How to categorize business expenses (and avoid an IRS audit)

Tax preparation has a reputation for being stressful. For many startups, tax-time stress comes from a pileup of put-off tasks or lacking organization systems. Receipts are scattered across inboxes. Expenses go uncategorized for months. And founders find themselves retracing purchases and questioning deductions as filing deadlines approach.

In most cases, the issue isn’t complicated tax rules; it’s unclear expense categorization. When transactions aren’t clearly classified, tax season becomes reactive. Deductions get missed, inconsistencies emerge, and errors crop up, which can make an IRS audit more likely for your startup.

You can avoid this situation by putting thoughtful expense categorization in place early. Clear categories support accurate deductions, reduce audit risk, and make tax preparation faster and more predictable without adding unnecessary overhead.

This guide explains how to categorize business expenses correctly, highlights common missteps, and outlines a simple, repeatable approach to keeping tax season controlled and refreshingly uneventful.

Expense categorization isn’t just about bookkeeping hygiene. It’s a core part of bookkeeping for startups and affects three things founders care about: your tax bill, IRS compliance, and financial clarity.

Your tax bill

Poor categorization leads to missed tax write-offs that entrepreneurs are legally entitled to claim. Over time, that’s real money left behind.

IRS compliance

Audits aren’t random. Inconsistent startup accounting categories, excessive deductions, or shaky business vs. personal expense separation raise red flags for the IRS.

Financial clarity

Clean categories make it easier to understand burn, forecast runway, and support IRS Schedule C / 1120 deductions without backtracking. In short, good categorization protects your downside and strengthens your upside.

If you’re unsure how to categorize business expenses, start with the business expense categories that the IRS already expects to see. 

Below are the most common startup accounting categories, what they include, and the areas where founders often slip up.

Advertising and marketing

Includes:

• Paid ads
• Brand and creative services
• Website development
• Sponsorships and events

Watch out for:

• Personal branding expenses without a clear business purpose
• Overly broad “growth” categories

Software and subscriptions

Includes:

• SaaS tools
• Cloud hosting
• Design and productivity software

Watch out for:

• Personal subscriptions billed to the company
• Annual prepayments that may require different treatment

Meals and entertainment

Includes:

• Client meals
• Business meals while traveling
• Team meals tied to work activities

Important note:

• Entertainment expenses are generally non-deductible.
• Meals are typically 50% deductible, with exceptions.

Meals and entertainment is one of the most misunderstood expense categories because the rules have changed over time, and the line between meals and entertainment is often unclear in practice. A client dinner may qualify as a meal, but tickets to an event may not, even if business is discussed at both events.

Without clear documentation of the business purpose, otherwise valid meal deductions can quickly become tax-time problem areas for small businesses. To stay compliant, categorize meals carefully and add a short note explaining who the meal was with and why it was business-related.

Travel

Includes:

• Flights and hotels
• Rideshare and ground transport
• Mileage for business use

Watch for:

• Mixing personal and business travel
• Deducting 100% of mixed-use trips

Office supplies

Includes:

• Desk supplies
• Small equipment
• Printer and office materials

Watch for:

• Incorrectly expensed capital assets 
• Home office items without documentation

Professional services

Includes:

• Legal and accounting
• Consultants and contractors

Watch for:

• Blending startup setup costs with operating expenses
• Missing contractor reporting requirements (If this applies to you, read Mercury’s guide on how to prepare for 1099 filing.)

Employee compensation

Includes:

• Salaries and wages
• Payroll taxes
• Benefits and stipends

Watch for:

• Inconsistent founder compensation
• Misclassified contractors

Rent and utilities

Includes:

• Office rent
• Coworking spaces
• Internet and utilities tied to workspaces

Watch for:

• Unsupported home office deductions
• Over-allocating shared expenses

When deciding whether something qualifies as a small business tax deduction, ask the question the IRS cares about most, “Is this expense ordinary and necessary for operating the business?”

Some expenses — such as business software, advertising spend, or professional services — are clearly business-related and generally straightforward to deduct. 

Other categories, including meals and travel, sit in a gray area. These expenses are often subject to limits or closer scrutiny, especially when the business purpose isn’t well documented.

Then there are expenses that are difficult or impossible to deduct because they aren’t considered ordinary or necessary for business operations. Personal expenses, entertainment, and fines typically fall into this category.

The table below provides a quick guide to common deductible, non-deductible, and limited-deductibility expenses to help you categorize your spending with confidence.

Understanding deductible vs. non-deductible expenses upfront will help you avoid surprises later.

Most audits don’t start with fraud. They start with patterns that don’t add up. If your goal is to avoid the  stress of a potential audit, watch out for these issues.

Mixing personal and business expenses

Blending your personal and business finances is a fast way to lose credibility and gain IRS scrutiny.

Examples:

• Personal subscriptions purchased on the company card
• Groceries categorized as meals
• Travel upgrades with no business explanation

How to fix it:

• Use separate accounts.
• Pay with separate cards.
• Make no exceptions.

Strong business vs. personal expense separation matters more than almost anything else when it comes to financial clarity. To streamline this process, Mercury’s business card helps keep expenses cleanly separated, with built-in categorization and cashback.

Excessive meal or travel deductions

High deductions compared to your company’s revenue tends to attract IRS scrutiny.

How to fix it:

• Add short memos to your expense documentation.
• Stay conservative with these types of deductions.
• Document who you shared a meal with and why.

Vague or catch-all categories

Using “miscellaneous” as a catch-all expense category may invite questions.

How to fix it:

• Use clear, IRS-aligned expense categories.
• Rename categories to match the reality of your spending.

Blurring startup costs and operating expenses

The IRS treats startup costs differently than ongoing expenses, so your company’s expense categories need to reflect this.

How to fix it:

• Track incorporation and setup costs separately.
• Know when amortization applies.

Waiting until year-end

If you’ve ever waited until the end of the year to sift through receipts, you know what a pain this is. Plus, rebuilding a year of transactions increases errors.

How to fix it:

• Review your expenses monthly.
• Treat categorization as part of your tax-season startup checklist.

You don’t need a whole finance team to stay tax compliant, but you do need consistent methods. 

Here are the best accounting practices that all startups can implement to be audit-ready all year long: 

• Keep digital receipts.
• Add one-line memos explaining business purpose.
• Use the same startup accounting categories all year.
• Review expenses monthly.
• Use expense categorization software to reduce manual errors.

Learn more about how accounting automations can help reduce bookkeeping hours.

If you remember nothing else during tax season, remember this: Most problems come from small, preventable habits. Use this checklist to keep your company’s expense categorization clean and audit risk low.

Do:

• Separate business and personal finances.
• Use IRS-recognized expense categories.
• Document meals and travel clearly.
• Review expenses monthly, not just at year-end.

Don’t:

• Don’t use “miscellaneous” expenses as a catch-all category.
• Don’t over-deduct meals or travel.
• Don’t ignore IRS deduction rules.
• Don’t assume software will fix poor inputs.

Clean systems beat major cleanups. When your expense categories are consistent and your habits disciplined, tax season becomes more predictable and manageable.

Founders don’t get audited for being human. They get audited for being messy.

When you categorize expenses with intention, clear categories, consistent habits, and modern tools, tax season becomes more predictable and even uneventful. And uneventful is exactly what you want when the IRS is involved.

Mercury is built to support bookkeeping for startups from day one by reducing errors and increasing confidence come filing time. Remember, the best tax strategy isn’t a loophole; it’s getting the basics right.

Learn more about how Mercury helps startups save time and get audit-ready for tax season.

For specific guidance on your tax filing obligations, please consult with a qualified tax professional. Mercury does not provide tax advice. Tax regulations can be complex and vary based on individual circumstances, so it's important to seek personalized advice from an expert who can assess your unique situation.