How to Account for Inventory on Taxes

If your business maintains an inventory of goods for sale, you will need to account for inventory costs to determine your profits or losses at tax time. The amount of inventory costs you can deduct from your taxable income depends on how much product you had on hand at the beginning of the year, how much you paid to buy or manufacture new products, and how much product you had on hand at the end of the year. Most small businesses report inventory information on Schedule C, Profit or Loss From Business.

Select the method you will use to value your inventory and stick with it. Most businesses select the cost method, which uses the cost of the products as their value. You will report which method you use on Line 33 of Schedule C. If you change methods from one year to the next, you have to explain your changes to the IRS when you file your next return.

Determine the value of your starting inventory. This amount includes items you have for sale, items that are in the process of manufacturing, raw materials used in manufacturing, and the cost of supplies used for manufacturing. You will enter this amount on Line 35 of Schedule C. The amount should be the same as you reported as your year-end inventory the previous year. If you just started your business, your beginning inventory is $0.

Calculate the amount you spent on new inventory. If you are a manufacturer, include the cost of raw materials and parts used to make the finished products. Make sure you exclude the cost of anything you took out of inventory for personal use. This total goes on Line 36 of Schedule C.

If you manufacture some or all of your products, you will need to determine your manufacturing costs. You should include the cost of labor used in the manufacturing process, supplies that are used up in the manufacturing process, and other costs such as in-bound freight charges and overhead that is essential to manufacturing. These amounts will be reported on lines 37 through 39 of Schedule C and should not be included in the general business expenses you claim on Part II of the form.

Add up all the previous amounts. This number represents the total cost of your starting inventory, plus the costs of new items you added throughout the year. This amount is reported on Line 40 of Schedule C.

Calculate the value of inventory you had on hand at the end of the tax year. Include the cost of raw materials and parts used to make finished items, and include the value of items that are in the process of manufacture. Exclude items you were holding on consignment, or items for which you already had received payment during the year. When calculating the value, use the same method you used the previous year. This amount goes on Line 41 of Schedule C.

Subtract the value of inventory you had on hand at the end of the year from your total inventory costs (starting inventory plus new inventory). The result represents your total cost of goods for the year. On Schedule C, you will subtract Line 41 from Line 40, and enter the result on Line 42. You can deduct this amount as an expense against your business income.

Tip

Businesses that are incorporated will use form 1125-A, Cost of Goods Sold, instead of Schedule C.