Tracking Expenses for Self-Employed Individuals: Tips and Tools

The ability to efficiently track expenses for self-employed professionals can mean the difference between having a profitable year and ending up with a tax season issue. While many contractors and freelancers view this process as a tedious administrative chore, it’s a critical aspect of running a business and a primary method of securing your revenue.

In this article, we’ll go through all the major reasons why expense tracking is important when you’re self-employed. We’ll also see what counts as a business expense, give you several expert strategies and self-employed accounting tips, and touch on the most common mistakes you need to avoid.

Why Is Tracking Expenses Important for the Self-Employed?

Expense tracking is important for the self-employed because it can have a direct impact on the bottom line. It’s not just about staying organized but about knowing how you spend your money and what shouldn’t be taxed.

#1. Reduces Taxable Income Through Deductions

The U.S. uses a progressive tax system, which means you’re taxed on your net earnings and not your gross income. As a result, you can spend a substantial amount of your revenue on various business affairs and not get taxed on it.

With meticulous small business expense tracking, you can lower your adjusted gross income (AGI) and only pay taxes on the money you take for yourself. This is essential for independent contractors who are responsible for self-employment tax (15.3% of income on account of Social Security and Medicare taxes) in addition to standard income taxes.

#2. Makes Quarterly Tax Payments Easier

While W-2 employees have their taxes withheld from paychecks by employers, freelancers and contractors need to pay estimates each quarter. This is done four times a year using Form 1040-ES.

If you don’t track your expenses, your estimates can be highly inaccurate. This can lead to either underpaying (and potentially facing penalties) or overpaying (and tying up too much of your valuable funds) on your taxes.

#3. Helps Separate Personal vs. Business Finances

Separating personal and business finances is one of the core aspects of successfully running a business. By maintaining the “corporate veil,” you avoid making a mess of your records by mixing up personal purchases with business expenses.

While this can make the tax season exceptionally difficult, it can lead to even bigger problems if the IRS audits you. In case they see mixed expenses in your accounts, they may consider it a red flag and disqualify even legitimate business purchases.

#4. Supports Accurate 1099 and Schedule C Reporting

At the end of the year, you must file Schedule C (Form 1040), Profit or Loss from Business. This form will have you sort your expenses into distinct categories (e.g., office expense, rent, utilities), which is much easier to do when you’ve kept track of everything.

Moreover, if you’ve been hiring contractors, you need to know how much you paid them. Paying a single contractor at least $600 in a tax year requires you to fill out and provide the Form 1099-NEC, Nonemployment Compensation.

#5. Prevents Issues During Audits

In case of an audit, you need to have solid proof for every inquiry from the IRS. If you can’t provide receipts, invoices, and other audit documentation, the auditor will likely disallow your expenses, increasing your tax liability and even deciding you need to pay penalties.

However, if you’re diligent with tracking deductible business expenses, you’ll have sufficient evidence to turn a potentially stressful audit into a quick and simple verification.

What Counts as a Business Expense for the Self-Employed?

For a payment to count as a business expense, it needs to be required for your operations and characterized as “ordinary and necessary.” An expense is ordinary when it’s common in your industry and necessary when it’s beneficial to your work.

Some of the most common deductible expenses include:

• Marketing: hosting your website, purchasing business cards, buying various ads, leveraging email marketing tools, etc.
• Office supplies: costs of hardware (e.g., computers and printers) and various consumable products (paper, ink, postage)
• Professional services: fees paid to different consultants, lawyers, accountants, and other professionals required by your business
• Insurance: this typically encompasses professional liability insurance, but can include health insurance premiums in some cases
• Education: professional courses, certifications, seminars, workshops, books related to improving your skills, etc.
• Travel: purchases associated with business travels outside your home base, like airfare, hotels, and taxis.
• Utilities: phone, internet, energy, water, sewage, etc.

Fully vs. Partially Deductible Expenses

Not all deductible expenses are treated the same by the IRS. Some of them can only be partially deducted, and knowing which ones are important for improving your financial planning and forecasting.

For starters, fully deductible expenses are, in general, operational ones. For instance, you can fully deduct a laptop that you buy for your operations, the required software, your business license, and the rent you pay for the workspace. The costs of marketing, office supplies, and contractors can also often be 100% deductible.

Now, here are some of the business expenses that are only partly deductible:

• Meals. You can typically deduct 50% of the cost of meals, including lunches with clients and meals while traveling. These meals also shouldn’t be “lavish or extravagant.”

• Home office. You can choose two methods for home office deductions. The simplified method allows you to deduct $5 per square foot, up to 300 sq. ft. The actual expenses method is based on costs like mortgage, rent, and utilities.

• Vehicle expenses. When deducting vehicle expenses, you can choose between a standard mileage rate and the actual expenses (such as the cost of gas, insurance, and repairs multiplied by the percentage for business use). You can’t deduct the cost of the entire vehicle.

How to Track Expenses as Self-Employed: 4 Methods Explained

Let’s take a look at some of the best methods and self-employed expense trackers you can use to make this administrative process simple and efficient.

#1. Spreadsheets

Spreadsheets are a cost-effective solution for freelancer expense tracking if you’ve recently started your business. They give you complete control, allowing you to create columns for different details, like the date, vendor, category, amount, etc.

While it is a free and flexible solution that gives you full control over the information, it does come with several downsides. Namely, spreadsheets require manual data entry, which is slow and prone to errors. Plus, when you need to track receipts for taxes, you must use a separate system (e.g., folders in your computer or Google Drive).

#2. Expense Tracking Software

Expense tracking software, like FreshBooks, Xero, or QuickBooks Self-Employed, is an industry standard for established freelancers and independent contractors. You can connect them to your credit cards and bank accounts to allow for seamless and automated expense tracking.

This saves hours of manual work and minimizes the chance of making a mistake. Plus, these software solutions can help you file taxes and calculate quarterly estimates with ease. The downside is that there is a learning curve to setting up and using the software. Plus, it comes with a monthly subscription fee.

#3. Invoices and Receipts

Collecting and keeping invoices and receipts is a must when it comes to expense management for freelancers. You can store both physical paper and use a digital solution, as long as it makes the records easily accessible.

Receipts should show all the important information, like the vendor’s name, description of purchase, date, and amount. Invoices should be detailed but easy to read, professional, and uniform. We recommend using our invoice generator to create them with ease, leveraging automated invoice numbering for simplified record-keeping.

You can also use our Form 1099 generator to file and record payments to other vendors and contractors, as well as a pay stub generator, for income and deductions.

#4. Credit Card and Bank Statements

Credit card and bank statements represent chronological records of your spending. This can significantly simplify the process of reconciliation. Keep in mind that you should use these statements as supplemental documentation, not the main financial records.

It’s good practice to keep your personal and business accounts separate and maintain the “corporate veil.” This makes it easy to isolate the transactions and track expenses as an independent contractor or business owner.

3 Common Expense Tracking Mistakes to Avoid

Before we wrap up, let’s take a look at some of the biggest and most common mistakes professionals make when tracking their expenses:

1. Completely relying on the “$75 rule.” Some contractors and business owners take this rule at face value and neglect the circumstances around the expense. For instance, if an auditor sees a $60 expense for a business lunch but no receipts to back it up, they can easily dismiss it. That’s why you should keep the receipts regardless of the amount.
   
   
2. Mixing up the accounts. Using a business credit card for a personal purchase and vice versa “pierces the corporate veil,” introducing unnecessary and dangerous bookkeeping complications. It forces you or your accountant to go through countless expenses later on to accurately separate business from personal ones.
   
   
3. Ignoring cash purchases. Minor cash expenses (e.g., paying for a parking fee or tipping a vendor) can add up over time and lead to significant sums. If you don’t track and log them accurately, you may end up having to pay taxes on hundreds, if not thousands, of dollars that would otherwise be tax-deductible.

Final Thoughts

Tracking expenses as a self-employed professional is not optional if you want to ensure the financial stability of your business and its compliance with tax laws. Fortunately, this potentially tedious and complicated administrative task can be streamlined and simplified by following several simple strategies.

Once you set up a workflow (be it a spreadsheet or a dedicated software), make sure to be consistent. There are many ways to track business expenses, but the best one is the one you stick to.

Track Expenses for Self-Employed FAQs

#1. What expenses can I claim if I'm self-employed?

If you’re self-employed, you can claim expenses that are related to your business and considered ordinary and necessary. This may encompass the costs of office supplies, advertising, business insurance, vehicle mileage, professional fees, portions of business meals (typically 50% of the full cost), etc.

#2. Do I need receipts for every expense?

Yes, you should keep the receipts for every expense. While the IRS has a general threshold of $75, below which receipts might not be mandatory for some expenses, it’s still good practice to be able to prove the nature of a purchase, as well as its time and place.

#3. How long should I keep expense records?

You should keep expense records for at least three years from the date you file your return. In some instances (e.g., if you file a claim for a loss from worthless securities), and for certain records, this limit may extend up to seven years.