Tax Tips: The Cost of Goods Sold

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Published on Aug 23, 2010 in Seller Handbook

Outright.com is back on the blog with straightforward tips on simplifying your accounting and putting the focus back on the creative. (Note: This info may only apply to U.S. sellers.)

As an Etsy seller, understanding accounting concepts like “the cost of goods sold” (a.k.a. COGS) can help you set your prices reasonably, value your work, and — hooray! — save money on taxes.

Cost of goods sold is an accounting term that describes the actual cost of the item you are selling. Cost includes all the supplies and effort that went into creating or obtaining the item and getting it into saleable condition, as opposed to price, which is the amount charged for the finished product.

Fortunately, cost of goods sold is a tax deduction, and Etsy sellers should keep track of what you spend on your products in order to claim the deduction at the end of the year.

What exactly is included in cost of goods sold for an Etsy product?

Cost of materials: The price of the fabric, thread, tallow, buttons, bows, beads, etc. you used to create your product.

Cost of packaging: The fancy branded label you slap on all of your soaps is part of COGS. So is the pretty velvet box you package your rings in. But watch out for this important distinction — while an item’s packaging as it would appear on a store shelf is COGS, the bubble wrap, outer box, packing tape, etc. that you use to ship it to the customer is not. (But don’t worry, even though it isn’t a COGS expense, it’s still a tax deductible expense and Outright will help you automatically list it in the right spot on the Schedule C you have to fill out at the end of the year.)

Shipping costs: The amount you paid to have your materials shipped to you.

What about my time? While the time you put into creating your wonderful crafts to be sold on Etsy is quite valuable, the IRS doesn’t allow you to deduct what cost you associate with your time for tax purposes.

Inventory

At the end of the year, you likely have some crafts that you haven’t sold, or a bin of materials you’ve purchased but not made into your Etsy crafts. Both of these are considered “inventory.” For many businesses, Uncle Sam wants to know how much inventory you have and will not allow you to deduct expenses for your inventory, but here’s something all Etsy sellers should know:

If you have under one million a year in sales, you can use what is called the “cash method of accounting” for your inventory, which allows you to deduct all inventory expenses. If you want the gory details, this is defined in IRS Publication 334 “Tax Guide for Small Business.”

If you’d rather spend your time creating your Etsy crafts, a free Outright.com account will automatically track all of your expenses using cash accounting so you minimize your taxes and make your Etsy bookkeeping a snap.

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Math Signs Coaster Set by etceteramedia

 

FAQ about Cost of Goods Sold

Q. Does cost of goods sold include PayPal fees or Etsy fees? 
A. No. When it come to reporting your expenses to the IRS, it’s best to categorize your fees as “selling expenses.” Think of cost of goods sold as the cost of obtaining or producing the goods you later sell. (They’re still expenses, and you still get the tax deduction, they just aren’t COGS.)

Q. I import supplies. Do taxes, duties, commissions and other fees I must pay to get these goods count as cost of goods sold?
A. Yes!

Q. I design logos for Etsy shops. Do I have any cost of goods sold?
A. No. If you only sell services, you don’t have to worry about cost of goods sold.

Q. Can cost of goods sold somehow get me in trouble with the IRS?
A. When it comes to taxes, there are far too many ways to get into hot water and miscalculating cost of goods sold is, sadly, no exception. Some business owners, for example, have been tempted to inflate their cost of goods sold in order to pay less in taxes. This is a bad idea for a number of reasons, including the fact that the IRS uses computer models to calculate whether or not your gross profit margin is significantly lower than the average. In other words, the IRS is going to notice if the amount you report on your taxes as cost of goods sold is too high in proportion to your gross profit.

Q. Oops, I didn’t really keep track of my cost of goods sold. Can I just enter $0 for that amount on my taxes?
A. You certainly can, but it isn’t recommended. Cost of goods sold is one of the categories that the IRS checks, and a business that should have cost of goods sold but doesn’t record any can be flagged, which can trigger an audit. If you are having trouble managing your receipts, Outright partner Shoeboxed takes care of categorizing your receipts for you and then imports the data right into Outright!

Though these are some of the most frequently posed COGS problems, you’re likely to run into other conundrums during the day to day running of your Etsy shop. But don’t fret — Outright has the answers! Sign up today for a free Outright account and start tracking your cost of goods sold (and, ahem, saving money) right now.

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