How to Categorize Subcontractor Expenses on Your 1120S Form
Introduction: Why Expense Categorization Matters
Filing taxes for your small business can feel like navigating a labyrinth, especially when it comes to expense categorization. Missteps in classifying your costs—whether you’re a solopreneur or managing a team—can lead to red flags with the IRS. One common dilemma for service-based businesses is figuring out where subcontractor expenses fit on the 1120S form. Should these costs be classified as “Cost of Goods Sold (CoGS)” or lumped under “Other Deductibles”?
If this sounds familiar, you’re not alone. Let’s unravel this tax conundrum, clarify best practices, and help you categorize expenses in a way that aligns with IRS expectations while keeping audits at bay.
Key Considerations When Categorizing Expenses
1. Understanding “Cost of Goods Sold” in a Service Business
For service-based businesses, "Cost of Goods Sold" may not seem immediately relevant because you’re not selling tangible goods. However, think of CoGS as the direct costs involved in delivering your services.
If you’re outsourcing work—like hiring graphic designers, SEO specialists, or web developers to fulfill client contracts—these costs are likely direct expenses. By categorizing them under CoGS, you provide a clearer financial picture of your business’s profitability and gross margins.
2. When to Use “Other Deductibles”
The “Other Deductibles” category can seem like a catch-all, but using it excessively can signal poor bookkeeping. This is particularly risky if a significant portion of your deductions, say 80% or more, ends up here. While it’s perfectly legitimate to include miscellaneous costs under “Other Deductibles,” these should be expenses that don’t fit into standard categories, such as rare or one-off items.
3. IRS Scrutiny and Audit Triggers
Audits aren’t random; they’re often triggered by anomalies, such as disproportionately high expenses in ambiguous categories like "Other Deductibles." By classifying subcontractor expenses under CoGS (when applicable), you minimize the chances of your return being flagged by IRS algorithms.
Steps to Categorize Subcontractor Costs Properly
Step 1: Identify Direct vs. Indirect Costs
- Direct Costs (CoGS): Expenses directly tied to client deliverables, such as subcontractors working on specific client projects.
- Indirect Costs (Overhead): General business expenses like rent, administrative salaries, and marketing campaigns for your business.
Step 2: Use Clear Labels in Your Chart of Accounts
Create a well-structured chart of accounts that includes:
- Revenue
- Cost of Goods Sold (or Services Sold)
- Operating Expenses (e.g., marketing, admin costs, rent)
This not only streamlines bookkeeping but also helps your CPA prepare accurate tax filings.
Step 3: Attach Detailed Statements to Your Return
If you’re following your CPA’s advice to use “Other Deductibles,” include a detailed statement that breaks down the expenses. Specify that these are subcontractor costs directly tied to revenue generation. Transparency is key to avoiding misunderstandings with the IRS.
Step 4: Align Your Team (CPA, Bookkeeper, and You)
Misalignment between your bookkeeper and CPA can lead to confusion and errors. If disagreements arise, seek a second opinion from a CPA with expertise in your industry.
Real-World Example: A Marketing Agency’s Tax Filing Dilemma
Consider a one-man marketing agency that outsources SEO, graphic design, and PR services. The bookkeeper classifies these expenses as CoGS, as they directly contribute to revenue. Meanwhile, the CPA suggests placing them under “Other Deductibles,” citing the absence of tangible goods.
Best practice? The IRS recognizes that service businesses can have CoGS-like expenses. Categorizing subcontractor costs as CoGS gives a clearer financial picture and avoids raising red flags.
Conclusion: Simplify Your Tax Season
Proper expense categorization is more than just a compliance task—it’s about showcasing your business’s financial health and minimizing IRS scrutiny. When in doubt, lean on professionals who understand your industry’s nuances, and always keep detailed records.
Want to make bookkeeping even easier? Check out the Manjasheets Bookkeeping Spreadsheet—the ultimate tool for organizing your finances, categorizing expenses, and staying audit-ready.
