Cost of goods sold (COGS) is deducted from the gross sales for the year to arrive at gross profit. Whether you are maintaining the books yourself, or whether you have hired someone else to do the work for you, it’s important that you understand how this is calculated.
Basically, cost of goods sold = Opening inventory + purchases + direct labor made during the year – closing inventory.
Why is audit proof for cost of goods sold necessary?
It is important to understand and calculate COGS properly? This number tends to be one of the largest numbers on the tax return. Therefore, adjustments against you can be very significant. Some businesses try to bring reduce gross profit so they can lower their taxes. Proof of payment, invoices, and a way to distinguish business use versus personal use is essential for evidence.
Why does the IRS need proof of your cost of goods sold?
The Internal Revenue Service or the IRS will ask for this proof because:
- The auditor wants to know if you have adequate proof to support the deduction. Many owners purchase personal items and attempt to deduct them under cost of goods sold.
- IRS Exam also attempts to reconcile various expenses on the return. For example, if they show salaries on the W-3 form to be $100,000 and salaries expanse is $100,000., and there is an item of cost of labor in COGS for $50,000, the assumption is that you paid contract labor to workers or there is an error in your calculation.
You need to ensure that the amount of your COGS is accurate. You need to have all the receipts, invoices, and to distinguish between business and personal use. You may also be asked to show that your expenses are ordinary and necessary. Extraordinary expenses may require further investigation. Taking inventory at the end of the year is a good practice that will help support you deduction.
As with any audit situation, you should consider experienced representation.
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