Why Is it Important to Categorize Expenses Properly for the IRS?

One of the most common questions we get at the Outright Community is “How do I categorize X?” As long as you have a legitimate business expense you may wonder why the expense category matters.   You’re probably thinking you could save some valuable time if all your expenses could just be lumped into the “other” category.

Categorizing Expenses on Your Schedule CExpense categories matter because the IRS really does care about your categories.  When you send your tax return to the IRS, they enter the amounts from your Schedule C into their computers and then start analyzing the numbers.  The analysis tells the service which tax returns they should audit.   For example, cost of goods from your return will be compared to the same cost of goods amounts for every other Schedule C that uses the same NIC code.  If your cost of goods sold is very high or very low compared to all the others, that is one red flag.  They will also compare what you report as wages to what you reported on employee W-2′s and 941′s for the same year.  You want those amounts to agree.   If you report a large amount of contract labor, but didn’t file any 1099′s last year-another red flag.  In fact every category of expense on your schedule C can be compared to industry averages to see if you have any categories that may require additional investigation from the IRS.

Speaking of 1099′s, we all know that the IRS can match up a 1099 to your tax return to know what you are being paid, but you may not know that  credit card companies are required to send a similar report to the service every year to report what you spend.  Those credit card reports are categorized.

If you have ever gone through an audit with the IRS you know that it can be a scary thing, but at a minimum it is time consuming, so spend the few minutes it takes to properly categorize your expenses in Outright.

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