Question about taxes and COGS

[Hermanam]

Having recently registered as a business, I should probably consult a tax advisor to make sure I am doing things correctly. Until then, I am hoping some more experienced small business owners/soapers might be able to provide some general direction (don't worry, I WILL talk to a tax professional, I just have a few general questions).

I have read about figuring cost of goods for tax purposes. However, can one not simply figure all their business "expenses" for the year (soap making supply purchases, overhead, etc.) and all their "income/sales" of soap sales, and use these numbers for end of year tax purposes?

Maybe I don't have a clear understanding of COGS...what is the benefit of using this number for tax purposes, and is it required? Or can you simply use expenses out and sales in?

If someone knows of a good resource to clarify this subject, I would really appreciate it. Accounting has never been my forte, but I want to make sure I am doing everything correctly. Thanks in advance for your help

 

[Belinda02]

The IRS and their forms require a breakdown in expenses and income. The purpose of talking to a professional will help u I'd All ur expenses as the year progresses.

 

[Hermanam]

Sorry, maybe my question wasn't clear. I understand that you would need to provide a detailed breakdown of all the expenses and income with receipts, etc. I am just wondering if it is incorrect to deduct these expenses simply as they are, or if I should use different numbers (from calculating the COGS)?

 

[Belinda02]

I don't think I understand. Expenses are listed on the IRS form and the program calculates cogs. This may be different from your numbers. Some costs are start up costs and not a part of cogs. Mileage is one of the largest costs people forget and utilities.

 

[Hermanam]

I am wondering if I did my taxes incorrectly, because everything I am reading says you cannot simply deduct supply purchases and report income earned, but rather you need to calculate the cost of goods sold and use these numbers instead. Maybe these are the same thing and I am just confused? I used Turbo Tax and, as a sole proprietorship, I have receipts for every supply purchase I made throughout the year. These were reported as expenses (they were split between startup expenses and operating expenses once the business began). Then I reported income from sales of soap. As general practice, is this correct? I have read that instead you need to take a starting and finishing inventory, calculate COGS, etc.

This year was VERY minimal dollar amounts, but I will clearly consult a professional going forward. But I'm just trying to get a handle on the big picture. I'm not sure if I am making sense, but I appreciate the help

 

[pamielynn]

You should be splitting out the expenses. COGS is basically raw materials, but includes other things that go into your manufacture. The IRS website has a pretty good breakdown of it.

 

[la-rene]

You are making sense. We, as soapmakers are not exempt from reporting an inventory. We are not allowed, due to the nature of our business, to simply do our accounting by the Cash method according to the IRS. Our business is soapmaking/cosmetic making and is not exempt from accrual accounting like others are. Because you are small peanuts yet, like we are, most likely, they won't call you out on just doing expenses and income (cash basis) this year. But, it would be best to go forward with your accrual accounting from here on.

So, COGS is an equation that deals with what you've bought to make stuff (items purchased to create goods to sell) What you've made and is ready to sell (this is finished soap or what ever else you make) Minus the cost of what you have sold. So, if you have, like us, many items ready to sell and lots of ingredient inventory but only a few items sold in the year (we started late) you will have a negative COGS, however, this is always treated at a positive as far as taxes go. So ideally, you want to have as little inventory sitting on your shelf as possible. That is hard to do for soapmakers, so therefore, we suffer.

Here is what my COGS looked like (numbers not accurate...just examples)
STARTING INVENTORY: 0
COST OF INVENTORY (INCLUDES ALL INGREDIENTS ON HAND AND SOAP READY TO SELL) $4000
COST OF ENDING INVENTORY: $3600
COGS is $400
2014 BEGINNING INVENTORY: $3600

Unfortunately, that ending inventory is considered income and not deductible until you sell it or throw it away or give it away.
It will hit your Tax bottom line. COGS is the deductible part. My acct adviser said that no one will ever come to your house to count an inventory but it's good to do it correctly. However, we did it right in the end, it was difficult as we did not compute our inventory correctly from the get go. That is crucial. If the cost of the item can be figured into the final cost of your item for sale then it needs to be inventoried and tracked.

We did figure out how much we had invested for deducting for start up costs, incident supplies (Website fees, CC/banking fees, supplies that we don't track, computer supplies, etc...) This is where we saved us some Tax dollars. Make sure you do track mileage, as we didn't and it would have saved us some $$.

We gave away a lot of soap in the beginning and did not track it well which gave us a lot of headaches. It is important to track the whereabouts of all your items you make because as soon as they leave your inventory, they are deductible.

Does this help?

I should add that calculating COGS can also include the cost of salary etc to employees and factory overhead. This would add to the final COGS it would be under "Any other costs related to making your items sold". For factory overhead you would need to know exactly how much electricity (etc) was used during your soap making day, the cost of the percentage of using your kitchen for only the time for soap making. We did not do this as we couldn't separate it out. Though, pretty much one day(+) a week for a year was spent in the kitchen making stuff. As we both have day jobs, we decided to let that one slide until the day we have a dedicated space.

 

[Hermanam]

Thanks la-rene for taking the time to provide such a detailed explanation...I really appreciate it! Yes, that helps clear thing up a lot. I was missing the big picture about cogs and inventory, but now it makes sense. Like you mentioned, I have been diligent about keeping records and receipts of supply purchases, but wayyy less diligent about keeping track of the whereabouts of the soap...yes, some was sold (and recorded as such), but a lot was given away or thrown away (failed batches, etc.). Realizing that as I am now a small business and sales are slowly picking up, I need to get a better handle on the accounting end of things. I am currently in the process of entering everything into Soapmaker 3, so I am hoping this will help me with tracking inventory and figuring cogs. Always learning...thank you so much

 

[Hermanam]

La-Rene, one question...you mentioned that the ending inventory is considered income? I'm still struggling with that...why is it income at that point? Would it not be income until I sell the soap? (Meaning, my supplies on hand and soap sitting on the shelf at the year are not yet income?)...what am I missing?

 

[la-rene]

La-Rene, one question...you mentioned that the ending inventory is considered income? I'm still struggling with that...why is it income at that point? Would it not be income until I sell the soap? (Meaning, my supplies on hand and soap sitting on the shelf at the year are not yet income?)...what am I missing?

That's what I initially thought too, but with the restrictions on how we, as soapmakers, need to account for our supplies in the accrual method, you can't deduct the supplies until they are removed from your final inventory. The best I can understand it is, the IRS is taxing it as Potential income.

If you were drop shipping from a supplier, then you would have no inventory and would be able to do the cash method and deduct your expenses as they happen and claim your income as it happens. But, because we make stuff, we can only deduct when we sell. Both claims happen at once when you sell a bar, which is why planning is crucial. Don't have a lot of inventory to make stuff on your shelves.

That was our problem. We have about 2k of inventory to make stuff just sitting there waiting. That is potential income and taxed accordingly. You can't claim it as an incidental supply because it may eventually make it into soap or what ever even years later and then it would be deducted twice. Does that make sense? Once as an incidental and once in the COGS when you eventually sell it. That would be tax fraud. We have designated some stuff as incidental supplies if we are testing them, but for actually making an item to sell, we would technically have to buy new supplies and put them into our COGS inventory. Nothing from the testing can make it into the final cost because it is accounted for in a different way. That is the shortest explanation I can give! lol! Sorry if confusing. I worked on taxes daily for almost two months to figure this out. OMG it sucked. Also, if you throw something out from your COGS ingredient inventory, you need to account for that and remove it from your total so it goes against your total and becomes COGS.

 

[Aline]

I do my own taxes using Turbotax and it is a learning curve every year!

From my understanding, if you are have less than $1M in sales you can use the cash accounting method and not report inventory, in which case you enter your cost of goods simply as expenses when you fill in your tax form.

Turbotax actually won't let you report COGs unless you are reporting inventory.

Hope that helps!
Aline

 

[Aline]

Aloha La-Rene,

I'm not sure where you are getting this info but I see everywhere that manufacturers (i.e. people like us who store the raw materials that they make their goods from) do not have to report inventory and use the accrual method unless they are making over $1 M in sales. For other types of businesses the threshold is higher.

Here it is from the horse's mouth: http://www.irs.gov/publications/p334/ch02.html#en_US_2013_publink1000313270

These are the relevant passages:

Inventories

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later).

A qualifying taxpayer under Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.

A qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.

Qualifying taxpayer. You are a qualifying taxpayer if:
Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by 3.)

Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.

Qualifying small business taxpayer. You are a qualifying small business taxpayer if:
Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.)

You are not prohibited from using the cash method under section 448 of the Internal Revenue Code.

Your principal business activity is an eligible business (described in Publication 538 and Revenue Procedure 2002-28.)

Business not owned or not in existence for 3 years. If you did not own your business for all of the 3-tax-year period used in figuring your average annual gross receipts, include the period of any predecessor. If your business has not been in existence for the 3-tax-year period, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts.

 

[la-rene]

After more reading, the difference might be the Small Business entity. We have an ein as a partnership. It might be different if you are self employed with no ein and work everything through your personal accts. Though this publication states that all taxpayers doing business under the entities below can not use the exemption... so.. nothing is really clear, of course.
http://www.imanet.org/PDFs/Public/SF/2003_06/0603taxes.pdf
But, what I do know is that if you use one, you have to stick with it unless you formally ask to change to another or the IRS does it for you in the case that they don't agree with you using the cash method. When the IRS does it, you are stuck with it forever.

Under small businesses, our business entity is not included in the exemption from accrual methods which works with the COGS. We fall under either (see below) B or D and hopefully C someday. Though, even if you are exempt, the IRS prefers you to use the accrual method if you carry inventory for sale. Both methods have advantages and disadvantages. Though, when :grin: we grow big, accrual is better and now that it's set up, there should be no more hiccups.

Here is a good explanation I found. https://www.etsy.com/teams/7744/etsy-us-tax-bookkeeping-and-business/discuss/12057040/

For us, this is the reason why we have to do Accrual:

Eligible business.
An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. You have an eligible business if you meet any of the
following requirements.
1. Your principal business activity is described in a North
American Industry Classification System (NAICS)
code other than any of the following NAICS subsector
codes:
a. NAICS codes 211 and 212 (mining activities).
b. NAICS codes 31-33 (manufacturing).
c. NAICS code 42 (wholesale trade).
d. NAICS codes 44-45 (retail trade).
e. NAICS codes 5111 and 5122 (information indus-
tries).
2. Your principal business activity is the provision of
services, including the provision of property incident
to those services.
3. Your principal business activity is the fabrication or
modification of tangible personal property upon de-
mand in accordance with customer design or specifi-
cations

 

[Hermanam]

Wow, thanks to everyone who has taken the time to share what they have found with regard to this. The whole thing gives me a headache...LOL. I definitely have a better understanding of the big picture, and one thing is for sure...I need to get MUCH more detailed with my accounting and general business practices.

 

[Bayougirl]

I keep a notebook on my counter in the soap house that I record any soap or product that I give away for promotions or gifts. I do two reports for the year; one for the promotional/giveaways that has the batch #, date, to who and how much it cost. And the second is for inventory adjustments, for batches that are bad, lose scent or for any other reason (miscount, so on) that has the same information, except why it's being taken out of stock. I do invoices (through SM3) and take them out of stock to keep the production inventory accurate. My BIL is a CPA and helped told me about these reports. I just go through the notebook a couple of times a year and type up a report in excel for each so I have them for the end of the years taxes.

 

[la-rene]

Hey there! I've highlighted the parts of where my business might differ from other soap makers. I'm a partnership and a business tax payer (1065), not an individual tax payer (schedule C) and I have a non qualifying business. Manufacturers and retail sales are non qualifying.

But, according to the IRS they still want you to do an inventory if you have inventoriable items AND if you have inventory, you might as well do accrual because you are still doing COGS with the Cash Method because that is how you offset your income. My accountant said accrual and inventory was the way to go for us, so we did. Our mistake was having so much in inventory at the end of the year. We learned.

QUOTE=Aline;418780]Aloha La-Rene,

I'm not sure where you are getting this info but I see everywhere that manufacturers (i.e. people like us who store the raw materials that they make their goods from) do not have to report inventory and use the accrual method unless they are making over $1 M in sales. For other types of businesses the threshold is higher.

Here it is from the horse's mouth: http://www.irs.gov/publications/p334/ch02.html#en_US_2013_publink1000313270

These are the relevant passages:

Inventories

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later).

A qualifying taxpayer under Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.

A qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.

Qualifying taxpayer. You are a qualifying taxpayer if:
Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by 3.)

Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.

Qualifying small business taxpayer. You are a qualifying small business taxpayer if:
Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.)

You are not prohibited from using the cash method under section 448 of the Internal Revenue Code.

Your principal business activity is an eligible business (described in Publication 538 and Revenue Procedure 2002-28.)

Business not owned or not in existence for 3 years. If you did not own your business for all of the 3-tax-year period used in figuring your average annual gross receipts, include the period of any predecessor. If your business has not been in existence for the 3-tax-year period, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts.[/QUOTE]

 

[Aline]

Hi la-rene,

According to the IRS the exclusions for manufacturers only apply to 'Qualifying Small Business Taxpayers' (i.e. if you have sales above $1 M but less than $10 M). If your sales are under $1 M then the manufacturer exclusion does not apply to you. And it doesn't make any difference if you are a Corporation.

If anyone wants to check this out it's on page 15 of http://www.irs.gov/pub/irs-pdf/p538.pdf
It's great bedtime reading :crazy:

Sounds like you are happy with doing the Accrual Method though and you're right that you are all set to make it big! I'm so glad I don't have to track inventory but I guess if I ever make it big can hire someone to do all that

Aline

 

[Lindy]

I just wanted to add a quick note. Inventory is consider an asset rather than income which is defined as products and services that are sold. It may not seem like a big difference but it is once you start doing true accounting procedures. An easy way of doing things is to actually buy accounting software as it does a lot of the work in the background. Most reputable accounting software firms offer training which is good to take so you understand what you're doing. I took a bookkeeping course this year and it was time well spent. I recommend a separate bank account for your business because you need to track your bank fees too as they are deductible to your income.

 

[Jenn2980]

Oy, this makes my head spin. I have a meeting with an accountant next week to go over all this so I know what I'm doing and do it right. Question though - I'm considering getting SM3, those who use it, is that adequate for your accounting and inventory tracking if you have to file using the COGS?

 

[Lindy]

Jenn I have SM3 and I don't find it adequate for proper accounting uses. You need to record things like rent, telephone, fuel, bank fees as well as other business expenses.