Cost of Goods Sold (COGS) With No Receipts or Inventory Records

What is cost of goods sold, and why does it lower the tax on resale income?

Cost of goods sold (COGS) is what the goods you sold cost you. Schedule C subtracts it, along with returns, from your sales to reach gross profit, and the rest of the return starts from that profit. Leave it out and the return taxes gross sales as if the goods cost nothing.

Under the usual inventory method, COGS is stock at the start of the year, plus purchases, minus stock left unsold at year end (Publication 334, chapter 6). Stock you bought but have not sold is not yet COGS: it waits in ending stock until the year it sells, unless a small business follows books that expense stock when paid (next section).

What makes a no-records case not simple:

• Several back years: each year's ending stock is the next year's starting stock, so one wrong year carries forward.
• Stock bought with cash, or paid from accounts mixed with personal spending.
• No count of stock at any year end.
• Past returns already filed that left COGS out, or deducted stock when bought without a method that allows it.
• Some years filed and others never filed (filed years may need a method fix), or a notice or an audit.
• Casual selling, or stock you owned before the business started: a different answer applies (see the last section).

If more than one of these applies, the method and the filing order are judgment calls; see the last section.

Gather first: bank and card statements for every account used to buy stock, personal ones included; payment-app, marketplace and supplier order histories and confirmation emails; import and freight-forwarder invoices; shipping labels; sales totals by year; and a count of the stock you hold now.

Work in this order:

1. Rebuild each year's purchases.
2. Count stock now and work back.
3. Run the gross-profit check.
4. Write a one-page memo of the method.
5. Handle every year the same way.

Do I need a physical inventory count, or can a small business skip formal inventory?

A business that sells goods generally must take inventory at the start and end of each year (26 CFR 1.471-1), but a small business taxpayer may choose not to keep one. It still needs a method that clearly shows income.

A small business taxpayer has average annual gross receipts at or below the limit for the three prior tax years and is not a tax shelter. The limit is indexed for inflation: the current figure is $32,000,000, and each back year uses its own, lower, limit. Receipts from all of your trades or businesses, and from businesses treated as one employer with yours, are generally added together, plus your share of the receipts of any partnership or S corporation you own (Publication 334; 26 CFR 1.471-1; 26 U.S.C. 471(c); 26 U.S.C. 448(c)). The exception applies to tax years beginning after 2017; earlier years follow older rules this page does not cover.

Skipping a formal inventory changes the year the cost is deducted. A small seller may treat stock as non-incidental materials and supplies, or follow its financial statements or its books. Which suits you is in inventory or supplies for small sellers. Books that expense stock when paid, with no count used in the books and no stock figure given to a lender or shareholders, support deducting the cost when paid, so unsold stock does not matter; books that carry stock do not (26 CFR 1.471-1). With no books there is nothing to follow, so rebuilding them comes first.

Use one method for every back year: a treatment that is not consistent from year to year may not clearly reflect income. If an earlier year was already filed, its method is the starting point, and a different one later is a change in method (Form 3115); see fixing inventory missing from past returns. If no year was ever filed, the first return that reports the business's income can adopt any permissible method without IRS consent (26 CFR 1.446-1); which back year counts as first is a judgment call. A business above the size limit has no simplified method and must keep inventory.

I have no receipts: what records can still show what I paid?

Statements can prove a payment was made, and order histories and emails can show what it bought; most reconstructions need both. Publication 583 says a bank or card statement may prove payment in place of a canceled check when it shows the amount, the payee and the date (and the check number, for a check). It also warns that proof of payment alone does not establish a deduction: keep records, such as invoices or sales slips, showing the cost was incurred. For stock, the records should show the amount paid and that it was for inventory. For other business costs without receipts, see lost receipts for business expenses.

Ask each bank, card issuer, payment app, marketplace and supplier for past statements and order histories. The IRS's own reconstruction training lists bank statements, invoices, canceled checks and card slips as the foundation (IRS National Tax Forum slides).

Cash buying leaves no payee. Cash withdrawals on bank statements show cash you took out, not what it bought, and cash from sales may have paid for stock too (see cash business sales records). Photos, listings, calendars and notes made at buying time can support the rest, and what the paper cannot support is an estimate (see below).

Label every rebuilt record as a reconstruction made now, with the source and date of each figure. Never create or alter a document to look as if it was made at the time: a disclosed, supported estimate is different from a record that is made up.

How do I rebuild each year's purchases from bank, card and payment-app statements?

Go through every outflow for the year, keep only what bought stock, and total it by the year bought.

1. List every account used to buy stock that year, personal ones included, plus the marketplace and payment-app histories.
2. Mark each outflow as stock, another business cost, personal, or a transfer between your own accounts. Count each purchase once: paying a card bill, or moving money into a payment app, is a transfer, so count the items on the card or app history, and the bank line only when no history shows them. Stock goes to line 36. Other business costs, such as shipping supplies and platform fees, go to other Schedule C lines; see Schedule C expenses for unfiled years.
3. Take out supplier refunds and credits, because returns and allowances reduce purchases, and take out goods you kept for personal use (Publication 334, chapter 6).
4. Add freight in and import duty on the stock you bought, which are part of COGS (Publication 334; 26 CFR 1.471-3; see landed cost in cost of goods sold).
5. Date each purchase by when you bought it, not when it sold, and total by year.
6. Match each year's purchases to that year's sales. Anything bought and not sold is ending stock, not COGS.
7. Keep a one-page log: accounts used, how each type of outflow was classified, and every gap.

A statement line with no clear payee, such as a cash withdrawal or a transfer to a person, needs a note on what it bought to count as a supported purchase. Without one, keep it in the log as a gap; whether any part can be estimated is the question in the estimate section below.

How do I put a value on beginning and ending stock for years I never counted?

Count what you hold today at cost, then work back one year end at a time using purchase and sale dates.

1. Count every unit on hand now and price it at what you paid. Match items to purchases where you can (specific identification). Where identical goods are mixed together and cannot be tied to invoices, first-in, first-out prices the stock left from your most recent purchases (Publication 538). Under the non-incidental materials and supplies method, use specific identification, first-in first-out or average cost (26 CFR 1.471-1).
2. Work back. An item was in stock at a past year end if you had bought it by then and it was still in your hands: it sold later, you still hold it, or it left stock another way (scrapped, lost, donated, returned or taken for personal use). Total the cost of those items for that year's ending stock. Order and sales histories give the dates; for goods that left without a sale, see writing off dead stock.
3. If you keep a formal inventory, value goods you cannot sell at normal prices, such as damaged, out-of-style or odd lots, at their genuine selling price less the cost of selling them (Publication 538). That price must be one the goods were actually offered at within 30 days after that year end, and you must keep records of how they were disposed of (26 CFR 1.471-2); dated listings can show it, a value picked now cannot. Schedule C line 33 allows cost, lower of cost or market, or another method the IRS approves (instructions). The non-incidental materials and supplies method allows neither this write-down nor lower of cost or market (26 CFR 1.471-1).
4. Link the years. Opening stock should usually equal the prior year's closing stock, and a difference needs an attached explanation (Publication 334). The first year starts at zero only if you owned nothing before; see starting inventory you already owned.
5. Prove the arithmetic: for each year, starting stock plus purchases minus ending stock equals COGS.

Is a reasonable estimate allowed, and what limits it?

Sometimes, for the part the records cannot cover, and only with support. The law requires records sufficient to establish income and deductions (26 U.S.C. 6001; 26 CFR 1.6001-1), and the taxpayer carries the burden of substantiating what is claimed (IRS recordkeeping). A court-made rule, the Cohan rule, lets a taxpayer who proves a cost was incurred estimate its amount. It is case law the IRS cites in training slides, not a rule in the Code or regulations, and each case turns on its facts (IRS National Tax Forum slides).

• Some cost must be proved. The rule fills in an amount; it does not create a cost with no evidence.
• The doubt falls on the taxpayer. Courts weigh the imprecision against a taxpayer who caused it by keeping no records (slides).
• The burden of proof stays with the taxpayer unless, in court, the taxpayer produces credible evidence and has also substantiated the items, kept the required records and cooperated with the IRS (26 U.S.C. 7491(a)). A partnership, corporation or trust must also meet net worth and employee limits. Missing records can keep the burden where it is.
• An estimate needs a visible source. A Tax Court case in the same slides rejected an outside report on cost of goods sold that did not show the data behind its conclusions.
• The IRS need not estimate for you. Where a nonfiler cannot substantiate expenses, the IRS has no legal requirement to estimate them, and in a no-response case that includes cost of goods sold. An estimate may be used if the taxpayer gives a reasonable basis, for example expenses proved for another year of the same kind of business (IRM 4.10.4).

What gross-profit check keeps the number believable?

Divide gross profit by net receipts (sales minus returns and allowances) for each year and compare the result with your usual markup. Little difference suggests the figures hold; a large one suggests sales, purchases or stock were not figured accurately, and the reason should be found (Publication 334, chapter 7).

1. Gross profit is net receipts minus COGS.
2. Find your own markup by tracing a sample of sold items, each from what you paid to what it sold for. Examiners test gross profit the same way, tracing specific items from purchase to sale (IRM 4.10.4). Use the check to find errors, not to set the stock figure: choosing ending stock so that gross profit hits the markup is an estimate with no support behind it.
3. Convert before comparing. A markup is measured on cost and gross profit is a share of sales; the Example shows both for the same items.
4. Compare year to year. Gross profit that swings between years, or is unusually high or low for the kind of business, is one sign the IRM lists as supporting an examiner's use of indirect methods (IRM 4.10.4).

The check also runs the other way. If rebuilt cost of goods sold (purchases adjusted for stock on hand), marked up at your own traced markup, comes to more than the sales you reported, the sales may be understated, which is a larger question than cost of goods sold. The IRS markup method starts from cost and applies the business's own markup to see what sales should have been. The IRM uses the actual markup when it is known and accepts a plausible explanation for a difference from national averages (IRM 4.10.4).

Where does the figure go on Schedule C, and does a corporation do it differently?

A sole proprietor enters it in Part III of Schedule C and carries line 42 to line 4. A partnership or corporation reports it on Form 1125-A, attached to its return. The cost rules are the same; the entity's own books are what differ.

On Schedule C, lines 33 and 34 record how closing stock was valued and any change in quantities, costs or valuations. Line by line, see Schedule C cost of goods sold.

A partnership or corporation that deducts COGS attaches Form 1125-A. Its line 8 goes on page 1 of the return: line 2 on Form 1120, or the line the return names for cost of goods sold. Line 9a records the valuation method. For tax years beginning after 2023 it has boxes for the small business choices (non-incidental materials and supplies, financial statements, or the books); for earlier years, use that year's form. The same size test applies to the entity itself (26 U.S.C. 471(c)).

For a corporation, "follow the books" means books that properly reflect the business for non-tax purposes. A corporation that counted stock for its books, or gave a lender or shareholders a stock figure, may have to follow that record. The regulation does not say whether books rebuilt after the fact qualify, and missing or unreliable books may need rebuilding first, a judgment call (26 CFR 1.471-1). For the choice of method, see inventory or supplies for small sellers.

What do examiners do when records are missing, and what helps in an audit?

Examiners first try to tie the return to the books. Where books are missing, incomplete or irregular, IRS procedures direct them to indirect methods that estimate income once they find a reasonable likelihood of unreported income, such as bank deposits, markup and net worth (IRM 4.10.4; IRS slides). For cost of goods sold, the IRM describes these steps:

• Test the gross profit percentage by tracing items from purchase to sale, and compare it with other years and industry ratios.
• Ask how stock was valued, review items valued at zero, and trace values back to purchase invoices.
• Prefer the taxpayer's own figures to industry averages where they exist, and accept plausible explanations for differences.

Poor records also feed the accuracy-related penalty: 20% of the part of an underpayment due to negligence, which the regulation says includes failing to keep adequate books or to substantiate items properly (26 CFR 1.6662-3). The Code also has a separate civil fraud penalty for an underpayment due to fraud (26 U.S.C. 6663). On a joint return, both spouses owe the whole tax (26 U.S.C. 6013(d)(3)). See penalties for not keeping business records.

What tends to help:

• Respond on time to every notice, and send the rebuild file, not a bare total.
• Keep the whole rebuild file: statements, histories, count sheets and a short memo of the method. Records must be kept as long as they may matter (26 CFR 1.6001-1).
• Use traced figures over averages, one method every year, and explain every difference.

No reconstruction is guaranteed to be accepted; each examiner and court weighs the support. For the full process, see an IRS audit of a small business.

Example

All figures are in US dollars and are illustrative. The first two examples assume a formal inventory or the non-incidental materials and supplies method.

Three years with statements only

A reseller starts with no stock, keeps no receipts and has three years of bank, card and payment-app statements. A count at the end of year 3, priced at cost, shows US$12,000 of unsold stock. Order and sales histories give the cost of the items held at each earlier year end.

Year 3 ending stock is the count; years 1 and 2 come from the histories. Each year's ending stock is the next year's starting stock, and starting stock plus purchases minus ending stock gives COGS. Buying US$45,000 in year 3 does not make COGS US$45,000: US$3,000 of stock growth stays on the shelf. A year with gross profit far from the other two would be checked first.

A cash buyer who never counted

A seller buys at estate sales for cash and sells US$50,000 in the first year. Statements show US$30,000 of cash withdrawn. The seller's calendar, listing notes and photos tie those withdrawals to estate-sale buying, so they count as purchases. With no ending stock figured, treating all of it as cost gives gross profit of US$20,000, or 40% of sales.

A sample of 20 sold items, with listing notes of what was paid, shows cost near 40% of the selling price. That is gross profit near 60% of sales, and a markup on cost of 150%, since a US$40 cost sold at US$100 earns US$60. The 20-point gap says a figure is off. Today's count, worked back to the end of that first year from order and sales histories, shows US$9,000 of unsold stock at cost, so COGS is 0 + 30,000 − 9,000 = US$21,000 and gross profit is US$29,000, or 58%. The withdrawals alone proved nothing; the notes tied them to buying, and the count and the sample give the figure support that can be shown.

A corporation whose books never tracked stock

A corporation sold US$300,000 of goods. Its books lump purchases into general expenses, no stock was ever counted, and no stock figure went to a lender or shareholders. As a small business taxpayer it may follow those books under section 471(c); because they expense stock when paid, the regulation lets it deduct the cost when paid. Form 1125-A still needs the stock split from other spending: sorting its statements and supplier histories shows US$195,000 of the spending was stock.

Different for you?

• You have several years of resale income and only statements, the IRS has asked for support, or the gross-profit check stays far off after you recheck it: each year's ending stock is the next year's starting stock, and which years to file first and whether returns already filed need a method change are judgment calls. See bookkeeping help for rebuilding each year's cost.
• Rebuilt cost of goods sold, marked up at your own markup, comes to more than the sales you reported: the sales may be understated, which is a larger question than cost of goods sold. See bookkeeping help for the rebuild, and an IRS audit of a small business if a notice has arrived.
• Your corporation or partnership never tracked stock in its books: the books must at least separate stock from other spending to report cost of goods sold; see catching up on overdue books.
• Past returns showed zero inventory, or deducted stock when bought, and you are not sure that matched an allowed method: see amend or Form 3115.
• Years of business income were never filed: see expenses for unfiled years and catching up on unfiled personal returns.
• A 1099-K shows gross sales far above profit: see platform gross sales and cost of goods sold.
• You want to expense stock when bought, or hold it as inventory: see inventory or supplies for small sellers.
• You owned the stock before the business started, or you sell casually: see starting inventory you already owned and hobby or business for resellers.
• You need Schedule C Part III line by line: see Schedule C cost of goods sold.
• You received an IRS audit letter: see an IRS audit of a small business.