What Qualifies as a Contract Expense?
Understand the costs that arise from business agreements and the correct procedures for managing them to ensure financial and regulatory compliance.
A contract expense is a cost a business incurs through a formal agreement for goods or services from another party. These agreements establish a clear understanding of deliverables, timelines, and payment terms. Understanding what constitutes a contract expense is necessary for properly managing, recording, and reporting these costs to track financial health and meet compliance obligations.
Common Categories of Contract Expenses
A primary type of contract expense involves payments to independent contractors, freelancers, and consultants. Businesses engage these individuals for specialized skills or to fulfill labor needs without hiring them as employees, such as hiring a graphic designer for a marketing campaign or an IT specialist for a system upgrade.
Legal fees for services like contract drafting, review, and general counsel also fall under this classification. Similarly, retainers paid to marketing or advertising agencies are contract expenses, as these agreements specify a recurring fee for ongoing services.
Many businesses rely on software-as-a-service (SaaS) platforms, and these subscription and licensing fees are contract expenses where the terms of service act as the contract. Another category is lease or rental payments for equipment or office space. A lease is a formal contract that grants the business use of an asset for a period in exchange for regular payments. Maintenance and service agreements for equipment are also contract expenses.
Accounting for Contract Expenses
The method for recording contract expenses depends on the company’s accounting basis: cash or accrual. The difference lies in the timing of when an expense is recognized. For businesses on a cash basis, an expense is recorded only when money leaves the company’s account. For instance, if a contractor’s invoice from June is paid in July, the expense is logged in July.
Under the accrual basis, an expense is recorded when it is incurred, regardless of when payment is made. Using the same example, the expense for work completed in June is recorded in June. This method involves creating an “Accounts Payable” liability to show the obligation to pay and provides a more accurate picture of a company’s financial health by matching expenses to the period in which they helped generate revenue.
The basic bookkeeping entry involves debiting an expense account, such as “Contractor Expense,” and crediting an asset or liability account. When a contract expense is paid, the “Cash” account is credited. If using the accrual method and an invoice is received but not yet paid, “Accounts Payable” is credited instead of “Cash.”
Tax Deductibility and Reporting
For a contract expense to be tax-deductible, it must meet the Internal Revenue Service (IRS) standard of being both “ordinary and necessary” for conducting business. An ordinary expense is common in your industry, while a necessary expense is helpful and appropriate for your business. This standard, outlined in IRC Section 162, ensures that personal expenses are not claimed as business deductions.
Sole proprietors report payments to independent contractors on Schedule C (Form 1040), Profit or Loss from Business, on the line for “Contract Labor.” It is important not to include payments here that belong on other lines, such as legal fees or wages. The total of these deductible expenses reduces the business’s net profit, which lowers the overall taxable income.
A compliance requirement for contract expenses is filing Form 1099-NEC, Nonemployee Compensation. If a business pays an independent contractor $600 or more during a calendar year, it must issue this form to the contractor and file a copy with the IRS. The form is due to both the recipient and the IRS by January 31 of the following year.
Documentation and Record-Keeping
Maintaining documentation is necessary for substantiating contract expenses for internal accounting and external audits. The IRS requires businesses to keep records that prove a transaction occurred and was for a legitimate business purpose. These records serve as the primary evidence during an IRS inquiry or financial audit.
The documents to retain include the signed contract or service agreement, all invoices received from the vendor, and proof of payment. Proof of payment can take the form of canceled checks, bank account statements, or credit card statements that reflect the transaction.
The IRS recommends keeping records for at least three years from the date you file your tax return, though this period can extend longer in specific situations. While the IRS allows exceptions for keeping receipts for expenses under $75, you must still log the amount, date, location, and business purpose of the expense. Proper record-keeping provides a clear audit trail and defends the deductions claimed on a tax return.