Operating Expenses: What Counts and Where They Go on Schedule C

Operating expenses (OpEx) are the ordinary, day-to-day costs of running your business: rent, utilities, advertising, software, insurance, and the wages of the people who keep it going. On a Schedule C, you deduct them in full in the year you incur them, on the expense lines that sit below gross profit. What trips people up is not the definition but the two costs that look like operating expenses and are not: the direct cost of the goods you sold, and the price of a long-lived asset. This guide draws those lines, then runs one small business's year through the return so you can see where each cost belongs.

What operating expenses are

An operating expense is a cost you pay to run the business, as opposed to a cost tied to a specific product or a cost that buys a lasting asset. The Corporate Finance Institute defines them plainly as the costs incurred by a business for its operational activities: supplies, advertising, administration, wages, rent, and utilities.

The tax rule behind the deduction is Internal Revenue Code section 162, which lets you deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Ordinary means common and accepted in your line of work. Necessary means helpful and appropriate for it. A graphic designer's Adobe subscription clears both tests; a jet ski does not. When a cost is ordinary and necessary and it is not one of the two exceptions below, it is an operating expense and you deduct the whole amount this year.

The two costs that are not operating expenses

Two buckets sit outside operating expenses, and both change how and when you deduct the money.

Cost of goods sold is the direct cost of the products you sold: the materials in them, the freight to get those materials in, and the labor to make them. The IRS subtracts cost of goods sold from sales before it reaches gross profit, so it lives above the operating-expense lines, not among them. On Schedule C it is computed in Part III and carried to line 4. Rent and advertising do not belong there.

Capital expenditures are amounts you pay for a long-lived asset: a kiln, a vehicle, a computer, office furniture. Section 263 of the tax code says "no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." You recover the cost over the asset's life through depreciation instead, or you elect to write more of it off up front under Section 179 or bonus depreciation. Either way the deduction runs through line 13, not the supplies line. The Corporate Finance Institute draws the same line the tax code does: the machine is a capital expenditure, but the repair and maintenance of the machinery is an operating expense.

Where each cost lands: a classification table

Here is the same set of costs sorted into all three buckets, with the Schedule C line and the deduction timing for each.

The pattern: cost of goods sold is what the product cost, a capital expenditure buys an asset that lasts, and everything else that keeps the doors open is an operating expense.

A worked year on Schedule C

Nadia runs a ceramics studio and sells mugs online. She files a Schedule C on the cash method for 2025, and her numbers walk down the form in the order the IRS lays it out.

She takes in $90,000 in gross receipts (line 1). The clay, glaze, and shipping boxes that went into the mugs she sold cost $22,000, her cost of goods sold (line 4). Sales minus that direct cost gives gross profit of $68,000 (line 5), which becomes her gross income on line 7.

Now come the operating expenses, Part II of the form. Each cost goes on its own labeled line:

The $6,000 kiln is the one to watch. It is a capital asset with a multi-year life, so section 263 blocks Nadia from dropping it on the supplies line as if it were a bag of clay. She elects Section 179 and writes the full $6,000 off this year, but it still runs through line 13, where depreciation and Section 179 live, and nowhere else.

Her gross income of $68,000 minus total expenses of $33,000 leaves a tentative profit of $35,000 on line 29. With no home-office deduction, that is also her net profit on line 31, the figure she carries to her 1040 and her self-employment tax. The form is doing one clean subtraction: gross profit minus operating expenses equals operating profit.

Operating income, and why interest and income tax sit outside it

That last subtraction is the accounting identity behind operating expenses. Operating income equals gross profit minus operating expenses. It measures whether the core business makes money before financing costs and taxes enter the picture. Nadia's studio earned $35,000 of operating income on $90,000 of sales.

On a formal income statement, two costs deliberately sit below operating income: interest expense on business borrowing, and income tax. They are non-operating because they depend on how the business is financed and how it is taxed, not on how well it runs. A sole proprietor's Schedule C blurs this by listing business-loan interest on line 16 among the operating lines, which does not make loan interest an operating cost; it only means the return is not a textbook operating-income statement. Two things are never business expenses at all: the owner's own federal income tax and self-employment tax, and any money you draw from the business for personal use.

How to classify any cost in three questions

When a new receipt lands, run it through three questions in order and it sorts itself:

1. Is it the direct cost of the specific goods I sold this year? Materials in the product, freight-in, production labor. If yes, it is cost of goods sold (Part III).
2. Does it buy an asset that will help the business for more than a year? Equipment, a vehicle, furniture. If yes, it is a capital expenditure: depreciate it, or elect Section 179 or bonus depreciation, on line 13.
3. Is it otherwise ordinary and necessary to run the business this year? Rent, utilities, ads, software, insurance, professional fees. If yes, it is an operating expense you deduct in full on Part II.

Most of what a solo operator spends falls into question three, which is why operating expenses make up the bulk of a typical Schedule C.

Common misconceptions

"Every dollar that leaves the business is an operating expense." No. Cost of goods sold and capital assets are separate buckets with different timing, and personal spending plus the owner's draw are not business expenses at all. Money out is not the same as an operating expense.

"Bigger operating expenses always mean a weaker business." What matters is operating expenses measured against revenue, the operating margin, and whether the spend produces revenue. Cutting the advertising that drives sales lowers operating expenses and profit at the same time. A rising OpEx figure alongside faster-rising sales is a growing business, not a leaking one.

How SparkReceipt keeps operating expenses in the right bucket

The hard part of operating expenses is not the year-end arithmetic. It is catching each cost during the year and giving it a category that maps to the return. SparkReceipt's expense tracker captures every receipt the moment you get it and sorts it into a tax-relevant category, so rent, utilities, and advertising land where operating expenses go and the direct product costs stay separate. At filing time, one expense report shows your operating spend by category with the receipt images attached, instead of a shoebox to reconstruct in April.

Frequently asked questions

Is rent an operating expense? Yes. Rent on your business premises is a classic operating expense, deducted in full the year you pay it. On Schedule C it goes on line 20b (or line 20a for leased vehicles, machinery, and equipment).

Are operating expenses the same as cost of goods sold? No. Cost of goods sold is the direct cost of the products you sold, and the IRS subtracts it before gross profit. Operating expenses are the costs of running the business and are deducted after gross profit. Putting an operating expense into cost of goods sold distorts both figures.

Are operating expenses tax deductible? Yes, when they are ordinary and necessary to your trade or business under Internal Revenue Code section 162. You claim them on Schedule C Part II, lines 8 through 27.

Is depreciation an operating expense? It functions like one on the income statement and lowers your profit, and on Schedule C it sits among the Part II expense lines (line 13). But it is the recovery of a capital expenditure spread over the asset's life, not a cash cost you paid this year.

Key takeaways

• Operating expenses are the ordinary, necessary cost of running the business, deducted in full the year you incur them under Internal Revenue Code section 162, on Schedule C Part II lines 8 through 27.
• Cost of goods sold is a separate bucket that sits above gross profit, not an operating expense. It is the direct cost of the goods you sold, computed in Part III and carried to line 4.
• Capital expenditures buy long-lived assets and are recovered through depreciation, or expensed up front under Section 179, on line 13. Section 263 blocks deducting them as ordinary supplies.
• Operating income equals gross profit minus operating expenses. Interest and income tax sit below it because they depend on financing and tax status, not on how the business runs.
• Sort every cost with three questions: direct cost of goods sold, long-lived asset, or ordinary running cost. The answer decides the bucket, the Schedule C line, and the timing of the deduction.

Every operating expense starts as a receipt, and the category you give it is what keeps it out of cost of goods sold and off the capital-asset line. Capture and sort them as they happen and your Schedule C practically fills itself. Get Started with SparkReceipt to keep operating expenses in the right bucket all year.