Page 30 - Tax Guide for Small Business

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The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
will sell to customers. If you are a manufacturer or pro- Trade discounts. The differences between the stated
ducer, it includes the total cost of raw materials, work in prices of articles and the actual prices you pay for them
process, finished goods, and materials and supplies used are called trade discounts. You must use the prices you
in manufacturing the goods (see Inventories in chapter 2). pay (not the stated prices) in figuring your cost of purcha-
Opening inventory usually will be identical to the clos- ses. Do not show the discount amount separately as an
ing inventory of the year before. You must explain any dif- item in gross income.
An automobile dealer must record the cost of a car in
ference in a schedule attached to your return. inventory reduced by any manufacturer's rebate that rep-
Donation of inventory. If you contribute inventory (prop- resents a trade discount.
erty that you sell in the course of your business), the Cash discounts. Cash discounts are amounts your sup-
amount you can claim as a contribution deduction is the pliers let you deduct from your purchase invoices for
smaller of its fair market value on the day you contributed prompt payments. There are two methods of accounting
it or its basis. The basis of donated inventory is any cost for cash discounts. You can either credit them to a sepa-
incurred for the inventory in an earlier year that you would rate discount account or deduct them from total purcha-
otherwise include in your opening inventory for the year of ses for the year. Whichever method you use, you must be
the contribution. You must remove the amount of your consistent. If you want to change your method of figuring
contribution deduction from your opening inventory. It is inventory cost, you must file Form 3115, Application for
not part of the cost of goods sold. Change in Accounting Method. For more information, see
If the cost of donated inventory is not included in your Change in Accounting Method in chapter 2.
opening inventory, the inventory's basis is zero and you If you credit cash discounts to a separate account, you
cannot claim a charitable contribution deduction. Treat the must include this credit balance in your business income
inventory's cost as you would ordinarily treat it under your at the end of the tax year. If you use this method, do not
method of accounting. For example, include the purchase reduce your cost of goods sold by the cash discounts.
price of inventory bought and donated in the same year in
the cost of goods sold for that year. Purchase returns and allowances. You must deduct all
A special rule may apply to certain donations of food in- returns and allowances from your total purchases during
ventory. See Pub. 526, Charitable Contributions. the year.
Example 1. You are a calendar year taxpayer who Merchandise withdrawn from sale. If you withdraw
uses an accrual method of accounting. In 2019 you con- merchandise for your personal or family use, you must ex-
tributed property from inventory to a church. It had a fair clude this cost from the total amount of merchandise you
market value of $600. The closing inventory at the end of bought for sale. Do this by crediting the purchases or
2018 properly included $400 of costs due to the acquisi- sales account with the cost of merchandise you withdraw
tion of the property, and in 2018, you properly deducted for personal use. You also must charge the amount to
$50 of administrative and other expenses attributable to your drawing account.
the property as business expenses. The charitable contri- A drawing account is a separate account you should
bution allowed for 2019 is $400 ($600 − $200). The $200 keep to record the business income you withdraw to pay
is the amount that would be ordinary income if you had for personal and family expenses. As stated above, you
sold the contributed inventory at fair market value on the also use it to record withdrawals of merchandise for per-
date of the gift. The cost of goods sold you use in deter- sonal or family use. This account is also known as a “with-
mining gross income for 2019 must not include the $400. drawals account” or “personal account.”
You remove that amount from opening inventory for 2019.
Example 2. If, in Example 1, you acquired the contrib- Line 37
uted property in 2019 at a cost of $400, you would include Cost of Labor
the $400 cost of the property in figuring the cost of goods
sold for 2019 and deduct the $50 of administrative and Labor costs are usually an element of cost of goods sold
other expenses attributable to the property for that year. only in a manufacturing or mining business. Small mer-
You would not be allowed any charitable contribution de- chandisers (wholesalers, retailers, etc.) usually do not
duction for the contributed property. have labor costs that can properly be charged to cost of
goods sold. In a manufacturing business, labor costs
Line 36 properly allocable to the cost of goods sold include both
Purchases Less Cost of Items the direct and indirect labor used in fabricating the raw
material into a finished, saleable product.
Withdrawn for Personal Use
Direct labor. Direct labor costs are the wages you pay to
If you are a merchant, use the cost of all merchandise you those employees who spend all their time working directly
bought for sale. If you are a manufacturer or producer, this on the product being manufactured. They also include a
includes the cost of all raw materials or parts purchased part of the wages you pay to employees who work directly
for manufacture into a finished product. on the product part time if you can determine that part of
their wages.

Page 28 Chapter 6 How To Figure Cost of Goods Sold