What is Cost of Goods Sold (CoGS) for tax?
Although all businesses incur direct costs providing goods and services, federal tax law limits the types of businesses that can report CoGS.
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Every business must generate revenue (eventually, at least) to sustain itself. And revenue generation requires some direct cost (eventually, at least) to generate that revenue. For financial and managerial reporting purposes, tracking CoGS provides useful information about an activity’s profitability.
Cost of goods sold, also known as cost of sales or cost of services, is the total of all costs necessary to create a good or perform a service that has been sold.1 Let’s break that down:
Until the good or service has been sold, the costs are capitalized as inventory or work in progress (WIP), which are reported on the balance sheet.
Upon sale, CoGS is reported on the income statement (or profit and loss, P&L), reducing the balance of inventory or WIP.
Any output available for sale, whether a tangible good or a service provided, incurs costs directly attributable to that good or service.
CoGS includes just the costs necessary to create the good or perform the service sold. It does not include other costs that, while perhaps necessary for selling the good or service or for the rest of the business to operate, are not specifically tied to the creation of the good or performance of the service sold.
Defining CoGS in federal tax law
IRC §162(a) allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, IRC §263A requires that taxpayers capitalize the costs of property produced or acquired for resale by the taxpayer; in other words, those costs cannot be immediately expensed.
Those capitalized costs are later recovered as an adjustment to the gross income from the sale of the property. Treas. Reg. §1.61–3(a) states the following:
In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Gross income is determined… without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162 (c), (f), or (g) in the case of a business expense. (Emphasis added.)
The Regulation restricts CoGS to manufacturing, merchandising, or mining businesses. But in businesses where “services are sold, gross revenue and gross income are synonymous… This is in contrast to a manufacturing, merchandising, or mining business where ‘gross income’ means the total sales, less the cost of goods sold…” (Rev. Rul. 74–374). And in Reading v. Comm., 70 T.C. 730 (1978), the Court held that “the ‘cost of goods sold’ concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold” (emphasis added). In other words, service businesses cannot have costs of goods sold for federal tax reporting.2
So only businesses with physical goods or real property for sale, i.e. inventory, can incur costs of goods sold for federal tax purposes. IRC §471(a) requires taxpayers to account for inventory when necessary to determine income. Treas. Reg. §1.471–1(a) adds that “in order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.3
IRC §471 cross references §263A, which provides the rules for capitalizing costs as inventory. §263A(a)(2) divides these costs into two types: direct4 and indirect.5 Indirect costs, such as indirect labor, rent or utilities, require allocation between production or resale and other activities. Thus, the basis of inventory represents the direct material and labor costs combined with a reasonable allocation of all other costs related to the production or retail activity.6
Reporting CoGS on a tax return
Sole proprietorships, reported on Schedule C, Profit or Loss From Business, use Part III to present the calculation of CoGS.
Other tax entity types—partnerships (Form 1065), C corporations (Form 1120), and S corporations (Form 1120-S)—use Form 1125-A, Cost of Goods Sold.
The two forms differ slightly, but they both use the same formula to determine cost of goods sold: CoGS = Beginning Inventory + Purchases + Labor + Other Costs – Ending Inventory
CoGS results from the difference between beginning inventory, along with direct costs (material purchases plus labor) and indirect (other) costs, less ending inventory.7
CoGS = Beginning Inventory + Purchases + Labor + Other Costs – Ending Inventory
There is no specific statutory requirement to substantiate CoGS, aside from the requirement to maintain inventories “on such basis as the Secretary may prescribe” in IRC §471(a).8 The Tax Court appeared to establish a precedent of requiring substantiation for CoGS in Metra Chem Corp. v. Comm., 88 T.C. 654 (1987); also see Wright v. Comm., T.C. Memo. 1993–27, and Ranciato v. Comm., T.C. Memo. 1993–536.9
But the Court recently allowed a construction subcontractor a partial adjustment for CoGS despite lacking sufficient records to substantiate the costs or any record of inventory. The Court applied the Cohan rule to cash withdrawals from the taxpayer’s bank account in Villa v. Comm., T.C. Memo. 2023–155:
[I]t is unclear from the record whether some portion of the above-estimated cost of goods sold for Mr. Villa’s direct contracting work might already have been included in the stipulated contract labor or “other” expenses-and such inexactitude will be held against the Villas under the Cohan rule… It is unclear to what extent these [withdrawals] include materials Mr. Villa used in his direct contracting work. It is clear, however, that a substantial portion of the “less cash” withdrawals represent material and labor costs. Accordingly, we will allow 50% of the “less cash” withdrawals as cost of goods sold.
How and when CoGS matters for tax reporting
Generally, taxpayers seek to arrive at an accurate calculation of taxable income, or gross revenue less all deductible expenses. Both CoGS and other allowable operating expenses reduce taxable income, so should the distinction matter? Put another way, is the differentiation between gross revenue and gross income meaningful?
The Tax Court addressed this question directly in Guy F. Atkinson Co. v. Comm, 82 T.C. 275 (1984), aff’d, 814 F.2d 1388 (9th Cir. 1987):
We note that whether an item is subtracted from gross receipts to arrive at gross income, or is deducted from gross income to arrive at taxable income, usually makes no difference because the figure upon which tax is imposed, taxable income, will remain the same in either case… However, in some instances, as in this case, the amount of gross income is as important because certain sections of the Code rely upon gross income as a ceiling or as an aid in definition.10 (Emphasis added.)
The distinction between gross receipts and gross income stems from the Sixteenth Amendment to the United States Constitution, which gives the Congress the “power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration” (emphasis added). The courts have maintained that allowing a deduction for CoGS from gross receipts to arrive at gross income avoids the implication of a tax on capital as opposed to income; for example, see Comm. v. Weisman 197 F.2d 221 (1952): “The return of capital is guaranteed by the ‘cost of goods’ offset against gross receipts and thus is avoided the charge that it is a tax on capital and not on income.” And in Reading v. Comm., 70 T.C. 730 (1978), the Court clarified that the “the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.”
Deducting CoGS under §280E
IRC §280E provides a clear example of the difference between gross revenue and gross income. The Code section disallows deductions and credits for businesses engaged in the sale of illegal drugs. Congress added the provision in 1982 after the Tax Court allowed a taxpayer to deduct ordinary and necessary business expenses incurred in dealing cocaine (Edmondson v. Comm. T. C. Memo. 1981–623). However, the Senate Finance Committee report on the bill carefully notes that to “preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”
Several court cases have addressed the deductibility of expenses related to the production and sale of illegal drugs, especially marijuana. In Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Comm., 128 T.C. 173 (2007), the business derived revenue from multiple operations, one of which was the sale of marijuana products. The Court found that the business could allocate and deduct expenses related to other activities.11 The Ninth Circuit affirmed the Tax Court’s decision in Olive v. Comm., 2015 PTC 229 (9th Cir. 2015), affirming 139 T.C. 2 (2012), that state legalization of a controlled substance does not override §280E’s disallowance of deductions for a business trafficking a controlled substance prohibited by Federal law.
Timing the deductibility of cost of goods sold
As an offset against gross receipts, CoGS become deductible upon the sale of the property. Treas. Reg. §1.61–3(a) adds that "cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer. Thus, for example, an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount" (emphasis added).12
While this may seem straightforward, some taxpayers have attempted to deduct CoGS before earning or collecting the associated revenue. In BRC Operating Company LLC v. Comm, T.C. Memo. 2021–59, the taxpayer attempted to deduct natural gas exploration costs as CoGS prior to earning or collecting any revenue. The Court held that cost of goods sold “does not exist in a vacuum, as a stand alone deduction in the Code, but serves as an offset against gross receipts” and is “allowed only as an offset against gross receipts from the sale of goods.”
In Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Comm., 151 T.C. 11 (2018), the Court contrasts the timing of CoGS, as an adjustment to income, with other deductions:
The big difference between deductions and COGS adjustments is timing… Taxpayers can usually claim at least part of a deductible expense for the year they incur it… But when accounting for COGS they have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding adjustment to gross income.
Conclusion
For financial and managerial accounting purposes, every business should identify and analyze its direct costs to assess and manage profitability. But for tax reporting purposes, only manufacturing, merchandising, or mining businesses may report CoGS. All other businesses should report direct costs as ordinary business expenses.
A tax return preparer can easily manage the translation from CoGS per books to ordinary expenses for the return using a tax mapping process. By tax mapping, I mean assigning each chart of accounts category to an appropriate line of the tax return. Multiple categories may map to the same tax return line, and the preparer only needs to report the totals. Mapping consolidates and simplifies tax reporting.
For businesses that produce or resell products, cost of goods sold is an adjustment to gross income, not a deduction from income. Although the tax effect usually remains the same, disallowance of deductions, e.g. under §280E, shows the importance of distinguishing gross receipts from gross income.
Finally, a business cannot report costs of goods sold until it realizes the associated revenue. Until a sale has occurred, the costs associated with the property sold must be capitalized as inventory.
CoGS is a central concept for cost accounting, the branch of accounting that focuses on determining and analyzing the cost of producing goods and delivering services. As a branch of managerial accounting, cost accounting provides management with useful analysis of the sources of profitability within a company. Managerial accounting is strictly provided for internal analysis and discussion. Whereas financial and tax accounting have written, authoritative sources—e.g. the Codification for US Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Code, respectively—no single source of authority exists for cost or managerial accounting. Except for the discussion of tax reporting of CoGS, the following discussion presents my interpretation and paraphrasing of concepts and principles because we lack any single, authoritative source for them.
The Tax Court denied an insurance salesperson costs of goods sold deducted on his Form 1040, Schedule C, citing the Regulation and other court cases affirming the position that service businesses cannot have costs of goods sold in Perry v. Commissioner, T.C. Memo. 2012–237. The petitioner was a CPA and former IRS revenue agent. The Court found that “he exercised a lack of care and reckless disregard for rules and regulations in reporting income and claiming deductions against income on the returns, resulting in the remaining underpayment” and “failed to offer any persuasive evidence that he acted with reasonable cause and in good faith with respect to any portion of the remaining underpayment.” The Court held him liable for the accuracy-related penalty on the underpayment. Also see Guy F. Atkinson Co. v. Comm, 82 T.C. 275 (1984), aff’d, 814 F.2d 1388 (9th Cir. 1987): “…where a business is engaged primarily in the providing of service, rather than mining, manufacturing, or merchandising, the business gross receipts will constitute gross income.”
A discussion of methods of calculating inventory is beyond the scope of this article. The Code allows for last in, first out (LIFO) valuation (IRC §§472–474). Treas. Reg. §1.471–2 provides additional rules on the valuation of inventory, including cost and lower of cost or market. It’s important to note that the calculated CoGS expense can substantially differ year-to-year depending on the method selected.
Direct costs include material costs and labor. See Treas. Reg. §1.263A-1(e)(2)(i): “Direct material costs include the cost of those materials that become an integral part of specific property produced and those materials that are consumed in the ordinary course of production and that can be identified or associated with particular units or groups of units of property produced… Direct labor costs include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced. For this purpose, labor encompasses full-time and part-time employees, as well as contract employees and independent contractors.”
See Treas. Reg. §1.263A-1(e)(3): “Indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities. Indirect costs may directly benefit or be incurred by reason of the performance of production or resale activities even if the costs are calculated as a percentage of revenue or gross profit from the sale of inventory, are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory.”
Congress amended IRC §263A(a)(2) in 1988 to disallow any indirect costs not otherwise deductible. This is important for businesses subject to IRC §280E, which was passed six years earlier (discussed below).
Given this construction it should appear obvious that reporting any amount as costs of goods sold on a tax return for a business that does not carry inventory is inappropriate. I routinely see tax returns for non-inventory businesses that report direct costs as “Purchases,” “Cost of labor,” or “Other costs.” Often, this results from directly mapping expenses recorded as CoGS on the company’s income statement. Instead, these expenses should be mapped to an appropriate operating expense category, such as Office Expense or Supplies.
Treas. Reg. §1.471–1(a) establishes a requirement for businesses to record beginning and ending inventory of each taxable year.
I read the Court’s opinion in Metra Chem Corp. v. Comm., and I cannot find the source of this precedent. In fact, the Court absolved the petitioners of an understatement penalty due to negligence despite inadequate recordkeeping and questionable accounting practices.
In Guy F. Atkinson Co. v. Comm., the Court determined that the taxpayer was entitled to a deduction based on meeting a percentage threshold of gross income derived in the Western hemisphere. During World War II, Congress increased corporate tax rates to raise additional revenue. Congress exempted corporations that derived at least 95 percent of their gross incomes from the Western hemisphere (exclusive of the US) and at least 90 percent of their gross incomes from an active conduct of trade or business (labeled a Western Hemisphere Trade Corporation, or WHTC; see §§921–922 of the 1954 Revenue Code). The Court found that, had the Guy F. Atkinson Co. deducted its reported costs of goods sold to determine gross income, it would not have qualified as a WHTC. However, the Court found its subsidiary’s activity—building dams in the Dominican Republic—was not “manufacturing, merchandising, or mining,” but rather a service, so its gross income equaled gross receipts. By this definition, it qualified as a WHTC.
In other cases involving marijuana businesses, the Court found that the other activities were not separate revenue streams; rather, they were incidental to marijuana sales, and the business could not allocate expenses. See, for example, Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Comm., 151 T.C. 11 (2018).
IRC §461(h) presents a three-part “all events test” in for determining when a taxpayer can deduct an accrued expense resulting from a liability:
All events have occurred that establish the fact of the liability;
The amount of the liability can be determined with reasonable accuracy; and
Economic performance has occurred.
Economic performance occurs when the taxpayer receives services or property from another party, provides property or services to another party, or uses property another party provided. The provision allows exceptions for certain recurring expenses and reserves for estimated expenses.