COGS vs Expense Tax Deduction: What Business Owners Should Know

Tracking costs properly is essential for business owners, especially when distinguishing between Cost of Goods Sold (COGS) and general business expenses. These categories impact profitability, tax deductions, and financial reporting differently, making accurate classification crucial.

Misclassifying costs can lead to inaccurate tax filings or missed deductions. Understanding how COGS and business expenses function separately ensures compliance with tax regulations and provides a clearer picture of a company’s financial health.

Components Assigned to COGS

COGS includes all direct costs related to producing or purchasing goods for sale. This covers raw materials, direct labor, and manufacturing overhead. A furniture manufacturer, for example, would factor in the cost of wood, nails, glue, and wages paid to workers assembling the products. These costs fluctuate with production volume and are directly tied to creating goods.

Manufacturing overhead, though less obvious, is also part of COGS. This includes factory rent, equipment depreciation, and utilities used in production. A bakery, for instance, would include electricity for ovens and mixer depreciation. Allocating these costs correctly ensures accurate financial reporting.

For businesses that purchase goods for resale, COGS consists of the purchase price of inventory, shipping costs, and any expenses incurred to prepare items for sale. A retail clothing store would include the wholesale cost of garments, freight charges, and necessary alterations before selling them. The IRS requires businesses to use an inventory valuation method, such as FIFO (First-In, First-Out) or LIFO (Last-In, First-Out), to determine the cost of inventory sold during a tax year.

Deductible Business Expenses

Operating a business involves costs beyond production. These general expenses cover day-to-day operations and are fully deductible in the year they are incurred if they meet the IRS criteria of being both ordinary and necessary. Ordinary expenses are commonly accepted in an industry, while necessary expenses are helpful for conducting business.

Administrative costs are a major category of deductible expenses. This includes office rent, utilities, and supplies such as computers, desks, and software subscriptions. If an entrepreneur rents an office for $2,000 per month, that amount qualifies as a deduction. Internet and phone service used exclusively for business can also be claimed. Home-based businesses may deduct a portion of rent or mortgage interest if they meet the IRS home office deduction requirements, which generally require the space to be used regularly and exclusively for business.

Employee-related expenses are also deductible. Salaries, wages, bonuses, and payroll taxes qualify, as do employee benefits like health insurance, retirement plan contributions, and professional development programs. A company contributing $5,000 annually to an employee’s 401(k) plan can deduct that amount. Payments to independent contractors also qualify, but businesses must issue Form 1099-NEC if payments exceed $600 in a tax year.

Marketing and advertising expenses are another deductible category. Costs related to website development, digital ads, billboards, and promotional materials qualify. A business spending $10,000 on a Google Ads campaign can deduct that entire amount. Expenses for attending trade shows or sponsoring events to attract customers are also eligible, though personal expenses disguised as marketing, such as extravagant client entertainment, may not be fully deductible under IRS regulations.

Business travel and meals are deductible but with limitations. Flights, hotels, rental cars, and ride-sharing services for business trips qualify, as do meals purchased during travel. The IRS allows a 50% deduction on business meals, meaning a $200 client dinner results in a $100 deduction. The meal must be directly related to business, and receipts should be kept to substantiate the expense.

Legal and professional fees are also deductible. Payments to accountants, attorneys, and consultants for business-related services qualify. If a company pays $3,000 for tax preparation and financial consulting, that amount reduces taxable income. However, legal fees for acquiring assets or handling personal matters are not deductible.

Tax Implications of Each Category

Classifying costs between COGS and general expenses affects taxable income, deductions, and financial reporting. Since COGS is subtracted from gross revenue to determine gross profit, inventory-based businesses see significant tax implications based on how they account for these costs. The IRS requires businesses to follow consistent inventory accounting methods, such as FIFO or LIFO, which influence taxable income. In an inflationary environment, LIFO results in higher COGS and lower taxable income, while FIFO leads to lower COGS and higher taxable income. The choice between these methods can have long-term tax consequences, particularly for businesses with fluctuating material costs.

Unlike COGS, which applies only to businesses selling physical products, deductible business expenses are available to all businesses, including service-based companies. These deductions lower taxable income on a dollar-for-dollar basis, though some expenses face limitations. While most business expenses are fully deductible, the IRS imposes restrictions on certain categories, such as the 50% deduction limit on meals and the disallowance of certain entertainment costs. Additionally, capital expenditures, such as purchasing equipment or vehicles, may need to be depreciated over time rather than deducted in full in the year of purchase. Section 179 of the Internal Revenue Code allows businesses to deduct up to $1,220,000 in equipment purchases for 2024, but only if total qualifying purchases do not exceed $3,050,000.

Tax credits also interact differently with COGS and general expenses. While business expenses reduce taxable income, certain tax credits provide a dollar-for-dollar reduction in tax liability. Research and development (R&D) costs, for example, may be deductible as a business expense or qualify for the R&D tax credit under IRC Section 41. This distinction matters because deductions reduce taxable income, whereas tax credits directly offset tax owed, often providing greater financial benefits. Businesses engaged in product innovation must carefully determine whether to expense R&D costs or claim a credit, as the tax impact can vary significantly.

Reporting COGS and Expenses

Accurate financial reporting requires businesses to properly categorize and document costs to comply with tax regulations and accounting standards. COGS and business expenses are reported separately on financial statements and tax filings, with COGS appearing on the income statement as a direct reduction from gross revenue to determine gross profit. Business expenses, on the other hand, are deducted further down to calculate net income. Misclassification can distort financial ratios like gross margin and operating margin, impacting investor confidence and lending decisions.

On tax returns, COGS is reported on Schedule C for sole proprietors or on Form 1125-A for corporations and partnerships, requiring a detailed breakdown of beginning inventory, purchases, labor costs, and ending inventory. Incorrectly inflating COGS can trigger IRS audits, as underreporting taxable income may be flagged as an attempt to evade taxes. The IRS scrutinizes inventory valuation methods and cost allocations, and discrepancies may result in penalties, including accuracy-related fines of 20% under IRC Section 6662. Businesses must reconcile reported COGS with inventory records and financial statements to avoid compliance risks.