Schedule C Part III
Inventory businesses (retailers, manufacturers, e-commerce sellers) compute COGS in Part III: beginning inventory + purchases + cost of labor + materials and supplies + other costs - ending inventory = COGS. The COGS amount flows to line 4 to reduce gross receipts.
Small-business inventory exception
Businesses with average annual gross receipts under the threshold ($30M in 2024) may treat inventory as non-incidental materials and supplies and use the cash method. Effectively, this lets you deduct purchases when paid (subject to a "consume in the production of income" test) rather than when sold. The simplification is substantial for small e-commerce.
UNICAP
Section 263A (UNICAP) requires capitalization of certain indirect costs into inventory. The small-business gross-receipts threshold also exempts you from UNICAP, dramatically reducing recordkeeping burden.
Inventory methods
FIFO, LIFO, and specific identification are all permitted. LIFO requires conformity with financial reporting and a Form 970 election. Most small businesses use FIFO or average cost.
Physical count
Maintain a physical inventory count at year-end. Differences between book and physical count are absorbed in COGS. Significant year-end shrinkage may indicate a control weakness worth investigating.
Worked example with numbers
Consider a sole prop with $100,000 in gross receipts and $30,000 in legitimate Schedule C deductions, including this category. Each additional $1,000 of qualifying expense reduces Schedule C net profit by $1,000, which reduces self-employment tax by approximately $1,000 × 92.35% × 15.3% ≈ $141, and reduces income tax by $1,000 × marginal rate. At a 22% federal marginal rate, the combined federal tax savings on each additional $1,000 of legitimate deduction is roughly $361, and state savings sit on top of that. The math is why disciplined categorization throughout the year pays for itself.
Common mistakes that disallow the deduction
The recurring ways this deduction gets disallowed in examination cluster in four categories: (1) personal-use expenses bundled with business (the deduction is disallowed entirely or apportioned downward); (2) inadequate substantiation (no receipt, no invoice, no business-purpose note); (3) the wrong line on Schedule C (not fatal, but it weakens audit defense); and (4) double-counting with another line (for example, deducting an expense on Schedule C and also on Form 8829, or as a personal itemized deduction on Schedule A). The fix in every case is contemporaneous bookkeeping and a clean chart of accounts.