How do Inventory and COGS Affect Taxable Income for Cash Basis Reporting?

While you're using cash basis accounting for your handmade furniture business, inventory is actually treated differently than your other expenses. Even on cash basis, you can't immediately deduct all inventory purchases - you need to use Cost of Goods Sold (COGS). To calculate your gross profit: Revenue - COGS = Gross Profit Your COGS would be: Beginning inventory + Purchases - Ending inventory In your example: Revenue: $1,250,000 Beginning inventory: $0 (assuming this is your first year) Purchases: $625,000 Ending inventory: $130,000 COGS: $0 + $625,000 - $130,000 = $495,000 Gross Profit: $1,250,000 - $495,000 = $755,000 Then subtract your other business expenses like advertising ($270,000) to get your taxable income of $485,000. That $130,000 of ending inventory isn't deductible this year because you haven't sold those items yet - they'll be part of next year's COGS calculation.

After reading all this, I finally got my inventory mess sorted out using https://taxr.ai and it was a huge relief. I was in almost the same situation with my pottery business - cash basis but completely confused about inventory. I uploaded all my purchase receipts and sales records, and it automatically calculated my proper COGS and showed me exactly what was deductible vs. what had to be capitalized as inventory. The system even flagged a bunch of supplies I had incorrectly categorized as inventory when they were actually immediately deductible! Made a $12k difference in my tax bill. Way better than the countless hours I spent trying to figure out the inventory rules on my own.

Wow, I need to apologize for being so skeptical about taxr.ai. I decided to give it a try with my woodworking business and I'm honestly impressed. Uploaded my QuickBooks data and receipts and within minutes it had properly categorized everything and showed me exactly how to handle my inventory for tax purposes. I had been incorrectly expensing about $45k of inventory that should have been capitalized. Would have been a real problem if I got audited! The system even created a detailed COGS worksheet showing beginning inventory, purchases, and ending inventory that I can include with my tax return. Definitely worth checking out if you're struggling with inventory accounting.

Dealing with the IRS on inventory issues can be a nightmare! Last year I had the same confusion, and when I called the IRS for clarification, I spent THREE DAYS trying to get through. Finally used https://claimyr.com (see how it works: https://youtu.be/_kiP6q8DX5c) and got a callback from an actual IRS agent in about 27 minutes. The agent confirmed exactly what the first commenter said - even cash basis taxpayers have to track inventory and COGS properly. She also warned me that inconsistent inventory accounting is a common audit trigger. The IRS callback service saved me days of frustration and probably an audit!

I need to eat my words about Claimyr. After posting that skeptical comment, I decided to try it because I had questions about my retail inventory that I couldn't get answered. Got connected to an IRS agent in about 45 minutes (which is LIGHT YEARS faster than my previous attempts). The agent walked me through exactly how to handle my situation where I had mistakenly deducted all inventory purchases immediately. She explained that I should file an amended return using Form 3115 to correct my accounting method. Turns out I was doing it wrong for YEARS and this could have saved me from an ugly audit. The $25 I spent on the callback service potentially saved me thousands in penalties and interest.

I use QuickBooks for my small retail shop and struggled with the inventory setup for years. What helped me was creating three distinct categories: 1) True inventory (items I purchase to resell) - these get tracked through COGS 2) Supplies that become part of my products (packaging, etc.) - these can be deducted when purchased 3) General business supplies (office stuff, cleaning supplies) - immediately deductible The key mistake I was making was treating everything as inventory when a lot of my purchases were actually category 2 or 3. Made my taxable income look way higher than it should have been.

One thing nobody mentioned yet - if you're a small business with less than $27 million in average annual gross receipts for the past 3 years, you might qualify for simplified inventory accounting under the "small business taxpayer exemption." Under this exemption, you can potentially treat inventory as non-incidental materials and supplies, which lets you deduct them when used or consumed rather than when the items are sold. This gets closer to true cash basis treatment but still isn't exactly the same as deducting everything when purchased.

This is exactly the kind of detailed breakdown I needed! I've been making the same mistakes with my handmade furniture business. Looking at my records, I think I've been incorrectly treating finishing supplies, sandpaper, and hardware as inventory when they should probably be supplies that get deducted when used. One follow-up question - for someone at my revenue level ($1.25M), would the small business taxpayer exemption that MidnightRider mentioned be worth exploring? It sounds like it could simplify things significantly, but I'm wondering if there are any downsides or complications I should be aware of before making that election. Also, does anyone know if switching accounting methods mid-year requires any special forms or if I need to wait until next tax year to implement changes?

This thread has been incredibly helpful! As someone who runs a small manufacturing business making custom cabinets, I've been struggling with the exact same inventory vs. supplies distinction. One thing that might help Sean and others is to think about it this way: if you walked through your workshop and counted everything sitting there at year-end, ask yourself "Is this something a customer would recognize as part of what they're buying?" The main wood pieces, cabinet doors, and hardware would be inventory. But the sandpaper rolls, wood glue, and finishing supplies are consumed in the process and should be supplies. I learned this the hard way when I had an IRS examination a couple years back. The agent spent hours going through my inventory calculations and pointed out that I was capitalizing way too much as inventory. She said a good rule of thumb is that if tracking the exact usage would require you to measure out every drop or ounce used per project, it's probably better classified as a supply expense. The audit adjustment actually worked in my favor - I got a refund because I had been overpaying taxes by not deducting legitimate supply costs! Sometimes these accounting rules can actually help reduce your tax burden when applied correctly.

This has been such an educational thread! I'm dealing with a similar situation in my craft brewery where I've been confused about how to handle ingredients versus packaging materials versus equipment. Reading through everyone's experiences, I think I've been making the same mistake as many others - treating everything as inventory when ingredients like hops and malt should be inventory (since they become the beer customers buy), but bottles, labels, and cleaning supplies should probably be expensed as supplies when used. The "would a customer recognize this as part of what they're buying" test from Jungleboo really resonates. Customers are buying the beer itself, not the bottle or label, even though those are necessary for the final product. I'm particularly interested in that small business taxpayer exemption mentioned earlier. At around $800K in revenue, I'd definitely qualify, and being able to deduct ingredients when they go into production rather than when the finished beer sells could really help with cash flow timing. Has anyone here actually made the Form 3115 election for the inventory exemption? I'm curious about the practical experience of filing that form and whether it's something a business owner can handle or if it really requires professional help.

I've been following this thread closely as a fellow small business owner, and I wanted to add one more perspective that might help Sean and others navigate these inventory rules more confidently. The key insight that finally clicked for me was understanding WHY the tax code treats inventory differently from other cash basis expenses. Regular business expenses like advertising or rent provide immediate benefit and are "consumed" right away. Inventory, however, represents stored value - it's essentially an investment that converts to income when sold. For your handmade furniture business at $1.25M revenue, I'd strongly suggest documenting your inventory counting and valuation methods consistently. The IRS pays close attention to businesses that show dramatic swings in inventory levels year-over-year without clear business reasons. One practical tip: take photos of your year-end inventory along with your physical counts. I started doing this after hearing about other business owners who had trouble substantiating their inventory values during audits. Having visual documentation of what was actually on hand makes the numbers much more defensible. Also, consider whether any of your inventory might qualify for the Section 263A uniform capitalization rules exemption. If you're primarily selling to retail customers (not other businesses) and your average gross receipts are under $27M, you might be exempt from having to capitalize indirect costs into inventory. This could simplify your calculations significantly. The accounting method changes discussed here really can make a meaningful difference in both tax liability and cash flow. Just make sure any elections are made properly and timely - these aren't decisions you can easily reverse later.

This entire discussion has been incredibly enlightening! As someone who just started a small woodworking business this year, I was completely lost on the inventory vs. supplies distinction until reading through all these examples. The "would a customer recognize this as part of what they're buying" test is brilliant - it immediately clarifies that my lumber and hardware are inventory, while my sandpaper, wood glue, and finishing supplies should be expensed when used. I've been tracking everything as inventory and making my taxes way more complicated than necessary. I'm particularly intrigued by the small business taxpayer exemption since I'm nowhere near the $27M threshold. Being able to deduct materials when they go into production rather than waiting for the finished piece to sell would be a huge cash flow improvement. The Form 3115 sounds intimidating, but if it simplifies ongoing accounting and provides better cash flow timing, it seems worth the professional help to get it filed correctly. One thing I'm still unclear on - if I make this accounting method change, do I need to physically track when materials are consumed in production, or can I use reasonable estimates based on project completion? For a small operation, measuring exact usage of glue and finish seems impractical, but I want to make sure I'm meeting the requirements properly. Thank you all for sharing your real-world experiences with these rules. It's so much more helpful than trying to decipher IRS publications alone!