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Costs Of Goods Sold Tax Deduction

If you are an entrepreneur who manufactures or purchases inventory for resale the costs you incurred during the year to produce and / or acquire your sold inventory would be deductible as a cost of goods sold. Costs of goods sold can include but are not limited to materials, labor and overhead. For an expense to be considered a cost of goods sold, you must have sold the product (costs associated with unsold products should be classified as inventory). Entrepreneurs who operate personal service businesses (lawyer, accountant, uber driver, etc.) and do not sell merchandise would not have any costs of goods sold for federal income tax purposes. Calculating cost of goods sold can be an involved or a simple process depending on your type of business, the size of your business and the quality of your records

ENTREPRENEUR

Miriam is a cash basis taxpayer who sells jewelry on Etsy. Last year she spent $15,000 on materials for per products, all of which she was able to sell during the tax year. When Miriam prepares her federal return at the end of the year she would include the $15,000 of materials she purchased as a cost of goods sold on line 36 of her Schedule C.

AUTHOR / SPEAKER

Ed is an author who just finished writing his third novel. He pays shipping to have his books delivered from a printer in Indonesia. The money Ed spends to have his books printed and shipped to him from Indonesia should be included as part of the value of his inventory and deducted as part of cost of goods sold when he sends sold books out to his customers.

DEVELOPER / ENGINEER

Carry is a U.S. based web designer who outsources certain components of her projects to offshore development teams. When she prepares her tax return she would include the cost of development labor on line 11 of her Schedule C. While this expense could be considered a cost of sales for financial accounting purposes, it would not be considered a cost of goods sold for tax purposes since Carry does not produce, buy or sell merchandise.

ENTREPRENEUR

Katie is a sole proprietor who sells products for Mary Kay. At the beginning of the year Katie had $3,000 of inventory. This year, she purchased an additional $5,000 of products from Mary Kay. At the end of the year she had $1,500 of inventory remaining. Katie would want to report cost of goods sold of $6,500 ($3,000 beginning inventory + $5,000 purchases - $1,500 ending inventory) on her Schedule C.

UBER DRIVER / RIDESHARE

Herb drives full time for Uber and uses the actual method to deduct his vehicle expenses. During the year he spent $9,700 on gas and maintenance attributable to his driving business. Herb record the $9,700 as a cost of goods sold on his Schedule C. Lucky for Herb, his accountant noticed the error and reclassified the expenses to line 9, car and truck expenses. Since herb doesn't produce or buy goods to sell, he would not record any activity in cost of goods sold.

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ENTREPRENEURS

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DEDUCTING COGS

If you make or buy goods to sell the cost of materials, labor and overhead associated with your sold products would be considered cost of goods sold. If you spent money during the year to make or buy a product that you did not sell, it would be considered inventory until it is sold, at which point you could reclassify and deduct your product as a cost of goods sold.
Cost of goods sold = Value of inventory at beginning of year + Purchases (materials or finished products) + Labor (if applicable) + Overhead / Other - Value of inventory at end of year.
If you have a business that provides personal services (carpenter, painter, delivery driver, speaker, etc.) you would not report any of your business expenses as costs of goods sold for federal income tax purposes, since costs of goods sold is only applicable for those who sell goods. Note however that for financial accounting purposes, personal service businesses could record costs directly associated with delivering their services as costs of sales.
In order to calculate cost of goods sold, you need to track and value your inventory using a method allowed by the IRS (last in first out, first in first out, and specific identification). Accounting for inventory can be a complicated topic so refer to IRS guidance and your tax advisor to understand how you should value the inventory for sale in your business. Remember that regardless of what method you choose, your inventory practices should be consistent from year to year.
Remember that some expenses, such as labor, could be considered as costs of good sold or as regular expenses. How you ultimately classify and deduct these costs should be based on the nature of the expense. In other words, if your expense is directly related to the production or acquisition of a product you sold, it should likely be classified as inventory / costs of good sold. On the other hand, if your expense is related to administrative functions, it should likely be classified as a regular expense.

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