Cost of goods sold

A business subtracts cost of goods sold from its gross receipts to find its gross profit. The formula begins with the inventory on hand at the start of the year. It adds purchases, labor, materials and other production costs, then subtracts the inventory left at year end.

A sole proprietor works it out in Part III of Schedule C. Corporations, S corporations and partnerships attach Form 1125-A to their returns instead. On Schedule C, the cost of labor leaves out anything you pay yourself.

A business that makes, buys or sells merchandise generally must keep inventories. The regulation requires them whenever merchandise is an income-producing factor in the business. A business that must keep them generally uses the accrual method for its inventory purchases and sales.

Small business taxpayers can skip those inventory rules. A business qualifies for 2026 if its average annual gross receipts for the prior three years are $32 million or less. The 2025 limit was $31 million. The receipts of related businesses are added together, and a tax shelter cannot qualify.

A qualifying business can follow its financial statements or books. It can also treat inventory as non-incidental materials and supplies, deducting each item’s cost in the year it goes to a customer. If the business pays for the item later, the deduction waits until that year.