Business Tax Preparation · Business Income

Cost of goods sold

The arithmetic is trivial and never the point. Cost of goods sold is beginning inventory plus purchases and production costs less ending inventory, and every question worth asking is about what belongs in one of those three figures — which goods, which costs, and at what value.

The rule

When an inventory is required. inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase or sale of merchandise is an income-producing factor^TY2026 (Reg. § 1.471-1(a)).

Which goods are in it. merchandise is included in inventory only if title is vested in the taxpayer — so goods out on consignment stay in the seller's inventory, goods sold with title passed do not, and goods purchased with title passed are included even while in transit^TY2026 (Reg. § 1.471-1(a)). Title, not possession.

The two statutory tests. an inventory must conform as nearly as may be to the best accounting practice in the trade or business, and it must clearly reflect the income^TY2026 (IRC § 471(a), Reg. § 1.471-2(a)).

How it is valued. the two bases that meet IRC § 471 are cost, and cost or market whichever is lower; unsalable or damaged goods are valued at bona fide selling prices less direct cost of disposition but never below scrap value^TY2026 (Reg. § 1.471-2(c)), applied the basis adopted must be applied with reasonable consistency to the entire inventory of the trade or business, except for goods inventoried under the LIFO method or under the elective unit livestock-price method, and a change requires the permission of the Commissioner^TY2026 (Reg. § 1.471-2(d)). Where goods cannot be traced, goods so intermingled that they cannot be identified with specific invoices are deemed to be the goods most recently purchased or produced — a first-in, first-out default^TY2026 (Reg. § 1.471-2(d)).

LIFO. goods on hand at the close of the year are treated as being, first, those in the opening inventory in order of acquisition to the extent of it, and second, those acquired during the year; they are inventoried at cost; and the opening inventory of the first LIFO year is treated as acquired at one time and costed by the average cost method^TY2026 (IRC § 472(b)), available only on the condition that LIFO is available only if the taxpayer establishes that it used no other procedure in inventorying those goods for a report or statement to shareholders, partners, other proprietors or beneficiaries, or for credit purposes, for the first year the method is used^TY2026 (IRC § 472(c)), and once taken, once adopted, LIFO must be used in all subsequent taxable years unless the Secretary permits a change, and any increase in the opening inventory value on adoption is taken into account ratably over 3 taxable years^TY2026 (IRC § 472(d), (e)).

What must be capitalised into inventory. {fig:cogs.263A_scope} (IRC § 263A(b)), and the costs swept in are {fig:cogs.263A_costs} (IRC § 263A(a)(2)). The exceptions are {fig:cogs.263A_exceptions} (IRC § 263A(c)).

The small business escape. {fig:method.small_263A} (IRC § 263A(i)) and a taxpayer other than a prohibited tax shelter that meets the IRC § 448(c) gross receipts test is exempt from the inventory requirement, and its inventory method does not fail to clearly reflect income if it either treats inventory as non-incidental materials and supplies or conforms to the method reflected in its applicable financial statement, or in its books and records prepared under its accounting procedures where it has no such statement (IRC § 471(c))^TY2026 (IRC § 471(c)), both keyed to $32,000,000 — a corporation or partnership meets the gross receipts test for a taxable year beginning in 2026 if its average annual gross receipts for the 3-taxable-year period ending with the preceding taxable year do not exceed that amount. The figure for taxable years beginning in 2025 was $31,000,000, and the unindexed statutory base in IRC § 448(c)(1) is $25,000,000^TY2026 (IRC § 448(c)). Where the exemption applies, a small business taxpayer meeting the IRC § 448(c) test may treat inventory as non-incidental materials and supplies, or may conform to the method reflected in its applicable financial statement or, having none, in its books and records prepared in accordance with its accounting procedures^TY2026 (IRC § 471(c)(1)(B)).

Current figures

How it works in practice

Cost of goods sold is not a deduction. It is a subtraction in arriving at gross income under in a manufacturing, merchandising or mining business, gross income means total sales less the cost of goods sold plus any income from investments and from incidental or outside operations or sources^TY2026 (Reg. § 1.61-3(a)). The distinction matters because a deduction can be disallowed, limited or suspended, and a cost of goods sold cannot be — but also because cost of goods sold is determined under the method of accounting the taxpayer consistently uses, and an amount cannot enter the computation any earlier than the taxable year in which economic performance occurs with respect to it^TY2026 (Reg. § 1.61-3(a)) applies its own timing rule, so an accrued cost cannot enter the computation before economic performance.

Decide membership by title. merchandise is included in inventory only if title is vested in the taxpayer — so goods out on consignment stay in the seller's inventory, goods sold with title passed do not, and goods purchased with title passed are included even while in transit^TY2026 (Reg. § 1.471-1(a)). Goods on consignment belong to the consignor’s inventory, however far away they are. Goods in transit belong to whichever party holds title under the terms of sale. Goods merely ordered for future delivery belong to nobody’s inventory. This is the most reliably examined point in the topic and it turns on a fact — where title sits — that the question always supplies.

Then choose a flow assumption, and note that it is a convention. Specific identification traces actual units. FIFO assumes the earliest goods are sold first, so ending inventory holds the latest costs. LIFO assumes the opposite, so ending inventory holds the oldest costs. Average cost divides total cost by total units. None of these needs to match how goods physically move; they are assumptions about cost flow, not about warehouses.

Know what each does in an inflationary period. With rising prices, FIFO leaves the newest and highest costs in ending inventory, which makes ending inventory larger and cost of goods sold smaller — and therefore income higher. LIFO does the reverse: the newest and highest costs go into cost of goods sold, ending inventory holds old low costs, and income is lower. Average cost lands between the two. Reverse the direction of prices and every one of those statements reverses with it, which is why a question must tell you which way prices moved.

LIFO carries conditions the other methods do not. LIFO is available only if the taxpayer establishes that it used no other procedure in inventorying those goods for a report or statement to shareholders, partners, other proprietors or beneficiaries, or for credit purposes, for the first year the method is used^TY2026 (IRC § 472(c)) is the one to remember: a business cannot report LIFO to the Internal Revenue Service and FIFO to its bank or its shareholders. And once adopted, LIFO must be used in all subsequent taxable years unless the Secretary permits a change, and any increase in the opening inventory value on adoption is taken into account ratably over 3 taxable years^TY2026 (IRC § 472(d), (e)). Adoption is by application, not simply by doing it.

Uniform capitalization sweeps indirect costs into inventory. {fig:cogs.263A_scope} (IRC § 263A(b)) — production of real or tangible personal property, and acquisition of property for resale. Property acquired to be rented out is in neither category, and neither is property produced for the taxpayer’s personal use. {fig:cogs.263A_costs} (IRC § 263A(a)(2)) is broader than the direct costing most businesses use for book purposes, and it is the reason a tax inventory figure often exceeds a book one.

Small businesses are out of both regimes. {fig:method.small_263A} (IRC § 263A(i)) and a taxpayer other than a prohibited tax shelter that meets the IRC § 448(c) gross receipts test is exempt from the inventory requirement, and its inventory method does not fail to clearly reflect income if it either treats inventory as non-incidental materials and supplies or conforms to the method reflected in its applicable financial statement, or in its books and records prepared under its accounting procedures where it has no such statement (IRC § 471(c))^TY2026 (IRC § 471(c)). The same IRC § 448(c) gross receipts test governs both, so a business either has both obligations or neither. Where it has neither, a small business taxpayer meeting the IRC § 448(c) test may treat inventory as non-incidental materials and supplies, or may conform to the method reflected in its applicable financial statement or, having none, in its books and records prepared in accordance with its accounting procedures^TY2026 (IRC § 471(c)(1)(B)) — and the second alternative is the useful one, because it lets the tax figure simply follow the books.

How this has changed

Both small business exemptions date from 2017 and are now the ordinary case. Before Pub. L. 115-97, the reseller exception in IRC § 263A was a much smaller fixed figure and reached resellers only, and the inventory rules of IRC § 471 had no general small business exemption at all — relief came through revenue procedures rather than statute. Section 13102 of that Act added IRC § 263A(i) and IRC § 471(c), tied both to a single IRC § 448(c) test, and indexed that test from 2019. For a taxable year beginning in 2026 the figure is $32,000,000 — a corporation or partnership meets the gross receipts test for a taxable year beginning in 2026 if its average annual gross receipts for the 3-taxable-year period ending with the preceding taxable year do not exceed that amount. The figure for taxable years beginning in 2025 was $31,000,000, and the unindexed statutory base in IRC § 448(c)(1) is $25,000,000^TY2026. The effect is that the great majority of businesses a preparer will meet are outside both regimes, and the questions that matter for them are the IRC § 471(c)(1)(B) alternatives rather than the capitalisation rules.

Nothing in Pub. L. 119-21 amended IRC § 263A, IRC § 471 or IRC § 472, so the 2026 rules are the 2025 rules apart from the indexed threshold. One adjacent change does touch the text. Pub. L. 119-21 § 70302(a) added IRC § 174A, which allows a deduction for domestic research or experimental expenditures notwithstanding the general capitalisation rule, with an election in IRC § 174A(c) to capitalise and amortise over not less than 60 months instead. IRC § 263A(c)(2) now reads “any amount allowable as a deduction under section 174 or 174A,” so a business that produces property and also conducts domestic research keeps those costs out of its inventory computation on the strength of a section that did not exist in 2025.

Exam focus

Expect a computation. Beginning inventory plus purchases less ending inventory is the formula, and the work is in the ending inventory figure. Practise all three conventions on one set of purchases until each takes seconds.

Expect a membership question. Consignment, goods in transit and goods on order recur, and the answer is always the title test of Reg. § 1.471-1(a).

Expect one question on IRC § 263A scope. The reliable discriminator is that the section reaches production and acquisition for resale, and reaches neither property acquired for rental nor property produced for personal use.

Finally, know that both the inventory requirement and uniform capitalization switch off together for a business under the IRC § 448(c) test, and that the escape route is the choice in IRC § 471(c)(1)(B) between non-incidental materials and supplies and conformity to the books.

Check yourself

1. A company’s beginning inventory is $3.80 million, purchases are $8.20 million and ending inventory is $2.42 million. What is cost of goods sold?

Answer: $9.58 million — beginning inventory plus purchases less ending inventory. Note that the figure has fallen out of the inventory count, not out of any expense ledger: cost of goods sold is derived, not accumulated.

2. A nursery buys 40 trees at $5 and later 30 at $4, and has 20 left at the year end. Under the average cost method, what is ending inventory?

Answer: $91.43. Total cost is $200 plus $120, or $320, over 70 units — $4.5714 each. Twenty units at that figure is $91.43. The result sits between what FIFO ($80) and LIFO ($100) would give, because prices fell.

3. A retailer has 200 units in its shop, 90 with an agent on consignment, and 60 in transit from a supplier under terms passing title on shipment. How many units are in its inventory?

Answer: 350. merchandise is included in inventory only if title is vested in the taxpayer — so goods out on consignment stay in the seller's inventory, goods sold with title passed do not, and goods purchased with title passed are included even while in transit^TY2026 — consignment does not pass title, so the 90 remain the retailer’s, and title to the 60 in transit has already passed to it. Physical possession is irrelevant in both cases.

4. Does IRC § 263A apply to a company that buys machinery to lease to customers?

Answer: No. {fig:cogs.263A_scope} (IRC § 263A(b)) covers property the taxpayer produces and property acquired for resale. Machinery acquired to be rented is neither, so the acquisition costs are not capitalised into inventory under this section — though the machinery is of course capitalised as a depreciable asset under other provisions.

5. A business adopts LIFO for tax but continues to present FIFO figures in the audited accounts it gives its bank. What is the consequence?

Answer: LIFO is unavailable. LIFO is available only if the taxpayer establishes that it used no other procedure in inventorying those goods for a report or statement to shareholders, partners, other proprietors or beneficiaries, or for credit purposes, for the first year the method is used^TY2026 (IRC § 472(c)) makes the method conditional on the taxpayer establishing that it used no other procedure in inventorying those goods for a report to shareholders, partners, other proprietors or beneficiaries, or for credit purposes.