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Part 6 Publication 334 (2009), Guide Small Bussine
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 Posted 12:35 PM Feb. 28, 2010 Table of Contents 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.
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.
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. A special rule applies to certain donations of food inventory. See Food Inventory in Publication 526, Charitable Contributions.
Example 1. You are a calendar year taxpayer who uses an accrual method of accounting. In 2009 you contributed property from inventory to a church. It had a fair market value of $600. The closing inventory at the end of 2008 properly included $400 of costs due to the acquisition of the property, and in 2008, you properly deducted $50 of administrative and other expenses attributable to the property as business expenses. The charitable contribution allowed for 2009 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 2009 must not include the $400. You remove that amount from opening inventory for 2009. Example 2. If, in Example 1, you acquired the contributed property in 2009 at a cost of $400, you would include the $400 cost of the property in figuring the cost of goods sold for 2009 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. 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 any 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 must also 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.”
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.
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. 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.
The total of lines 35 through 39 equals the cost of the goods available for sale during the 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.  Table of Contents After you have figured the gross receipts from your business (chapter 5) and the cost of goods sold (chapter 6), you are ready to figure your gross profit. You must determine gross profit before you can deduct any business expenses. These expenses are discussed in chapter 8. If you are filing Schedule C-EZ, your gross profit is your gross receipts plus certain other amounts, explained later under Additions to Gross Profit. Businesses that sell products. If you are filing Schedule C, figure your gross profit by first figuring your net receipts. Figure net receipts (line 3) on Schedule C by subtracting any returns and allowances (line 2) from gross receipts (line 1). Returns and allowances include cash or credit refunds you make to customers, rebates, and other allowances off the actual sales price.
Next, subtract the cost of goods sold (line 4) from net receipts (line 3). The result is the gross profit from your business.
Businesses that sell services. You do not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for your business. Your gross profit is the same as your net receipts (gross receipts minus any refunds, rebates, or other allowances). Most professions and businesses that sell services rather than products can figure gross profit directly from net receipts in this way.
Illustration. This illustration of the gross profit section of the income statement of a retail business shows how gross profit is figured.
Income Statement Year Ended December 31, 2009
The cost of goods sold for this business is figured as follows:
Consider the following items before figuring your gross profit. Gross receipts. At the end of each business day, make sure your records balance with your actual cash and credit receipts for the day. You may find it helpful to use cash registers to keep track of receipts. You should also use a proper invoicing system and keep a separate bank account for your business.
Sales tax collected. Check to make sure your records show the correct sales tax collected.
If you collect state and local sales taxes imposed on you as the seller of goods or services from the buyer, you must include the amount collected in gross receipts. If you are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments, you generally do not include these amounts in income.
Inventory at beginning of year. Compare this figure with last year's ending inventory. The two amounts should usually be the same.
Purchases. If you take any inventory items for your personal use (use them yourself, provide them to your family, or give them as personal gifts, etc.) be sure to remove them from the cost of goods sold. For details on how to adjust cost of goods sold, see Merchandise withdrawn from sale in chapter 6.
Inventory at end of year. Check to make sure your procedures for taking inventory are adequate. These procedures should ensure all items have been included in inventory and proper pricing techniques have been used.
Use inventory forms and adding machine tapes as the only evidence for your inventory. Inventory forms are available at office supply stores. These forms have columns for recording the description, quantity, unit price, and value of each inventory item. Each page has space to record who made the physical count, who priced the items, who made the extensions, and who proofread the calculations. These forms will help satisfy you that the total inventory is accurate. They will also provide you with a permanent record to support its validity. Inventories are discussed in chapter 2.
If you are in a retail or wholesale business, you can check the accuracy of your gross profit figure. First, divide gross profit by net receipts. The resulting percentage measures the average spread between the merchandise cost of goods sold and the selling price. Next, compare this percentage to your markup policy. Little or no difference between these two percentages shows that your gross profit figure is accurate. A large difference between these percentages may show that you did not accurately figure sales, purchases, inventory, or other items of cost. You should determine the reason for the difference. Example. Joe Able operates a retail business. On the average, he marks up his merchandise so that he will realize a gross profit of 331/3% on its sales. The net receipts (gross receipts minus returns and allowances) shown on his income statement is $300,000. His cost of goods sold is $200,000. This results in a gross profit of $100,000 ($300,000 − $200,000). To test the accuracy of this year's results, Joe divides gross profit ($100,000) by net receipts ($300,000). The resulting 331/3% confirms his markup percentage of 331/3%.
If your business has income from a source other than its regular business operations, enter the income on line 6 of Schedule C and add it to gross profit. The result is gross business income. If you use Schedule C-EZ, include the income on line 1 of the schedule. Some examples include income from an interest-bearing checking account, income from scrap sales, and amounts recovered from bad debts.
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