Federal Taxes

Learn more about keeping your business compliant with federal tax requirements.

How to Compute Business Income

Computation of business income begins with reporting your gross receipts or sales. If your business makes or buys goods to sell and maintains an inventory, you're entitled to deduct the cost of goods sold from your revenues in computing your gross profit from your business. Valuation of inventory and identification of inventory items is important to accurately determine your income.

Any income you receive that is connected with your business is considered "business income" that should be reported on your business tax return. Income is "connected with your business" if it's clear that the payment would not have been made if you did not have the business.

The starting point for computing your income tax is your gross business receipts or sales. From this amount, you must subtract your cost of goods sold (if any) to arrive at your gross profit.

This article discusses some rules you need to know about exactly what is and isn't reportable business income. It also touches on the distinctions between various types of income that must be reported in different places on your tax forms.


Sole proprietors, use Schedule C or C-EZ to determine their income and expenses. The resulting income (or loss) is then reported on the Form 1040. 

Partnerships (and limited liability companies that are taxed as partnerships) use Form 1065 to determine their income.

Corporations (and limited liability companies who elect to be taxed as corporations) report their income and expenses on Form 1120 (for regular corporations) or Form 1120S (for S corporations.)

Sales Constitute Most Business Income

"Gross income from sales" includes business income that you received from sales to your customers, regardless of the form in which you receive the income. You should only report income you received within your tax year according to your established accounting method.

Most businesses receive their income in the form of cash, checks, or credit card charges. However, if you receive income in the form of goods or services in some type of bartering transaction, you must report the fair market value of whatever you receive.


You own a plumbing business and provide plumbing services for a friend of yours who owns a landscaping business. In return, your friend installs some new shrubs in front of your office. The IRS expects you to report the value of the shrubs and installation as income, although you can deduct any of your costs incurred in providing the plumbing services.

If the shrubs had been installed in front of your home instead of your office, their value would still be reported as business income. However, if you had received the shrubs in exchange for some personal, non-business service such as babysitting, they should be reported as miscellaneous personal income on your Form 1040.

If you receive a negotiable promissory note in payment for a sale and you use the cash method of accounting, the fair market value of the note is reported in gross income at the time you receive it. Accrual method taxpayers would generally recognize the discounted value of the note at the time of economic performance (e.g., when they had provided the services or goods to the customer).

How to Compute Gross Profit

Once you know your gross income from sales (which is reported on Line 1 of Schedule C, for sole proprietors), you must reduce your gross receipts or sales by your returns and allowances and your cost of goods sold to arrive at your "gross profits."

You must account for returns and allowances. If, during the year, you booked some income but then accepted some returned merchandise or made an allowance to a customer for unsatisfactory products or services, you must enter the total of these amounts as "returns and allowances" on your tax form, and subtract them from your gross sales receipts to arrive at your net receipts.

"Returns and allowances" can include things like rebates, cash refunds, or merchandise credits. Almost any kind of business can have returns and allowances, including professional service businesses. 

If you have types of business income other than sales, that is added to gross profits to determine gross income. 

If your business uses inventory, however, you'll need to go through a few more steps to complete the business income portion of your tax return. You need to compute your cost of goods sold, which means determining your change in inventory for the year.

Computing Cost of Goods Sold

If your business makes or buys goods to sell and maintains an inventory, you're entitled to deduct the cost of goods sold from your revenues in computing your taxable income.

It's a given that all manufacturers, retailers, and wholesalers must use an inventory to accurately track their costs. Other types of businesses, such as those providing professional services or working in the trades, will need to use inventory accounting methods if they bill customers separately for materials and supplies. And, under IRS rules, unless one of the safe-harbors for small businesses applies, most businesses that use inventory must use accrual accounting, least for purchases and sales of inventory items.

Safe Harbors Can Avoid Inventory Accounting

Not every business is eligible to use the cash method. The most significant exception applies to businesses that have inventory. However, most small businesses qualify for an exception to this prohibition based upon one of several safe harbor provisions.

Gross Receipts of $1 Million or Less. You are not required to use inventories or the accrual method of accounting if you have average gross receipts (income from your business) of $1 million or less for the three most recent tax years. 

To determine if you qualify for this exception for this tax year, add your gross receipts for the three preceding years and then divide by three. You qualify for the exception if the resulting amount is $1 million or less. You can also use this safe-harbor for a business that is not your primary business, if it meets one of the these three definitions.

Gross Receipts of $10 Million or Less. If your average annual receipts are greater than $1 million, you may still be able to qualify for an exception to the requirement that you use inventory accounting. To qualify under this second exception, you must have average gross receipts of $10 or less for the three most recent tax years and your business must be considered a "qualifying business."

A business is a "qualifying business" if it meets any one of the following definitions:

  • your principal business activity is not retailing, wholesaling, manufacturing, mining, publishing, or sound recording.
  • your principal business activity is providing services, even if your customer receives property incidental to the services.
  • your principal business activity is custom manufacturing

How to Compute Cost of Goods Sold

In general terms, the formula used to compute your cost of goods sold is the following:

    Inventory at beginning of year
Purchases or additions during the year
=     Goods available for sale
Inventory at end of year
=     Cost of goods sold


If you are a sole proprietor filing Schedule C, this equation is the basis for Part III on the back of the Schedule C. Your inventory at the beginning of the year is reported on Line 35, purchases are reported on Line 36 (with a reminder to subtract the cost of items you withdrew for your own personal use), goods available for sale appears on Line 40, inventory at the end of the year is reported on Line 41, and the result is your cost of goods sold on Line 42.


If you are using either of the small business exceptions discussed above, then your calculation is much simpler. See the Instructions for Schedule C for the method that you need to use.

If you are a reseller of goods, these would be the only five items you need. But if you are a manufacturer, things get a little more complicated.

Inventory methods for manufacturers. After accounting for the usual inventory additions and purchases during the year, a manufacturer would report the cost of raw materials or parts purchased for manufacture into a finished product. A manufacturer would also report the cost of labor, including both direct labor costs for production workers, and indirect costs for other employees who perform a general factory function that is necessary for the manufacturing process.

The cost of materials and supplies used in the manufacturing process such as hardware, lubricants, abrasives etc.are reported, as is the cost of overhead. Overhead costs include rent, utilities, insurance, depreciation, taxes, and maintenance for the production facility, as well as the cost of supervisory personnel.

In their accounting records, small manufacturers traditionally use three categories of inventory:

  • raw materials,
  • work in process, and
  • finished goods awaiting sale.

As raw materials are purchased, their costs (including delivery charges) are debited to the raw materials account. As materials are taken from storage and used in the manufacturing process, their costs are removed from (credited to) raw materials and added (debited) to the work in process account. The work in process account also collects the costs of direct and indirect labor and factory overhead.

When the goods are finished, their costs are transferred (credited) out of work in process and added (debited) to the finished goods inventory. By taking beginning and ending counts of items in each of these three types of inventories, manufacturers can keep a handle on their costs.

Valuing Your Inventory

How do you determine the numbers to plug into the inventory equation? As a starting point, you need to determine the number of items in your inventory (or each category you use) at the beginning and end of each year.

You don't need to physically count your inventory at the end of the year, although that would be the most accurate way to do it. The IRS recognizes that requiring every business to do a complete inventory count on the last day of their tax year would be unworkable and would result in poor information, since workers would be rushed and not likely to make an accurate count.

As long as you take regular physical inventory counts at intervals during the year, you may extrapolate your beginning/ending amounts. The inventory at the end of year 1 becomes the beginning inventory for year 2; if there is a discrepancy, you should attach an explanation to your tax return.

But once you know the number of each kind of item in your inventory, how do you determine the value of the inventory at the beginning and at the end of the year, which in turn will determine the value of inventory items sold during the year?

There are two issues that need to be addressed before you can answer that question:

  • Is cost or market value a better way to evaluate your inventory?
  • How do you identify the inventory items that were sold?

Choosing an Inventory Valuation Method: Cost or Cost-or-Market

If your business carries inventory, you will need to keep track of it. For tax purposes, as well as for general management purposes, you'll need to know the value of the inventory at the beginning and end of the year.

Although there are many possible ways of valuing inventories, the IRS strongly prefers that small business retailers, wholesalers and manufacturers value inventories under either of these methods:

  • cost, or
  • the lower of cost or market.

Cost method tied to costs of acquiring inventory. If you are using the cost method, the value of the inventory would be all the direct and indirect costs of acquiring it. For example, the cost of goods you purchased would be the invoice price, less appropriate discounts, plus transportation or other charges you incur in acquiring the goods.

For goods that you produced, the cost would be the cost of labor, materials, and plant overhead used in production. Manufacturers must generally use the uniform capitalization (UNICAP) rules to determine exactly which costs are to be included in the formula; if you are subject to these rules, you'll probably need an accountant's help to interpret and apply them. Luckily, resellers with average annual gross receipts of $10 million or less for the last three tax years are exempt from the UNICAP rules.

Lower of cost or market method man account for reduced value. The second method--the lower of cost or market method--permits you to reduce your gross income to reflect any reduction in the value of inventories. This method is based on the assumption that if the market price falls, the selling price falls correspondingly. If this is so, a business owner will report a lower income, and thus defer until the following year a part of the taxes that would otherwise have to be paid under the cost method. One big drawback to using this method is that you need to compute the value of your inventory both ways in order to determine which is lower.



In Year 1, John Smith purchased merchandise for $50,000 and sold half of the goods for $60,000. On December 31, Year 1, his inventory was $25,000 (under the cost method) and $15,000 (under the lower of cost or market method). In Year 2, he sells the remaining goods for $50,000. If he had used the lower of cost or market method, his income would have been $10,000 less in Year 1 and $10,000 more in Year 2 than if he had used the cost method, as shown below.



Cost or

Year 1




Less: cost of sales (purchases, less ending inventory)



Gross income



Year 2




Less: cost of sales (beginning inventory)



Gross income



In this example, the selling price of the goods in Year 2 is $10,000 less than in Year 1, the same amount by which the market value of the goods sold in Year 1 fell below cost on December 31, Year 1. But suppose that the selling prices do not drop in relation to the market values. Then, the lower of cost or market method may produce a higher total tax over a two-year period than would the cost method because of an imbalance of income and the graduated tax rates. This could happen, for example, if a tax rate increase takes effect in Year 2.

If you are just starting your business and do not use the LIFO cost method (see identification of inventory items), you may select either the cost or the lower-of-cost-or-market method of accounting. You must use the same method to value your entire inventory, and you may not change to another method without the IRS's consent.


The IRS is less concerned about the nuances of the specific inventory procedures you use, than with your being consistent from year to year so that your inventory method accurately reflects your income.

You must use the same method to value your entire inventory, and you may not change to another method without the IRS's consent.

Identify Inventory Items Remaining at Year End

Besides deciding how you will value your inventory (at cost, or at the lower of cost or market)you must also decide how you will identify which items were sold and which are still in inventory.

The IRS does not specify a single method that is acceptable for identifying which items were sold and which remain in inventory: however it does require that your method be accurate and used consistently.

The most basic way of doing this is called the "specific identification method," in which you match each item sold with its cost (or market value).


Although modern computer-based inventory control systems could allow you to track each widget, the IRS doesn't require it. Instead, you can usually choose one of two identification methods.

These methods make broad assumptions about which inventory items were sold and which remain in inventory, without reference to the particular inventory items that were actually bought and sold. These two methods are known as the "first-in, first-out" (FIFO) and the "last-in, first out" (LIFO) methods.

Specific Identification Method Tracks Each Item

The specific identification method is easy to understand, but may be totally impractical for your business. It may work well for companies that sell relatively few big-ticket items like cars or pianos. But if your business has a large, quick-moving inventory of smaller items, you soon would be doing little but tracking inventory if you had to do it piece by piece.


The "We're Widgets World Wide" ("4W") company, buys and sells thousands of widgets each year. Because 4W depends on several suppliers for widgets, and frequently must outbid other wholesalers for them, the price that 4W must pay usually varies daily. Listed below are just four of the thousands of widgets that came into 4W's inventory in Year 1:

Widget 2301, bought 1/1, $49.00; sold 12/1

Widget 3904, bought 6/1, $49.50; sold 9/1

Widget 5039, bought 6/30, $50.45; sold 7/14

Widget 7932, bought 7/1, $50.20; sold 12/15

FIFO, LIFO Make Assumptions on Order of Sale

The First-in, First-out (FIFO) method assumes that sales are made from the items that have been longest in the inventory. This conforms to the usual business practice of trying to sell the older items first, before they become obsolete, spoiled, or out-of-fashion. This is also the method the IRS prefers.

In contrast, the Last-in, First-out (LIFO) method assumes that the most recently purchased items are the ones you sold, and the oldest items are still sitting in your warehouse or on your shelf.

Work Smart

One consequence of using FIFO is that if prices are generally going up over time, your gross income will be matched against the lowest-priced items in your inventory, resulting in higher net profits.

In contrast, LIFO would match your gross income against the most expensive items in your inventory, resulting in lower net profits and, consequently, a lower tax bill. If your business and inventory are constantly growing over time, LIFO will generally be preferable.


Using the four widgets described in the example above, let's say you know that you sold two of these widgets in Year 2, for a price of $60 each. Under FIFO, you'd be treated as having sold the first two widgets you purchased, so your net income would be $120.00 - ( $49.00 + $49.50) = $21.50.

Under LIFO, you'd be treated as having sold the last two widgets you purchased, so your net income would be $120.00 - ($50.45 + $50.20) = $19.35.

The IRS does not favor LIFO. If you want to use it, you must file IRS Form 970 and follow some very complex tax rules. There is also a "simplified" dollar-value LIFO method available to small businesses (those with average annual gross receipts of $5 million or less for the last three tax years). For more information, see your tax advisor.

Category : Federal Taxes
Tags :
  • Tax Planning
  • Business Income Tax

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