Is It Normal to Allocate 83% of Business Expenses to “Other Deductibles” on a Tax Form?
Introduction
Hello readers, I’m facing a bit of a dilemma with how to categorize expenses on the 1120S tax form, and I’m seeking advice from the broader community.
Business Context
I operate a one-man marketing and advertising agency. Initially a single-member LLC since 2022, I elected S-Corp status this year upon my CPA’s recommendation to save on self-employment taxes. Though I’m the only W2 employee, I frequently hire outside help. These subcontractors include graphic designers, web developers, SEO.html" target="_blank" rel="noopener noreferrer">SEO specialists, and PR consultants, usually sourced through platforms like UpWork or hired directly from other agencies.
Current Situation
Recently, while reviewing and categorizing expenses with my bookkeeper for tax filing, we encountered a significant disagreement. We previously categorized subcontractor payments as “Contract Labor” on Schedule C, but the 1120S form lacks a similar option. With these expenses not aligning with “Advertising” or “Wages Paid,” my CPA suggests categorizing them as “Other Deductibles” with an attached statement explicating the nature of these expenses. Given our service-based business, the CPA also proposes listing “Cost of Goods Sold” as zero, seeing no tangible goods production under our business activity code.
Bookkeeper’s Concern
However, my bookkeeper strongly disagrees, arguing that labeling 83% of deductions as “Miscellaneous Expenses” could flag an Audit. He believes “Cost of Goods Sold” really translates to “Cost of Sales” or “Cost of Revenue,” and that these expenses should be considered operating expenses directly tied to business growth. From his perspective, categorizing these under CoGS offers the IRS a clearer understanding of profit margins, minimizing Audit risks.
Seeking Opinions
Though I’m not a tax expert, my bookkeeper’s reasoning resonates with me. Nonetheless, I’m keen to gather opinions from others: Should these expenses fall under “Other Deductibles,” or are they better suited as CoGS? Your insights would be greatly appreciated.
One response
When deciding how to categorize expenses on your 1120S tax form, you’re right to be cautious, especially if a significant percentage of your business expenses might fall into the “Other Deductibles” category. Your situation is not uncommon for service-based businesses, particularly those heavily reliant on subcontractors. Here’s a breakdown of the issues and considerations:
Understanding the Key Categories
Contract Labor: On the Schedule C form used for sole proprietorships, you would indeed list subcontractor expenses as “Contract Labor.” The confusion arises because the 1120S form, used for S-Corporations, doesn’t have this explicit category.
Cost of Goods Sold (CoGS): Primarily used by businesses dealing with physical goods, CoGS refers to the direct costs tied to producing those goods. For your service-based business, the concept needs a slightly altered interpretation. Many service companies view the costs directly linked to service delivery as akin to CoGS.
Other Deductions: This category is a catch-all for expenses that don’t fit neatly into predefined categories. However, using it excessively (e.g., for 83% of expenses) can raise red flags with the IRS.
Considerations for Categorizing Expenses
Service-Based Business Context: In a service-based business, direct expenses for subcontractors could arguably be seen as the cost of providing your service. The IRS allows some flexibility, acknowledging industry-specific practices.
Transparency and Supporting Documentation: If your CPA advises using “Other Deductions,” it’s crucial to include a detailed statement that breaks down these expenses explicitly. This transparency helps mitigate Audit risks.
Risk of Audit: Your bookkeeper rightly points out that excessive reliance on ambiguous categories like “Other Deductions” can trigger automated Audit systems. The IRS looks for clarity and consistency in reporting; a high percentage in miscellaneous or other categories often draws attention.
Balancing Perspectives: CPA vs. Bookkeeper
CPA’s Approach: The CPA is likely prioritizing a straightforward adherence to IRS categories as they appear on the form. Their suggestion to detail expenses in an attached statement reflects an awareness that clarity and backup documentation are key during any Audit consideration.
Bookkeeper’s Approach: Your bookkeeper leans toward a more nuanced interpretation tailored to your business model. Using a category akin to CoGS acknowledges the direct impact of subcontractor expenses on revenue generation.
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