This week focuses on the connection between bookkeeping and tax preparation. A clean Form 1120-S begins with accurate business records.
Learning Objectives
- Separate business income from nonbusiness deposits.
- Distinguish deductible business expenses from personal expenses.
- Understand why owner distributions are not ordinary business expenses.
- Connect bookkeeping categories to Form 1120-S.
Primary IRS Materials
- Instructions for Form 1120-S
- IRS guidance on deducting business expenses
- Publication 334, Tax Guide for Small Business, where relevant
Ordinary and Necessary Expenses
A business expense generally needs to be ordinary and necessary for the trade or business. For a small service business, possible expenses may include software, web hosting, domain registrations, advertising, professional fees, office supplies, business insurance, and qualifying equipment costs.
Do Not Mix These Categories
- Business expense: A qualifying cost incurred for the business.
- Personal expense: A personal cost that is generally not deductible by the corporation.
- Shareholder distribution: Cash or property transferred to the shareholder in the shareholder’s ownership capacity.
- Payroll: Compensation paid to an employee, including a shareholder-employee.
- Reimbursement: Payment to an employee or shareholder for qualifying business expenses under an appropriate reimbursement arrangement.
Practice Exercise
Create a fictional S corporation with $20,000 of annual revenue. Categorize 20 sample transactions into revenue, payroll, business expense, shareholder distribution, reimbursement, or personal expense.
End-of-Week Goal
You should be able to look at a transaction and explain not only how you would categorize it in the books, but also why that classification matters for the tax return.