Proper transaction categorization throughout the year makes tax season straightforward. This guide covers best practices for tax-ready bookkeeping.
Why Categorization Matters for Taxes
The IRS requires businesses to report income and expenses by category. Clean, consistent categorization helps you:
- Maximize legitimate deductions
- Support your tax return if audited
- Identify tax planning opportunities
- File accurately and on time
Key Expense Categories for Tax
While TraceEntry uses intuitive category names, these map to standard tax deduction categories. Here are the most important ones:
Advertising & Marketing
Includes: Online ads, print advertising, promotional materials, sponsorships, marketing software subscriptions.
Car & Truck Expenses
Includes: Gas, maintenance, repairs, insurance, registration, parking, tolls. Note: If you use the standard mileage rate, you can't also deduct actual expenses.
Contract Labor
Includes: Payments to independent contractors, freelancers, and consultants. Remember: You must issue 1099s for payments over $600.
Insurance
Includes: Business liability, professional liability, property insurance, workers' comp. Health insurance is reported separately for self-employed.
Legal & Professional Services
Includes: Attorney fees, accountant fees, bookkeeping services, tax preparation, consulting fees.
Office Expenses
Includes: Office supplies, small equipment under $2,500, cleaning supplies, postage, printing.
Rent or Lease
Includes: Office rent, equipment leases, vehicle leases. Keep separate from home office deduction.
Repairs & Maintenance
Includes: Building repairs, equipment maintenance, janitorial services. Major improvements may need to be capitalized instead.
Travel
Includes: Airfare, hotels, rental cars, meals during travel (50% deductible), conference fees.
Utilities
Includes: Electricity, gas, water, internet, phone. Home office portion calculated separately.
Meals & Entertainment
Includes: Business meals (50% deductible), client entertainment. Must have business purpose documented.
Common Categorization Mistakes
Mixing Personal and Business
Personal expenses in business accounts are not deductible and can trigger audit flags. See our guide on Handling Mixed Transactions.
Miscategorizing Capital Expenses
Large purchases (equipment, vehicles, improvements) over $2,500 may need to be depreciated rather than expensed. Watch for:
- Computer equipment over $2,500
- Furniture and fixtures
- Vehicle purchases
- Building improvements
Missing Contractor Payments
Payments to contractors must be tracked separately for 1099 reporting. Create a specific category or tag for contractor payments.
Lumping Everything into "Miscellaneous"
Avoid catch-all categories. If more than 5% of expenses are "miscellaneous," review and recategorize. Large miscellaneous amounts attract IRS attention.
Using TraceEntry for Tax Prep
Choose the Right Industry Template
TraceEntry's industry templates include tax-relevant categories. Select the industry that best matches your business for optimal categorization.
Review Low-Confidence Transactions
Don't let uncertain categorizations slip through. Low-confidence items are often the ones that need careful consideration for tax purposes.
Use Consistent Categories Year-Round
Process transactions monthly rather than waiting until year-end. This ensures consistent categorization and catches issues early.
Flag Items Needing Documentation
Some deductions require receipts or documentation. Flag transactions where you need to follow up for:
- Meals over $75 (receipt required)
- Travel expenses (itinerary, business purpose)
- Home office expenses (square footage calculation)
- Vehicle expenses (mileage log or expense receipts)
Year-End Categorization Checklist
Before December 31
- Process all bank statements through November
- Identify any expenses that should be prepaid before year-end
- Review large purchases for depreciation vs. Section 179 election
- Verify contractor payment totals for 1099 preparation
January Tasks
- Process December bank statements
- Reconcile all accounts to year-end balances
- Generate annual expense summary by category
- Compare to prior year for anomalies
- Prepare 1099s (due January 31)
Before Filing
- Review expense categories against tax form line items
- Verify all deductions have supporting documentation
- Check for personal expenses that slipped through
- Reconcile categorized expenses to bank statements
Documentation Best Practices
What to Keep
The IRS requires documentation for all business expenses. Keep:
- Bank and credit card statements
- Receipts for expenses over $75
- Invoices from vendors and contractors
- Mileage logs for vehicle deductions
- Home office square footage calculations
How Long to Keep Records
- 3 years — Standard retention for most documents
- 6 years — If you underreported income by 25%+
- 7 years — If you claimed a loss from worthless securities
- Indefinitely — If you didn't file or filed fraudulently
Digital vs. Paper
The IRS accepts digital records. TraceEntry exports serve as documentation of your categorization. Keep exports organized by year and client.
Working with Your Tax Preparer
What They Need
Provide your tax preparer with:
- Annual Profit & Loss by category
- Year-end Balance Sheet
- Summary of categorized expenses (TraceEntry export)
- List of capital purchases
- Contractor payment summary (for 1099s)
Answering Questions
Be prepared to explain unusual items or large expenses. Your categorized transaction list makes this easy—you can point to specific transactions rather than digging through bank statements.
Prepare Now for Tax Season
- Process any backlogged bank statements through TraceEntry
- Review categories for tax-relevance
- Flag items needing documentation
- Generate a year-to-date expense summary
- Schedule a pre-tax season review with your accountant
Questions about tax categorization? Contact us for guidance.