Schedule C Cost of Goods Sold (COGS): Part III and Inventory

Where does cost of goods sold go on Schedule C?

Cost of goods sold is figured in Part III (lines 33 to 42). The result on line 42 carries to line 4, which comes off net sales to give gross profit on line 5 (Schedule C). Line 4 is filled from line 42, so the figure is built in Part III. That is why tax software asks for beginning inventory, purchases and ending stock: Schedule C needs lines 35 to 42 to fill line 4. Line numbers here are the same on the 2025 Schedule C and the 2026 draft; check the final form for your year.

The arithmetic is one line (Publication 334, chapter 6): beginning inventory, plus purchases, labor, materials and other costs, minus ending inventory, equals cost of goods sold.

Not every seller has to count stock. A small business may choose not to keep a formal inventory, but it must still use a method that clearly reflects income, and the Schedule C instructions do not say which lines then carry the cost (see the section on skipping the inventory below). If you do keep an inventory, Part III is where it is reported.

A case is not simple when:

• earlier returns left Part III blank, or this year's opening figure does not match last year's closing figure;
• you are not sure whether you keep an inventory or skip it;
• the year-end count or the costs cannot be rebuilt from records (no invoices, cash purchases, or supplier invoices in another language or currency);
• you make what you sell, or pay freight and other costs to get goods to you;
• you want to change how you handle inventory, which needs Form 3115;
• your gross profit looks off, or sales run through a marketplace and the platform's totals do not match your books.

Gather first: last year's return (for its ending inventory), a dated count of the stock you hold at year-end, purchase invoices, canceled checks and card slips that show what you paid for stock (Publication 583), supplier credits, and a list of goods you took for personal use or gave away. Keep an invoice in another language or currency with a note of what it covers and the dollar amount your statement shows.

Do I have to report cost of goods sold?

Generally yes, if your business earns income partly by making, buying or selling goods (the IRS calls this an income-producing factor). The Schedule C instructions say such a business must take inventories into account at the beginning and end of the year, and Treasury Regulation 1.471-1 says the same. Cost of goods sold is the result.

An empty Part III leaves line 4 at zero, so all of line 3 becomes gross profit. A small business that skips a formal inventory still has to account for the cost of the goods it sells (see below).

A business that sells only services does not figure cost of goods sold, and its gross profit equals its net receipts (Publication 334, chapter 7). A service business that also sells or charges for the materials it normally uses is covered. See cost of goods sold for a service business.

What do lines 33 to 42 of Part III mean?

Lines 35 to 42 are the arithmetic; lines 33 and 34 describe how you valued the stock. A seller who buys and resells usually fills lines 35, 36 and 41, and line 39 if she pays freight-in.

Source: Schedule C and Publication 334, chapter 6. Small merchandisers usually have no labor that can be charged to cost of goods sold. Supplies that do not go into the product are not part of Part III; the form labels line 22 "Supplies (not included in Part III)". For that choice, see materials and supplies or inventory. For items you make, see cost of goods sold for handmade products.

How do I work out beginning inventory?

Beginning inventory is the cost of the goods on hand on the first day of the year that you will sell, and it is usually the same as last year's ending inventory (Publication 334). Copy last year's line 41 to this year's line 35.

• First year in business: with no stock on hand when you started, there is nothing to enter. If you owned stock before you opened, see starting inventory you already owned.
• Earlier returns showed no inventory but you held stock: the right opening figure depends on what those returns reported. See fixing inventory missing from past returns.
• No records for earlier years: see inventory and cost of goods without records.

What if beginning inventory is not last year's ending inventory?

Line 35 requires an attached explanation of any difference. Reasons the IRS sources describe include:

• A change in inventory method: refigure last year's closing inventory under the new method, enter that on line 35, attach an explanation, and take the difference into account in the section 481(a) adjustment (Schedule C instructions, line 35). That adjustment keeps income from being counted twice or missed.
• Donated stock: remove the amount of your contribution deduction from opening inventory (Publication 334).
• A casualty or theft loss claimed separately: adjust opening inventory or purchases to take out the loss items, so the loss is not counted twice (Publication 538).

If the difference is because last year's figure was wrong, it may call for correcting the earlier return or a method-change filing, in addition to the explanation on line 35. See fixing inventory missing from past returns.

What goes into purchases, and what stays out?

Line 36 is the cost of merchandise you bought to sell this year, at the prices you actually paid, less returns and the goods you took for yourself (Publication 334).

For inbound shipping, duties and packaging, and for what stays out, such as shipping to your customers, see landed cost in cost of goods sold.

How do I count and value ending inventory?

Count the stock on hand at year-end, price each item, and add up the total for line 41. If you also keep a running (book) inventory, Publication 538 requires a physical count at reasonable intervals and an adjustment so the books agree with it.

1. Decide what to count. Count merchandise you own (title is yours), including goods in transit, goods you placed with others on consignment, and goods held at a booth or display room away from your place of business. Leave out goods you sold once title passed, goods consigned to you, and goods ordered but not yet yours (Publication 538; Treasury Regulation 1.471-1). For stock in a marketplace fulfillment center, see fees and year-end counts for fulfillment-center stock. If a supplier ships each order straight to your customer, you may have no stock to count; see online seller income tax.
2. Record it. A dated count sheet with each item's description, quantity, unit cost and total, and who counted and priced it, is the record Publication 334 describes.
3. Match costs to items. Use specific identification when you can tie an item to its invoice. If identical goods are mixed together, assume the stock on hand is from your most recent purchases (first in, first out), unless you elected last-in, first-out on Form 970 with the return for the first year you used it (Treasury Regulation 1.471-2; Treasury Regulation 1.472-3).
4. Value it by one of the line 33 methods below.

Source: Schedule C instructions, line 33 and Publication 538. Use one method across the whole inventory and the same method each year; Treasury Regulation 1.471-2 gives consistency more weight than any particular method. Changing the method needs Form 3115.

Goods you cannot sell at normal prices because of damage, shop wear or style changes may be valued at the price you actually offered them for, less the direct cost of disposing of them, under either method (Treasury Regulation 1.471-2). The offering test, the proof you carry and the records to keep are in writing off unsold or obsolete inventory.

Can a small business skip the inventory?

Yes, a small business taxpayer may choose not to keep an inventory, but it must still use a method of accounting for inventory that clearly reflects income (Schedule C instructions; 26 U.S.C. 471(c)).

You qualify if your average annual gross receipts for the three prior tax years are $32,000,000 or less (the section 448(c) amount in Rev. Proc. 2025-32, section 4.30, in Internal Revenue Bulletin 2025-45; Treasury Regulation 1.471-1 applies it to sole proprietors), and you are not a tax shelter. W-2 wages do not count, and a new business averages over the years it has existed (Schedule C instructions). Related businesses, your share of a partnership's or S corporation's receipts, a predecessor's receipts and short years also change the count; see materials and supplies or inventory.

A qualifying business that skips the formal inventory has two methods:

• Non-incidental materials and supplies: the cost of goods is recovered through cost of goods sold in the year they go to the customer, or the year you pay for them if later. The de minimis safe harbor election cannot be used to expense them (Treasury Regulation 1.471-1).
• Financial statements and books: follow the way the business's applicable financial statement treats inventory (for example, an audited statement used for credit or for reporting to owners; 26 U.S.C. 451(b)(3)) or, with no such statement, the way its own books do. The books must properly reflect the business's activities for non-tax purposes, and a cost is still not recovered before it is paid or incurred under your overall method (Treasury Regulation 1.471-1).

The instructions show no line-by-line layout for either method. Pick one and use it every year. The test reruns every year: once your three-year average passes the limit, you go back to a counted inventory. Any switch needs Form 3115 (Treasury Regulation 1.471-1, paragraphs (b)(1) and (b)(8)).

Do cash-method sellers still need to count stock?

Not if you qualify as a small business taxpayer and choose not to keep an inventory, though under the non-incidental materials and supplies method unsold stock is still not deducted until it goes to a customer. A small business taxpayer that does keep an inventory values it each year in Part III and still need not use an accrual method for sales and purchases; a seller over the limit counts stock and must use accrual for sales and purchases of inventory items (Schedule C instructions, line F; Treasury Regulation 1.446-1(c)(2)(i)). Publication 334, chapter 2, says a seller who keeps an inventory must generally use accrual, but the regulation exempts a small business taxpayer, so follow the regulation. For the cash or accrual choice itself, see cash or accrual for a small business.

How do I check that gross profit looks right?

Divide gross profit (line 5) by net receipts (line 3) and compare the result with the gross profit percentage your pricing is meant to give, which Publication 334 calls your markup policy. A small gap is a good sign, not proof; a large one may mean sales, purchases, inventory or other costs were figured wrongly (Publication 334, chapter 7).

Before filing, also check that:

• line 35 equals last year's line 41;
• the ending count is complete and priced consistently, since leaving stock out of ending inventory raises cost of goods sold by that amount;
• net receipts agree with your sales records, not only with a platform's report;
• sales tax is handled correctly: tax imposed on you as the seller is part of gross receipts, but tax imposed on the buyer, which you collect and pay over to the state or locality, generally is not (Publication 334, chapter 7).

For gross sales that sit far above profit, see platform gross sales and cost of goods sold.

Example

All figures are in US dollars and are illustrative.

Jo sells candles online

Jo's last return closed with $3,000 of inventory, so line 35 is $3,000. She bought $20,000 of goods to sell (line 36), with nothing taken for personal use. Line 40 is $23,000. Her year-end count prices at $4,500 (line 41). Cost of goods sold (line 42, copied to line 4) is $18,500. On $40,000 of sales with no returns, gross profit is $21,500, about 54% of net receipts. Jo compares that with the gross profit percentage she prices for; a big gap would send her back to the count and the invoices.

A reseller skips the formal inventory

A reseller whose gross receipts averaged $60,000 over the three prior years is a small business taxpayer and chooses not to keep a formal inventory. She starts the year with no stock and pays $30,000 for stock this year; goods that cost $24,000 sell and $6,000 is still on the shelf. Under the non-incidental materials and supplies method, $24,000 is recovered through cost of goods sold this year and the other $6,000 in the year those items go to customers; the instructions do not show which lines carry it. Skipping the count does not mean deducting everything bought. She uses the same method every year, and switching to a counted inventory later needs Form 3115.

Maya's opening figure does not match

Maya's last return closed with $3,000 of inventory, but this year's opening figure is $2,600. She enters $2,600 on line 35 and attaches a statement saying why. If the reason is a change of inventory method, the instructions have her refigure last year's closing inventory under the new method; she takes the $400 difference into account in the section 481(a) adjustment on Form 3115. The refigured figure is lower, so that item reduces income; a net negative adjustment is generally taken in the year of change, a net positive one generally over four years (Schedule C instructions, line F). If $3,000 was simply wrong, the earlier return may need correcting, not just this year's line.

Different for you?

• Earlier returns left Part III blank or showed no inventory: the opening figure depends on what they reported. See fixing inventory missing from past returns. Rebuilding the opening count and cost is bookkeeping work: bookkeeping help.
• The count or the costs cannot be rebuilt: see inventory and cost of goods without records. Rebuilding them from bank, card and payment statements is bookkeeping help.
• The margin looks wrong or sales far exceed profit: see platform gross sales and cost of goods sold, and for online sellers online seller income tax. Books that will not reconcile to sales are bookkeeping help.
• You skip the formal inventory, are deciding between expensing and inventory, or are not sure which method fits: the choice sets when your stock cost reaches your profit. See materials and supplies or inventory. Setting up the books on the method you choose is bookkeeping work: bookkeeping help.
• You want to change how you handle inventory: a change needs Form 3115 (About Form 3115) and a section 481(a) adjustment may apply. Moving to or from a small business method is generally an automatic change (Treasury Regulation 1.471-1; Rev. Proc. 2025-23, sections 22.18 and 22.20): attach the original to your timely filed return, extensions included, for the year of change, and send a signed copy to the IRS by the day you file it (Instructions for Form 3115). The steps and exceptions are in materials and supplies or inventory. The opening and ending figures that feed it come from the books: bookkeeping help.
• You make what you sell, or pay freight and duties: see handmade products and landed cost.
• You owned stock before opening, or have unsold or damaged stock: see starting inventory you already owned and writing off unsold or obsolete inventory.
• You are deciding between cash and accrual: see cash or accrual for a small business.
• Your business is a partnership, S corporation or corporation, or is about to become one: these do not file Schedule C. A single-member LLC that adds a member (a partnership by default) or files Form 8832 to be taxed as a corporation generally stops using Schedule C (IRS: Limited Liability Company). The year the Schedule C ends has its own inventory consequences: see materials and supplies or inventory and which returns your business files.