How to Calculate Cost of Goods Sold on Form 1125-A
Correctly calculating the cost of goods sold on Form 1125-A involves key inventory valuation rules and cost capitalization principles.
IRS Form 1125-A, Cost of Goods Sold, is used to calculate a business’s cost of goods sold (COGS) for the tax year. The form guides a filer through the components of COGS, starting with beginning inventory and accounting for purchases and other costs. It is not a standalone return but is filed as an attachment to a primary business income tax return, such as Form 1120 or 1120-S.
The information on Form 1125-A provides the IRS with a breakdown of expenses directly associated with the products a company sells. This includes the cost of items purchased for resale or the direct costs of manufacturing products. For businesses that deal with physical goods, this form is a part of their annual tax filing to ensure the deduction for the cost of those goods is accurately reported.
Determining if Form 1125-A is Required
Filing Form 1125-A is a requirement for specific business structures that engage in the production or sale of merchandise. This includes C corporations filing Form 1120, S corporations filing Form 1120-S, and partnerships filing Form 1065. The condition that triggers the need for this form is the presence of inventory and the associated cost of goods sold. If a business buys goods to resell or manufactures products to sell, it must calculate COGS to determine its gross income.
Information and Calculations Needed for Form 1125-A
The form is built around the COGS formula: Beginning Inventory + Net Purchases – Ending Inventory. This calculation determines the direct cost of the merchandise that the company sold during the tax year. The accuracy of this figure depends on the precise valuation of inventory and the correct categorization of associated costs.
A business must first establish its inventory valuation method, which dictates how it assigns costs to its ending inventory. Common methods include First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). The IRS requires that the chosen method be used consistently from year to year, and a change in method requires filing Form 3115, Application for Change in Accounting Method.
The costs included in inventory extend beyond the purchase price of materials, encompassing all direct and certain indirect costs associated with getting goods ready for sale. Direct costs include the cost of raw materials and the wages of labor directly involved in production. Indirect costs can include expenses like rent and utilities for the production facility and salaries of supervisors who oversee manufacturing.
A component of these calculations involves the Uniform Capitalization (UNICAP) rules. These rules require certain businesses to capitalize, rather than immediately expense, specific direct and indirect costs associated with their inventory. This means these costs become part of the inventory’s value and are only deducted as COGS when the inventory is sold. Producers of property and certain resellers are subject to UNICAP.
Businesses subject to UNICAP must allocate a portion of their indirect costs, such as purchasing, handling, and storage expenses, to their inventory. For example, the salaries of employees in the purchasing department or the costs of an off-site storage warehouse would be subject to these rules. Resellers are subject to UNICAP if their average annual gross receipts for the preceding three tax years exceed a specific inflation-adjusted threshold. For tax year 2025, this threshold is $31 million.
Completing Form 1125-A Line by Line
The form is structured to logically follow the COGS formula. You will begin by entering the inventory value at the start of the tax year on Line 1. This number must match the ending inventory figure reported on the prior year’s Form 1125-A.
Next, you will report the cost of all merchandise purchased for resale or raw materials on Line 2. Line 3 is for the cost of labor directly related to the production of goods, excluding labor that should be capitalized under UNICAP rules. Any additional costs required to be capitalized under the UNICAP rules are entered on Line 4, and other miscellaneous costs are entered on Line 5.
The form then directs you to sum Lines 1 through 5 to arrive at the total cost of goods available for sale, which is entered on Line 6. From this total, you will subtract the value of your inventory at the end of the year, entered on Line 7. The result is your cost of goods sold for the tax year, which is reported on Line 8.
The final step is to transfer the COGS amount from Line 8 of Form 1125-A to the appropriate line on the business’s main income tax return. For C corporations, this amount is entered on Line 2 of Form 1120. For S corporations, it is reported on Line 2 of Form 1120-S, and for partnerships, it is entered on Line 2 of Form 1065.