How do you book cost of revenue on your taxes (1065 return or otherwise)?

[goldstein8]

If I have a SaaS (software as a service) based company, and I am tracking cost of revenue in my accounting software, so that I have useful income statements and can track gross profit, how does that map onto my tax return (1065 in my case).

My company doesn't have inventory and a COGS deduction doesn't apply. So I'm assuming I don't fill that in the COGS line 2. But then gross profit on line 3 is not really accurate.

Do I just put the cost of revenue items down into regular expense categories below line 8 in the expenses section of the 1065, or should it be handled differently? 

[GeoffreyG]

As an accountant (CPA) myself, I can think of at least two different ways to handle your situation for income tax purposes, your financial accounting statements, as well as for informal internal accounting purposes (i.e., generating monthly or quarterly profit & loss statements).

Let's start with the assumption that you actually do have some ongoing costs, even if yours is a software as a service (SaaS) business.  It probably costs you something to provide the software services to others (your customers), and so that in itself could be called Purchase (or acquisition) costs, or even Cost of Goods Sold (COGS).  It shouldn't matter that you are selling an intangible good.

If we take this approach, then we can briefly examine what that would look like on a Form 1065 (Partnership) tax return, by opening up screenshot #1, attached to this answer below.

Here we do consider our costs for providing the software service as a COGS.  We just have no opening or closing inventory.  And we would then fill out our accompanying Form 1125-A as shown in screenshot # 2 (or we could use instead Form 1125-A, Line 5 to input our costs, in lieu of what is demonstrated).  No matter, because the costs will ultimately appear the same way when we take our Form 1125A data and transfer it back onto our main Form 1065.

Alternative number two would have you record your costs instead on Line 20 of your Form 1065, and then you can attach any customized statement that you like to further report and / or justify your deductible expenses for tax purposes.  Please see screenshot # 3 for an example to see what this would look like.

Basically, I should think that any reasonable accountant would be comfortable with using either of these two broad methods (or an acceptable, but similar, alternative).  All solutions resolve the basic accounting equation:  REVENUE - EXPENSES = NET INCOME

Thanks for asking this important question, and good luck with your business!

[goldstein8]

Thanks for the feedback. Really appreciate it. Of those two approaches, if the 2nd approach had been taken in the previous year, and one wanted to switch to the 1st approach going forward, is that an issue? Do old returns need to be adjusted? Or are they fine as they are, given as you mentioned REVENUE - EXPENSES = NET INCOME either way.

[GeoffreyG]

Hi goldstien8:

You're very welcome.  Changing revenue / expense approaches shouldn't really cause any accounting issues that I can think of, except where you might be using these figures for internal comparison purposes over time, and in which case at least one expense category wouldn't, obviously, match the dollar amount for a prior period if you change expense treatments.  However, with respect to income tax reporting, again it is really the "bottom line" that the IRS is going to be monitoring, as well as seeing that all of the "flow through" items of income, gains, losses, and deductions correctly are reported by the individual 1065 Partners (via Schedules K-1).  How you get to that "bottom line" though, as long as any reasonable accounting treatment results in the same Net Income, is typically a decision left up to the discretion of company management (i.e., you).  In other words, you shouldn't need to amend any prior year tax returns, because there has been no actual change in taxable income.  The same should be true for your financial accounting records.  Simply make the accounting change "prospectively," that is, going forward.

[abardik]

Thanks for your responses. We have a similar situation, but with a little exception. We are "information services" company (multi-member LLC) and we have no inventory and do not sell any tangible goods. This year we've provided custom software development services for our customer, but outsourced some of those services to the freelancers. So, should we put the full amount of payments for outsourced services to 1125-A as a Cost of Labor or Purchases or Other Costs? Or we can just put it as Contracted Services under the Ordinary Expenses on 1065? This decision will change a gross business income; does it metter for business or individual members tax purposes? Thank you!