Cost of Goods Sold for a Service Business: Direct Costs or None?

Does a service business have cost of goods sold?

Usually not on the tax return. Cost of goods sold (COGS) is the cost of the products you sell. Most businesses that sell services rather than products do not have to figure it: when selling merchandise is not an income-producing factor, gross profit is the same as net receipts, which is gross receipts less refunds and allowances (Publication 334, chapters 6 and 7). Corporations (Forms 1120 and 1120-S) and partnerships (Form 1065) attach Form 1125-A, which figures it, when they report a cost of goods sold deduction (IRS).

The books are a separate choice. A bookkeeper can group direct labor, subcontractors and job materials above a gross profit line so the profit and loss statement (P&L) shows margin. Some call this group cost of revenue or cost of sales. Gross margin is gross profit divided by revenue. The IRS does not require this grouping for a service business, and it does not change net profit.

A case is not simple if:

• you bill customers for parts or materials, or resell products;
• the gross profit on your P&L does not match the gross profit on your return;
• a lender, investor or buyer wants gross margin and defines it its own way;
• you cannot say which of your costs are direct;
• the P&L shows no cost of goods sold, or every cost as cost of goods sold, and no one can say why;
• your LLC, corporation or partnership is formed in or does business in Texas (franchise tax counts costs its own way, if you owe it).

Gather the P&L for the year, the last filed return with its Schedule C or Form 1125-A, your chart of accounts, payroll reports, a list of subcontractor payments, a list of jobs or customers, and invoices for any parts or materials you resell.

When does a service business have cost of goods sold anyway?

When it sells goods, including materials and supplies it charges customers for. When a personal service business also sells or charges for the materials and supplies it normally uses, the cost of goods sold rules apply to it (Publication 334).

Generally only the cost of the goods goes in, with freight-in on merchandise bought for sale. The labor to install or apply them generally does not, because labor is usually part of cost of goods sold only in a manufacturing or mining business (Publication 334, "Cost of Labor"). A helper's pay stays on the wage line. If you make the product you sell, as a manufacturer does, the labor of making it can be part of cost of goods sold.

A small business taxpayer may choose not to keep an inventory. It then either treats what it resells as non-incidental materials and supplies, recovered through cost of goods sold in the later of the year the goods go to a customer and the year the cost is paid or incurred, or follows how its books treat inventory (26 CFR 1.471-1; Schedule C instructions, Part III). Form 1125-A has a box for each method, but Schedule C does not say which lines carry them, and changing the method later needs Form 3115. Who qualifies and what changes on the return is in inventory or supplies for small sellers, and Part III of Schedule C, including labor, is in cost of goods sold on Schedule C.

What are direct costs in a service business?

Direct costs are the costs that exist because of the work you bill: pay of employees on billable work (with the employer's payroll taxes and benefits, if you want true labor cost), subcontractors, materials used up on a job, and the fuel or equipment costs of delivering the service. For a service business, "direct cost" is a bookkeeping term you define, not a tax category. Publication 334 defines direct labor only for employees working on goods being manufactured (IRS).

A working test: would the cost shrink or disappear if you did one fewer job? If so, it is a candidate for the direct group. If it stays (rent, software, office staff, advertising, insurance), it usually sits below gross profit.

• Trucking: fuel, driver pay, tolls.
• Marketing agency: freelancers and tools bought for one client.
• Trades: helper pay, subcontractors, supplies used on the job.

Owner pay usually stays on its own line even when the owner does billable work, so margin does not move each time the owner changes their pay. The return treats it separately too: the Schedule C wage line excludes amounts paid to yourself, Form 1065 reports payments to partners for services, set without regard to partnership income, as guaranteed payments, and Form 1120-S reports officer compensation apart from other wages.

Should direct costs sit above gross profit if my return has no cost of goods sold?

They can, and it helps when you need margin by job, customer or service line. This is a presentation choice in the books: the return can show the same costs on expense lines.

Showing direct costs above gross profit helps when you price jobs from past margin, when a lender or investor asks for gross margin, or when you compare months. It may add little for a one-person business with almost no direct costs, where gross profit equals revenue.

Whatever grouping you pick:

1. Write down which accounts are direct.
2. Apply the same rule to every month and every period you compare.
3. Do not move a cost between groups to change the margin.
4. Keep a map from each account to its return line, like the table of wages and subcontractors by form.

Chart of accounts setup is in chart of accounts for Schedule C.

Where do subcontractors and wages go on Schedule C, Form 1120-S and Form 1065?

On expense lines, not cost of goods sold, unless the business sells goods and the labor is part of making them. Line numbers below follow the latest published forms and can shift.

Sources: Schedule C instructions, Form 1120-S instructions and Form 1065 instructions. Neither entity form has a contract labor line; the instructions send deductions with no line of their own to other deductions, listed by type and amount. Form 1120 follows the same pattern: officers' compensation on line 12, wages on line 13, other deductions on line 26, and goods through Form 1125-A to line 2 (Form 1120 instructions).

A cost is deducted once. The Form 1120, 1120-S and 1065 instructions say to leave out of the wage lines any wages already included in cost of goods sold, and the Schedule C instructions say to leave out of contract labor any amount deducted elsewhere.

Employer payroll taxes that sit with wages in the books are reported on Schedule C's taxes and licenses line (line 23). A report grouped by direct cost therefore will not match the return line for line without a map. Which contractors get Form 1099-NEC is in which contractors get a tax form.

Does putting costs above or below gross profit change my taxable profit?

Not by itself. Net profit is gross profit less expenses, so a cost counted once lowers net profit by the same amount wherever it sits on the P&L. The grouping changes the gross profit and margin lines only.

Three things can still change a result:

• Goods you resell. Their cost is cost of goods sold, and the year it is deducted depends on how inventory is handled (26 CFR 1.471-1; Publication 538).
• A cost in two places. Counting a cost both in cost of goods sold and as an expense deducts it twice.
• A tax that starts from revenue less allowed costs. Texas franchise tax is the usual example: it allows cost of goods sold only for goods, not services.

Moving a service business's labor into cost of goods sold on the return is generally not supported: Publication 334 ties labor in cost of goods sold to manufacturing and mining. A business above the small business taxpayer limit that produces or resells property may have to include more costs in inventory under the uniform capitalization rules (Form 1125-A).

Does cost of goods sold affect Texas franchise tax, lenders or investors?

For Texas franchise tax, grouping costs as cost of goods sold in the books does not create a subtraction. Texas allows cost of goods sold only to a taxable entity that sells real or tangible personal property in the ordinary course of business, and a service is not tangible personal property (Tax Code 171.1012; Comptroller FAQ). A service business compares the other margin methods instead, such as the compensation deduction (Tax Code 171.101).

For a sale that mixes goods and services, only the costs of the goods count. The Comptroller's example is an oil change: the filter and oil count, the labor does not. Whether your entity owes the tax is in Texas franchise tax. The computation, and the different rule for contractors who work on real property, are in Texas franchise tax deductions.

A lender, investor or buyer reading your P&L may recalculate gross margin using its own list of costs. Ask which costs it counts before you build the report, and keep the map from your accounts to the return. Lender requests are covered in proving income to a lender and financial statements for a bank loan.

How do I set up the profit and loss so margins show?

Put revenue first, then a direct costs group, then gross profit, then everything else. The layout:

If you sell goods as well as services, keep the cost of the goods on its own line inside the direct group, so it ties to any cost of goods sold on the return and helpers and subcontractors stay separate.

Then:

1. Give the direct group its own section of the chart of accounts, with an account for each kind of direct cost.
2. Tag each bill or payment with the job or customer, if your software has the field.
3. Run a second report grouped by return line for the person who prepares the return.

Is my bookkeeper wrong if my P&L shows no cost of goods sold, or every cost as cost of goods sold?

Not necessarily either way. A business that sells no goods generally has no cost of goods sold. Every cost in cost of goods sold is a grouping choice that can leave gross profit and net profit nearly the same and hide overhead. Check these:

How to review a bookkeeper's work is in checking your bookkeeper's work, and other causes of a wrong P&L are in a profit and loss statement that looks wrong.

Example

These examples use US dollars and round, illustrative numbers.

A plumber who bills for parts

A plumber bills $260,000: $200,000 of labor and $60,000 for parts. The parts cost $40,000. A helper earns $50,000 and a subcontractor is paid $20,000. Other costs total $30,000.

If he keeps an inventory, he reports the parts in Part III, so cost of goods sold is $40,000, the parts only, and gross profit is $220,000. If he is a small business taxpayer and keeps no inventory, the parts are still cost of goods sold, recovered when they go to customers and not before the cost is paid or incurred. Either way the helper is on line 26, the subcontractor on line 11, and net profit is $120,000 when he paid for the parts and used all of them in the year. In the books, direct costs are the parts, helper and subcontractor, $110,000, so gross profit is $150,000. Net profit is also $120,000. Only the gross profit line differs.

A trucking LLC with no merchandise

A trucking LLC taxed as an S corporation earns $500,000. Fuel is $120,000, driver wages are $150,000 and other costs, including the owner's officer pay, are $80,000. It sells no goods, so there is no Form 1125-A. On Form 1120-S, driver wages are on line 8, officer pay is on line 7, with Form 1125-E attached because total receipts reach $500,000, and fuel is in other deductions. The bookkeeper groups fuel and driver wages as direct costs, showing gross profit of $230,000, a 46% margin. Net profit is $150,000 on the P&L and on the return.

A marketing agency and its freelancers

An agency has $400,000 of revenue and pays freelancers $120,000. Grouped as direct costs, gross profit is $280,000, a 70% margin. Left in operating expenses, gross profit equals revenue, a 100% margin that shows no cost structure. On Schedule C the return reports the freelancers as contract labor (line 11); a corporation or partnership lists them in other deductions. Net profit does not change either way.

Different for you?

• Your P&L margin does not match the return, a lender or investor needs gross margin, or you cannot tell which of your costs are direct: which accounts are direct, and how each one maps to a return line, need to be settled against your last return. Start with bookkeeping help.
• Your books are behind or came from a bookkeeper you doubt: see catching up on overdue books and bookkeeping help.
• Past returns show cost of goods sold for a business with no goods, or no inventory for one that resells: see fixing inventory missing from past returns and, for the books going forward, bookkeeping help.
• You sell products or resell parts: use cost of goods sold on Schedule C and inventory or supplies for small sellers.
• You are a contractor with jobs and progress billing: see construction job costing.
• You run a restaurant: see restaurant profit and loss statement.
• You run a software or startup company and investors read your gross margin: see chart of accounts for a startup.
• You own a Texas LLC, corporation or partnership: whether the tax applies and which deduction fits are in Texas franchise tax and Texas franchise tax deductions.
• You pay freelancers or contractors outside the US: see paying contractors abroad and records for paying contractors abroad.
• Your 1099 shows the full job amount, or your contractors may really be employees: see subcontractor pass-through on Schedule C and contractors who may be employees.