Subscriptions for general charitable purposes and/or to political funds are seldom wholly and exclusively for business purposes and therefore generally not allowed (Private and Personal Expenditure Toolkit).
However, a limited company can pay less corporation tax by donating to charity (Gift Aid) i.e. the value of the donation can be deducted from profits before corporation tax. Higher rate tax payers can also claim some tax back through charitable donations. They can do this by claiming the difference between the rate of tax they pay and the basic rate of their donation.
Drawings and Capital Account
There needs to be a clear distinction between drawings and wages/salary. Drawings are any income taken from the business that doesn’t include wages/salary or out of pocket expenses. Drawings are debited from the capital account or director’s fund (in the case of a limited company). It is important to keep drawings to a minimum because any money taken out of the business should either be for an out of pocket expense or wages/salary (particularly from a company perspective).
As a business owner it is extremely important to understand what is classified as a business expense in order to ensure that your expenses are being recorded correctly. Once you understand that business expenses need to be wholly and exclusively incurred for the purposes of business/trade then it will be easier for you to differentiate between a business expense and a personal expense.