For Schedule C (Form 1040), Part III is used by taxpayers engaged in a trade or business involving the production, purchase, or sale of merchandise. These taxpayers generally must account for inventory unless an exception applies.
Cost of goods sold (COGS) is computed by adding beginning inventory and purchases (Line 36 and related entries in Part III), then subtracting ending inventory (Line 41). The resulting cost of goods sold is entered on Line 42 and carried to Line 4 of Schedule C.
Small Business Taxpayer Exception
A small business taxpayer (generally defined under section 448(c) as having average annual gross receipts at or below the IRS inflation-adjusted threshold and not being a tax shelter) may qualify for simplified inventory rules.
Eligible taxpayers may:
- Not maintain inventories under the traditional §471 rules, if applicable
- Use an inventory method that clearly reflects income under §471(c)
- Treat inventory as nonincidental materials and supplies, deducting amounts when used or consumed in the business
- Follow the method used in applicable financial statements or books and records, if consistent with IRS rules
Even if inventories are not maintained under full rules, taxpayers must still clearly reflect income.
Inventory Valuation Methods
When inventory accounting is required, inventories are generally valued using:
- Cost
- Lower of cost or market
- Any other method permitted under IRS rules that clearly reflects income
Inventory valuation must be applied consistently and in accordance with the taxpayer’s accounting method.
Nonincidental Materials and Supplies
Taxpayers qualifying under the simplified inventory rules may treat inventory as nonincidental materials and supplies. Under this treatment, costs are generally deducted in the year the items are used or consumed in operations.
Financial Accounting Treatment
If applicable, inventory accounting may follow the method used in an applicable financial statement (as defined in IRC §451(b)(3)). If no such statement exists, the taxpayer must use a method consistent with their books and records and applicable accounting principles that clearly reflect income.
Change in Accounting Method
A change in inventory accounting method generally requires filing Form 3115, Application for Change in Accounting Method.
If approved or required:
- Prior-year ending inventory must be recomputed using the new method
- Adjustments are made under section 481(a)
- The adjustment may be reported over the required adjustment period
Additional Information
- For more details on small business exceptions and inventory accounting, refer to IRS Publication 538.
Source:
Schedule C Instructions (2025)
Disclaimer: Always verify details with current Federal or State Department of Revenue Forms and Instructions. For complex situations, consult a CPA or tax attorney.