 Income tax 2021-2022. How to figure? Cost of goods sold. Get ready to get refunds to the max. Diving into income tax 2021-2022. Most of this information can be found in Publication 334, Tax Guide for Small Business Tax Year 2021. Income tax formula lied one income, which would be supported by another schedule and essence and income statement. Having income and expenses, expenses basically being deductions that net then rolling in to line one income of the income tax formula and first page of the form 1040, which we see now. We would basically have the schedule C rolling into the schedule one, schedule one rolling into the first page of the form 1040, line number eight here. This is the schedule C basically an income statement where we would be having the reporting of income and expenses are focused now on the cost of goods sold, which would be used. You would have cost of goods sold. In other words, if you sell inventory. So you've got inventory calculation. This is basically the second page of the schedule C that you'll have to be populating. In that instance, you got the standard kind of formula from an accounting standpoint that we'll look at in basically an expanded format. But the general idea is that you got the beginning inventory plus the purchases or if you have manufactured, it's going to be the goods manufactured gives you the amount available for sale minus the ending inventory calculates the cost of goods sold, which you got to tie out to the first page of the schedule C where you have the cost of goods sold there. So you got that supporting schedule for that cost of goods sold will have to deal with. If you make or buy goods to sell, you can deduct the cost of goods sold for grocery seats on the schedule C. So clearly that would be one of the biggest deductions. That's basically an expense, but it's a super special expense. If you sell your primary income is from the selling of the goods because the cost of the goods sold is usually one of your biggest expenses because that's the primary thing you're selling. So however, to determine these costs, you must value your inventory at the beginning and end of each tax year. So they want this calculation, which is kind of, you could think of it as kind of like a periodic type of inventory calculation, the beginning inventory plus the purchases minus the ending inventory in essence giving you that cost, a good sold calculation. You can have to construct that or build that, this being something that if you're using accounting software, you might not have directly in the accounting software. You might have to kind of back into it a little bit to make sure that you have that added detailed information for it. So this chapter applies to you if you are a manufacturer, wholesaler, retailer, or if you are engaged in any business that makes buys or sells goods to produce income. So obviously, if you're like a wholesaler or retailer, if you just buy goods, you mark it up and then you sell the goods. It's usually an easier type of calculation because you got the beginning inventory plus the purchases and then minus the ending inventory. If you actually manufacture the goods or make the goods that you sell gets a little bit more complex because then you've got the beginning inventory plus the goods that you're making and you might have a whole manufacturing calculation to figure that number out as well, which could include things as you make it the costs that would be involved, the labor, the materials, and the overhead, for example. So this chapter does not apply to a personal service business such as the business of a doctor, lawyer, carpenter, or painter. So however, if you work in a personal service business and also sell or charge for the materials and supplies normally used in your business, this chapter applies to you. So if you do like service businesses like a doctor or a lawyer or something like that, then you would think that you don't have inventory involved. However, you might then have some components of the supplies that you're putting in place that then could be applied to you because they could be basically considered inventory. So however, if you work in a personal service business, you provide personal services, you don't primarily sell inventory and also sell or charge for materials and supplies normally used in the business, now you are kind of doing the inventory in your service business, this chapter applies to you. So there are exceptions for small business taxpayers that may change how you figure cost of goods sold for your business. For more information, you can see chapter number two. Figure cost of goods sold on Schedule C line 35 through 42. Figure your cost of goods sold by filling out lines 35 through 42 of Schedule C that's basically page two of the Schedule C that you'd have to fill out if you have cost of goods sold that's going to be on page one of the Schedule C, which if you're getting from accounting software, you might just have that number. It's just going to have cost of goods sold and you might not have from like a client or software, for example, this calculation, which is like a periodic kind of cost of goods sold or inventory type of calculation. So you'll have to, you know, figure it out and so that you have the supporting schedule. So these lines are reproduced below and are explained in the discussion that follows. So we got 35 inventory at the beginning of year. So if different from last year's closing inventory, attach explanation. So obviously the beginning inventory, if we're talking about the entire year, should be the same as the ending inventory on your Schedule C on your tax return from the prior year, unless there's some exception. So that would generally be the case. Number 30, line 36, purchase lease cost on items withdrawn for personal use. We've got our purchases line. So the purchases less cost of items withdrawn for personal use. So this, if you were just buying something, marking it up and then selling it, this would be the general item that you would have here for the purchases that increases. And then if you were making something, not just buying, marking up and selling, you'd have the line 37 cost of the labor because labor is going to be part of the cost of the ending inventory that you're selling. Do not include any amounts paid to yourself. And then line 38 materials and supplies because if you're making something, now you've got the materials and supplies that aren't just going to go under the purchase item because they're not just the end product that you're just marking up and selling, but they're the supplies like if you make a guitar, this would be like the wood and stuff. And the cost of the labor would be the stuff that you're paying to four people to put together the guitars. And then you've got the other costs, which you might think of as kind of like overhead possibly for other items that could be in the cost and then that would give us the lines 35 through 39. So if we were to say take all of these items to beginning inventory and the normal accounting equation for this, if you've memorized this in accounting, beginning inventory plus purchases gives us the amount available for sale minus the ending inventory and then you adjust it for a manufacturing company beginning inventory plus what we created cost of goods manufactured, which includes the labor, the materials overhead gives us the items available for sale, meaning in essence ending inventory that we had the capacity or ability to sell at that point in time. And then we're going to count the inventory at the end of the year. And you can imagine basically doing this in a periodic system. This is kind of like a periodic accounting system where we count the inventory at the end of the year and also have to value the inventory in terms of dollars. That's going to be our ending inventory. The amount of inventory that we have the capacity or ability to sell and line 40 minus the ending inventory that we have not yet sold that is still on hand will then give us the cost of goods sold calculation. That is going to be the subtraction of line 41 from 40 into the result here. That then is going to match what's on page one of the schedule C. So line and just note again, you might just have the cost of goods sold if you got the income statement from a client or software. And then you got to kind of reconstruct this, this, this calculation here. So obviously you'll have the beginning number. You might have the cost of goods sold from the actual software. And then you might have basically the Indian inventory number, for example, and if in that case it was purchases, you might then back into, you can kind of back into the unknown algebra back into X here, which would be the purchases item because you'd have the beginning inventory from the prior year cost of goods sold from the software that's being reported possibly on a perpetual inventory system as opposed to a periodic inventory system here. And you'd have the Indian inventory, which would be on the balance sheet. And then if the only other item here in the equation is the purchases, you might then back into using good old algebra X being line 36 purchases. Okay, line 35 inventory at the beginning of the year. If you are a merchant, beginning inventory is the cost of merchandise on hand at the beginning of the year that you will sell to customers. So that's what we had at the start. If you are a manufacturer or producer, it includes the total of cost of raw materials, work in process, finished goods and materials and supplies used in manufacturing goods. So now we're talking about all of the inventory for the whole process, the in process stuff here. If you got want more detail on that, you could take a look at chapter two. Opening inventory will usually be identical to the closing inventory of the year before. That should typically be the case. If it's not, then the IRS is going to possibly look at that and say something funny is going on here. What's going on? You explain any difference in a schedule attached to your return. So if there is a difference, you should explain it or the IRS might have questions about it. So line 35 inventory at the beginning of the year, donation of inventory. If you contribute inventory property that you sell in the course of your business, the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your operating inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold. If the cost of donated inventory is not included in your opening inventory, the inventory basis is zero and you cannot claim a charitable contribution deduction. So obviously this is a bit of a kind of an unusual kind of situation or not the norm where you got the donated property. Treat the inventory cost as you would ordinary treat it under the method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of the goods sold for that year. So a special rule may apply to certain donations of food inventory. You can see publication five to six charitable contributions there. Line 3035 inventory at the beginning of the year continued example. You are a calendar year taxpayer who uses an accrual method of accounting in 2021. You contributed property from inventory to a church. It had a fair market value of $600. The closing inventory at the end of 2020 properly included $400 of the costs due to the acquisition of the property. And in 2020, you properly deducted $50 of the administrative and other expenses attributable to the property as business expenses. The charitable contribution allowed for 2021 is $400, which is going to be the 600 minus the 200. The 200 is the amount that would be ordinary income if you had sold the contributed inventory at fair market value on the date of the gift. The cost of goods sold you used is determining gross income for 2021 must not include the $400. You removed that amount from opening inventory for 2021. Example two, if in example one, you acquired the contribution property in 2021 at the cost of $400. You would include the $400 cost of the property to figure the cost of goods sold for 2021 and deduct the $50 at the administration and other expenses attributable to the property. For that year, you would not be allowed any charitable contribution deduction for the contributed property. So obviously that's a little bit more of a specialized situation where you're the contribution of the inventory. So you could dive into that in more detail. If that's applicable to you, you got line number 36, purchase less cost of items withdrawn for personal use. So if you are a merchant, use the cost of all merchandise you bought for sale. So obviously when you're talking about merchants, then you're just purchasing stuff, you're marketing it up, you're selling it. So that means this line is going to be all your purchases items. That's something that you might not exactly have if you're looking at just the bookkeeping and just looking at the financial statements that are generated from software, for example, that are on a perpetual inventory system. So you could basically run other reports to kind of pick that up or it might be something that you kind of back into as kind of like the unknown that we talked about. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacturer into the finished product. Line 36 purchases less cost of items withdrawn for personal use, trade discounts. The differences between the stated price of articles and the actual prices you pay for them are called trade discounts. You must use the prices you pay, not the stated price in figuring your cost of purchases. So obviously the stated price, if that's different than what you paid, then you need to record it at the amounts you actually paid. Do not show the discount amount separately as an item in gross income. An automobile dealer must record the cost of a car in inventory reduced by any manufacturer's rebate that represents a trade discount. So you got to net that out there. So continuing on cash discounts. Cash discounts or amount, your supplier let you deduct from your purchase invoices for prompt payment. So now you got a discount because of the cash that you paid earlier. So they're trying to improve their cash flow. So they give you a small discount if you pay at an earlier point in time. So there are two methods of accounting for cash discounts. You can either credit them to a separate discount account or deduct them from the total purchase for the year. So if you got a cash discount, again, you would think that you might have recorded it on the books at the original purchase price. And then it was lower than that because they gave you a discount. So you would think you would need to adjust then your inventory. But that can be a little bit tedious depending on the inventory method that you're using. So in that case, you might be able to record the cash discount basically as income. So you could choose your method there. So one more time. Cash discounts or amounts that suppliers let you deduct. There are two methods of accounting for cash discounts. You can either credit them to a separate discount account or deduct them from the total purchase for the year. Whichever method you use, you must be consistent. So consistency is always a key. If you want to change your method or figure inventory costs, you must file form 3115 for more information. See change in accounting method in chapter two. If you credit cash discount to a separate account, you must include this credit balance in your business income at the end of the tax year. If you use this method, do not reduce your cost of goods sold by the cash discount. So line 36 continued on here. Purchase returns and allowances. So now you've got a return that happened. The inventory basically came back. You sold it, but then they returned it. You must deduct all returns and allowances from your total purchases during the year. So you're going to reduce the returns and allowances from your purchases. So merchandise withdrawal from sale. If you withdraw merchandise for your personal or family use. So now you've got inventory and you're taking it out for your own use. You must exclude this cost from the total amount of merchandise you bought for sale. Do this by crediting the purchase or sale discount with the cost of the merchandise you withdrew for personal use. You must also charge the amount to your drawing account. So it would be basically a form of a draw that you would be taking out, which would be, you know, increasing the draws and decreasing in essence the inventory. Your drawing account is a separate account. You could keep to record the business income you withdraw to pay for personal and family expenses. As stated above, you also use it to record withdrawals of merchandise for personal or family use. This account is also known as withdrawals account or personal account. Line 37 cost of labor. Labor costs are usually an element of cost of goods only in a manufacturer or a mining business. So you're not going to include labor in like if you just buy an inventory and then marking it up. But if you're making the inventory and you have labor wages generally that's helping you to do that, that's when you have this line item because labor is going to be part of the cost of the inventory. So small merchandisers, wholesalers, retailers, excess, etc. Usually do not have labor costs that can promptly be charged to cost of goods sold in a manufacturing business. Labor costs properly allocated to the cost of goods sold include both the direct and indirect labor uses in fabricating the raw materials into finished sellable products. So basically when you're saying indirect meaning you don't know which type of inventory, actual unit it's going to, it might be indirect versus direct so that gets into kind of accounting terminology so I won't go too depth into that. Line 37 costs of labor continue direct labor. Direct labor costs are the wages you pay to those employees who spend all their time working directly on product being manufactured. They also include a part of the wages you pay to employees who work directly on the product part time if you can determine the part of their wages. And then we have indirect labor. Indirect labor costs are the wages you pay to employees who perform a general factory function. So we don't know exactly which product to basically put it into but they were working in the factory and therefore their work is indirectly applied to the production process. That does not have any immediate or direct connection with making the sellable product but that is a necessary part of the manufacturing process. And then we have other labor. Other labor costs not properly chargeable to the cost of goods sold can be deducted as selling and administrative expenses. So if you have a manufacturing company you might have some people that work directly on it if we make the guitars. We got people working directly on the guitars which would be direct labor. We got people that work in the factory possibly where you make the guitars so we do not tie directly to the guitars which you might call kind of overhead but then that would be part of the cost of the inventory and then you might have other people that aren't in there like in the admin accounting department for example and the sales department which would then not be on the cost of goods sold calculation but rather in just other expenses, administrative expenses and selling expenses. Generally the only kinds of labor costs properly chargeable to your cost of goods sold are the direct or indirect labor costs and certain other costs treated as overhead expenses properly charged to the manufacturing process as discussed later under line 39 other costs. Line 38 materials and supplies, materials and supplies such as hardware and chemicals using the manufacturing goods are charged to cost of goods sold. So those that are not used the manufacturing process are treated as deferred charges. You deduct them as a business expense when you use them. So business expenses are discussed in chapter 8. So the materials and supplies once again such as the hardware and the chemicals used in manufacturing the goods and the services so these are like the smaller supplies as opposed to basically the materials themselves which might go under the purchasing item if you're in a manufacturing type of business. Line 39 other costs, containers, containers and packages that are an integral part of the product manufactured or a part of your cost of goods sold. If they are not an integral part of the manufactured product their costs are shipping and selling expenses. So if the packaging is a major part of the inventory it's going to be part of the cost of goods sold. If it's not then it's going to be part of a shipping costs. So freight in, express in and carter in on raw materials, supplies you use in production and merchandise you purchase for sale are all part of the cost of goods sold. Overhead expenses, overhead expenses include expenses such as rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor and supervision. Anything that's basically on the factory that basically you're producing stuff in might be thought of as basically overhead which you can't directly apply to possibly a specific piece of inventory but is clearly part of the cost of the inventory that you're making if you're making the inventory in a manufacturing process. The overhead expenses you have as direct and indirect expenses of the manufacturing operation are included in your cost of goods sold. Line 40, add lines 35 through 39. The total of line 35 through 39 equals the cost of goods available for sale during the year. Line 41 inventory at the end of the year. Subtract the value of your closing inventory which you can basically do a physical count on or you would find on the balance sheet that would give you the ending inventory including as appropriate the allocable parts of the cost of raw materials and supplies direct labor and overhead expenses from line 40 inventory at the end of the year is also known as closing or ending inventory. Your ending inventory will usually become the beginning inventory of your next tax year. Line 42 cost of goods sold, bottom line we finally got to it the cost of goods sold. When you subtract your closing inventory inventory at the end of the year from the cost of goods available for sale the remainder is your cost of goods sold during the tax year. So once again beginning inventory plus purchases gives you the goods available for sale minus the ending inventory gives you the goods that you sold if you manufactured it. Beginning inventory plus the cost of goods manufactured gives you the goods that you could have sold throughout the year minus the ones that you didn't sell otherwise known as ending inventory gives you the cost of goods that are sold.