If you make or buy goods to
sell, you can deduct the cost of
goods sold from your gross
receipts on Schedule C. However,
to determine these costs, you
must value your inventory at the
beginning and end of each tax
year.
This chapter applies to you
if you are a manufacturer,
wholesaler, or retailer or if
you are engaged in any business
that makes, buys, or sells goods
to produce income. This chapter
does not apply to a personal
service business, such as the
business of a doctor, lawyer,
carpenter, or painter. However,
if you work in a personal
service business and also sell
or charge for the materials and
supplies normally used in your
business, this chapter applies
to you.
If you must account for an
inventory in your business, you must
generally use an accrual method of
accounting for your purchases and
sales. For more information, see
chapter 2.
Figuring Cost of
Goods Sold on
Schedule C Lines 35
Through 42
Figure your cost of goods
sold by filling out lines 35
through 42 of Schedule C. These
lines are reproduced below and
are explained in the discussion
that follows.
35
Inventory at
beginning of year.
If different from
last year's closing
inventory, attach
explanation
36
Purchases less cost
of items withdrawn
for personal use
37
Cost of labor. Do
not include any
amounts paid to
yourself
38
Materials and
supplies
39
Other costs
40
Add lines 35 through
39
41
Inventory at end of
year
42
Cost of goods
sold.
Subtract line 41
from line 40.
Enter the result
here and on page 1,
line 4
Line 35
Inventory at
Beginning of
Year
If you are a merchant,
beginning inventory is the
cost of merchandise on hand
at the beginning of the year
that you will sell to
customers. If you are a
manufacturer or producer, it
includes the total cost of
raw materials, work in
process, finished goods, and
materials and supplies used
in manufacturing the goods
(see Inventories
in chapter 2).
Opening inventory usually
will be identical to the
closing inventory of the
year before. You must
explain any difference in a
schedule attached to your
return.
Donation of inventory.
If you contribute
inventory (property that
you sell in the course
of your business), the
amount you can claim as
a contribution deduction
is the smaller of its
fair market value on the
day you contributed it
or its basis. The basis
of donated inventory is
any cost incurred for
the inventory in an
earlier year that you
would otherwise include
in your opening
inventory for the year
of the contribution. You
must remove the amount
of your contribution
deduction from your
opening inventory. It is
not part of the cost of
goods sold.
If the cost of donated
inventory is not
included in your opening
inventory, the
inventory's basis is
zero and you cannot
claim a charitable
contribution deduction.
Treat the inventory's
cost as you would
ordinarily treat it
under your method of
accounting. For example,
include the purchase
price of inventory
bought and donated in
the same year in the
cost of goods sold for
that year.
Example 1.
You are a
calendar year
taxpayer who uses an
accrual method of
accounting. In 2004
you contributed
property from
inventory to a
church. It had a
fair market value of
$600. The closing
inventory at the end
of 2003 properly
included $400 of
costs due to the
acquisition of the
property, and in
2003, you properly
deducted $50 of
administrative and
other expenses
attributable to the
property as business
expenses. The
charitable
contribution allowed
for 2004 is $400
($600 - $200). The
$200 is the amount
that would be
ordinary income if
you had sold the
contributed
inventory at fair
market value on the
date of the gift.
The cost of goods
sold you use in
determining gross
income for 2004 must
not include the
$400. You remove
that amount from
opening inventory
for 2004.
Example 2.
If, in Example 1,
you acquired the
contributed property
in 2004 at a cost of
$400, you would
include the $400
cost of the property
in figuring the cost
of goods sold for
2004 and deduct the
$50 of
administrative and
other expenses
attributable to the
property for that
year. You would not
be allowed any
charitable
contribution
deduction for the
contributed
property.
Line 36
Purchases Less
Cost of Items
Withdrawn for
Personal Use
If you are a merchant,
use the cost of all
merchandise you bought for
sale. If you are a
manufacturer or producer,
this includes the cost of
all raw materials or parts
purchased for manufacture
into a finished product.
Trade
discounts.
The differences
between the stated
prices of articles and
the actual prices you
pay for them are called
trade discounts. You
must use the prices you
pay (not the stated
prices) in figuring your
cost of purchases. Do
not show the discount
amount separately as an
item in gross income.
An automobile dealer
must record the cost of
a car in inventory
reduced by a
manufacturer's rebate
that represents a trade
discount.
Cash
discounts.
Cash discounts are
amounts your suppliers
let you deduct from your
purchase invoices for
prompt payments. There
are two methods of
accounting for cash
discounts. You can
either credit them to a
separate discount
account or deduct them
from total purchases for
the year. Whichever
method you use, you must
be consistent. If you
want to change your
method of figuring
inventory cost, you must
file Form 3115,
Application for Change
in Accounting Method.
For more information,
see
Change in Accounting
Method in
chapter 2.
If you credit cash
discounts to a separate
account, you must
include this credit
balance in your business
income at the end of the
tax year. If you use
this method, do not
reduce your cost of
goods sold by the cash
discounts.
Purchase returns and
allowances. You
must deduct all returns
and allowances from your
total purchases during
the year.
Merchandise withdrawn
from sale. If you
withdraw merchandise for
your personal or family
use, you must exclude
this cost from the total
amount of merchandise
you bought for sale. Do
this by crediting the
purchases or sales
account with the cost of
merchandise you withdraw
for personal use. You
should charge the amount
to your drawing account.
A drawing account is a
separate account you
should keep to record
the business income you
withdraw to pay for
personal and family
expenses. As stated
above, you also use it
to record withdrawals of
merchandise for personal
or family use. This
account is also known as
a “withdrawals
account” or “personal
account.”
Line 37 Cost
of Labor
Labor costs are usually
an element of cost of goods
sold only in a manufacturing
or mining business. Small
merchandisers (wholesalers,
retailers, etc.) usually do
not have labor costs that
can properly be charged to
cost of goods sold. In a
manufacturing business,
labor costs properly
allocable to the cost of
goods sold include both the
direct and indirect labor
used in fabricating the raw
material into a finished,
saleable product.
Direct
labor. Direct
labor costs are the
wages you pay to those
employees who spend all
their time working
directly on the product
being manufactured. They
also include a part of
the wages you pay to
employees who work
directly on the product
part time if you can
determine that part of
their wages.
Indirect labor.
Indirect labor costs
are the wages you pay to
employees who perform a
general factory function
that does not have any
immediate or direct
connection with making
the saleable product,
but that is a necessary
part of the
manufacturing process.
Other
labor. Other labor
costs not properly
chargeable to the cost
of goods sold can be
deducted as selling or
administrative expenses.
Generally, the only
kinds of labor costs
properly chargeable to
your cost of goods sold
are the direct or
indirect labor costs and
certain other costs
treated as overhead
expenses properly
charged to the
manufacturing process,
as discussed later under
Line 39 Other Costs.
Line 38
Materials and
Supplies
Materials and supplies,
such as hardware and
chemicals, used in
manufacturing goods are
charged to cost of goods
sold. Those that are not
used in the manufacturing
process are treated as
deferred charges. You deduct
them as a business expense
when you use them. Business
expenses are discussed in
chapter 8.
Line 39
Other Costs
Examples of other costs
incurred in a manufacturing
or mining process that you
charge to your cost of goods
sold are as follows.
Containers.
Containers and
packages that are an
integral part of the
product manufactured are
a part of your cost of
goods sold. If they are
not an integral part of
the manufactured
product, their costs are
shipping or selling
expenses.
Freight-in.
Freight-in,
express-in, and
cartage-in on raw
materials, supplies you
use in production, and
merchandise you purchase
for sale are all part of
cost of goods sold.
Overhead expenses.
Overhead expenses
include expenses such as
rent, heat, light,
power, insurance,
depreciation, taxes,
maintenance, labor, and
supervision. The
overhead expenses you
have as direct and
necessary expenses of
the manufacturing
operation are included
in your cost of goods
sold.
Line 40 Add
Lines 35 through
39
The total of lines 35
through 39 equals the cost
of the goods available for
sale during the year.
Line 41
Inventory at End
of Year
Subtract the value of
your closing inventory
(including, as appropriate,
the allocable parts of the
cost of raw materials and
supplies, direct labor, and
overhead expenses) from line
40. Inventory at the end of
the year is also known as
closing or ending inventory.
Your ending inventory will
usually become the beginning
inventory of your next tax
year.
Line 42 Cost
of Goods Sold
When you subtract your
closing inventory (inventory
at the end of the year) from
the cost of goods available
for sale, the remainder is
your cost of goods sold
during the tax year.
