Income from the Sale of Goods

Reporting income from the sale of goods involves a 2-step process. First you must figure your gross receipts—amounts received from sales (determined by your method of accounting). Then you must subtract from gross receipts your cost of goods sold.

Cost of Goods Sold

Cost of goods sold (COGS) is determined each year by adjusting beginning inventory for changes made during the year. For Forms 1065, 1120, and 1120S, the cost of goods sold is figured on Form 1025-A (rather than on a schedule on the return).

Inventory at the beginning of the year (generally your closing inventory reported on last year’s return) is increased by adding any inventory purchases or manufactured items purchased that year. Include not only purchases but also the cost of labor and other costs required to be included under the uniform capitalization (UNICAP) rules explained in Chapter 4. Decrease this figure by sales from inventory.

To know what your opening inventory and closing inventory is, you need to take a physical inventory. A physical inventory must be taken at reasonable intervals and the actual count must be used to adjust the inventory figures you have been maintaining all along. Generally, a physical inventory is taken at year-end. You are permitted to estimate year-end inventory by factoring in a reasonable allowance for shrinkage (for example, loss due to theft that you failed to detect). If you make such an estimate, then you must take a physical count on a consistent basis and adjust—upward or downward—the actual inventory count.

There are 4 methods for reporting inventory. They are:

Resellers—those who buy items for sale to others—use certain rules and methods to assign the cost of these items to those sold during the year:

• First-in, First-out (FIFO). An item sold is deemed to be the first item booked into inventory. For example, if you bought 10 widgets on 3 occasions at a cost of 10 each, 15 each, and 20 each and you sell 15, under FIFO you have sold 10 at 10 each and 5 at 15 each.
• Last-in, First-out (LIFO). An item sold is deemed to be the last item booked into inventory. In the widge example, you have sold 10 at 20 each and 5 at 15 each.
  Note: The Administration has proposed the repeal of LIFO, but at the time of publication, there has been no legislation to do this; check the Supplement.
• Specific identification method. The actual cost of the items is used. This method generally is used when a business owns large or unique items (for example, an antique store would use this method for its objects since items are not identical and cannot be commingled).

Small businesses are allowed to use a simplified value LIFO method that makes it easier to determine the value of inventory. If you elect FIFO, you must use the lower of cost or market method to report inventory. If you elect LIFO, you must use cost to report inventory.

Gross Profits

Gross profits from the sale of goods is the difference between the gross receipts (sales revenues) and the cost of goods sold (as well as other allowances). If you remove items from inventory for your personal use, be sure to adjust your figures accordingly.

You generally cannot use the installment method of accounting to report the sale of inventory items—even if you receive payment on an installment plan. You report the sale according to your usual method of accounting so that on the accrual basis you pick up the income in full in the year of sale even though the full payment will not be received at that time.

Other Income for Direct Sellers

In addition to income from sales of products to customers, direct sellers may receive income in other ways:

• Commissions, bonuses, or percentages you receive for sales and the sales of others who work under you.
• Prizes, awards, and gifts resulting from your sales activities.