How To Include Cost Of Goods Sold On Your Business Tax Return

What’s Included in COGS?

Cost of goods sold includes direct costs related to the products you are selling:

Cost of products for sale or raw materials, including freightStorage of products, raw materials, or parts used in production.Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the productsFactory overhead and warehouse costs.

Cost of goods sold doesn’t include indirect costs, including:

General overhead costs for areas of your business not related to the production or storage of products.Cost of managers and administrative employees.

Taking Inventory

The first – and last – steps in calculating the cost of goods sold is taking inventory. You will need to know the value of that inventory, including:

Merchandise or stockRaw materialsWork in processFinished products, andSupplies that are part of inventory items.

Calculating Cost of Goods Sold

The cost of goods sold is calculated in a separate section of your business tax return, not in the list of expenses. It’s deducted from your company’s gross receipts to figure a gross profit for the year. The process for calculating the cost of goods sold is the same for all business types. Before you begin, you will need to set the inventory valuation method you want to use – cost, lower of cost or market, or retail. The cost of inventory can be specific identification, LIFO, or FIFO.
Gather Information. Begin by gathering the necessary information about your inventory: Calculate COGS. Now you’ll do the cost of goods sold calculation. It starts with the beginning inventory (inventory at the beginning of the year) and adds in the costs of materials and labor sold during the year It then calculates your ending inventory (at the end of the year).

Cost of Goods Sold for Small Businesses

The general IRS rule is that businesses with inventory must use actual accounting rather than cash accounting. This method is more complex, so the IRS has recently made inventory easier for small businesses. If you have a small business, you don’t have to keep an inventory or capitalize (depreciate) certain costs, rather than deducting them. To avoid capitalizing, you must comply with IRS requirements for accounting for that inventory. You can account for inventory as non-incidental materials and supplies or use a method that conforms to your financial accounting treatment for inventories. To use this easier method of valuing inventory, you must:

Use the accrual method of accounting, and You must value the inventory every year to determine COGS.

To qualify as a small business, you must have $25 million or less in average annual gross receipts (indexed for inflation), for the past three tax years, and your business can’t be a tax shelter (as defined by the IRS).

COGS Calculation on Your Business Tax Return

The Internal Revenue Service provides worksheets for calculating COGS. The one you would use depends on the type of tax return you’re filing. For sole proprietors and single-owner LLCs, the calculation is done on Schedule C. For all other business types, the calculation is done on Form 1125-A.

Sole Proprietor or Single-owner LLC

Sole proprietors and single-owner LLCs calculate and report their business taxes on Schedule C. The cost of goods sold calculation is in Part III. This calculation is added to other expenses and income to get a net income (taxable income) for the business. This amount is included with other business income on Line 12 of Schedule 1 of your 1040. Then the total from Schedule 1 is moved to your 1040 form.

Other Business Types Using Form 1125-A

IRS Form 1125-A is used to calculate the cost of goods sold for corporations, S corporations, partnerships, and multiple-member LLCs. The form asks for: You will need to report the method you used to value inventory. Here are the details for each business type: Corporations. Form 1120 is the U.S. corporate income tax return. Form 1120 is used to calculate the net income, profit or loss, of all incorporated businesses. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1120. Partnerships and Multiple-owner LLCs. Form 1065, the U.S. Return of Partnership Income, is used to calculate the net income, profit or loss, of partnerships. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1065. S Corporations. An S corporation files its business income taxes on Form 1120S. The cost of goods sold is calculated on Form 1125-A and included on Line 2 of Form 1120S.

Do I Need an Accountant for Cost of Goods Sold?

The information in this article is a general overview and it’s not intended to be tax preparation advice. If you have a very simple business and the COGS calculation is fairly straightforward, you might be able to do this yourself. The most difficult part is typically the inventory valuation method—LIFO, FIFO, actual, or average—which can be quite complicated. It’s always worthwhile to have a tax preparer do at least this part of the calculation and perhaps even to review everything when you’ve finished.