Schedule C Tax Deductions - How to Deduct the Cost of Goods Sold

Are you a sole proprietor who sells a product? Then you need to know how to deduct expenses related to the sale of those products. The purpose of this article is to give you an overview of what is potentially your biggest tax deduction.

First, let's discuss an important concept related to this deduction known as "Cost of Goods Sold." Let's say in 2008 you start a business to sell widgets. You buy the widgets for $50 each and sell them for $100 each. Now it's tax time and you've got to figure out how to calculate the deduction for the cost of what you sold.

Here are just 2 possible scenarios. Scenario #1: You sell all the widgets that you bought. Let's assume you bought 100 widgets for $5,000 (100 widgets x $50) and sold all 100 widgets for $10,000 (100 widgets x $100). End result for tax purposes: you get to deduct the entire $5,000 that you spent to buy the widgets. $10,000 sales - $5,000 cost of goods sold = $5,000 Gross profit from sale of product.

Now let's move on to scenario #2: You sell some of the widgets, but not all of them. You bought 100 widgets for $5,000 (100 widgets x $50) but you only sold 50 widgets for $5,000 (50 widgets x $100). Do you still get to deduct the cost of all 100 widgets that you bought? No, you don't. You only get to deduct the cost of the widgets that were sold. If you didn't sell all the widgets, you don't get to deduct the cost of all the widgets. So here's how this scenario plays out: $5,000 sales - $2,500 cost of goods sold (50 widgets sold x $50) = $2,500 Gross profit from sale of product.

Still with me? It's critical that you understand this concept. If you don't sell all your product during the year, and still have some product sitting on the shelf at the end of year, don't make the mistake of deducting the cost of product you haven't yet sold.

Now let's discuss how all these numbers get reported on Schedule C. On page 1, notice that Line 4 is called "Cost of goods sold." So that's where you put the $5,000 from Scenario #1 or the $2,500 from Scenario #2. But that's just the end result of a slick calculation that you must do on page 2, Part III. This is the detailed Cost of Goods Sold section of Schedule C, and if you sell product, you must complete this section. Don't make the mistake of putting a number on page 1, Line 4 without filling out Part III, Lines 33-42. The Schedule C instructions do a good job of walking you through this section, line by line, so if you are preparing your own return, take the time to read those instructions for helpful tips.

If you hire an accountant to prepare your Schedule C, he/she should be well versed in the Cost of Goods Sold calculation, but you will still have to provide him/her with the annual totals for the following amounts:
1-Inventory at the beginning of the year.
2-Product purchased during the year.
3-Inventory at the end of the year.

If this is your first year in business, you won't have any inventory at the beginning of the year. And if you happen to sell all product during the year, you won't have any inventory at the end of the year. But after you've been in business for awhile, most product sellers have beginning and ending inventory, so you must keep track of that and be able to report them on your Schedule C every year. Once you know the three amounts listed above, it's easy to calculate cost of goods sold.