Schedule C - Cost of Goods Sold

For Schedule C, Part III – Cost of Goods Sold, taxpayers engaged in a trade or business involving the production, purchase, or sale of merchandise must account for inventories at the beginning and end of the tax year. The cost of goods sold is calculated by subtracting the ending inventory (line 41) from the total of beginning inventory and purchases (line 40), with the result entered on line 42 and then transferred to line 4 of Schedule C.

Small Business Taxpayer Exception

• Small business taxpayers (defined as those with average annual gross receipts of $31 million or less over the prior three tax years, indexed for inflation, and not a tax shelter) may choose not to keep an inventory.
• If inventory is not kept, the taxpayer must still use a method of accounting for inventory that clearly reflects income. This can be achieved by treating inventory as nonincidental materials or supplies or by conforming to financial accounting treatment of inventories.
• If inventory is maintained, it must be valued annually to determine cost of goods sold.

Valuation Methods

• Inventories may be valued at cost, the lower of cost or market, or any other method approved by the IRS (Schedule C, Line 33).
• Line 33 does not apply to filers of Form 1040-SS.

Treating Inventory as Nonincidental Materials or Supplies

• If inventory is treated as nonincidental materials or supplies, the costs are deducted in the year they are first used or consumed in operations.

Financial Accounting Treatment

• The financial accounting treatment of inventories is determined based on the method used in the applicable financial statement (as defined in section 451(b)(3)) or, if none exists, based on the method used in books and records prepared under accounting procedures.

Changing Accounting Method

• If changing the method of accounting for inventory, Form 3115 must be filed.
• If changing methods beginning in 2025, refigure last year’s closing inventory using the new method and enter it on line 35. Any difference must be explained and accounted for in the section 481(a) adjustment.

Additional Information

• For more details on small business exceptions and inventory accounting, refer to IRS Publication 538.

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Disclaimer: Always verify details with current Federal or State Department of Revenue Forms and Instructions. For complex situations, consult a CPA or tax attorney.