How Do I Deduct Crafts Inventory on My Taxes?

Dear Rich: Last year we started selling handmade jewelry at places like Etsy. We had a good year but we ran into few problems at tax time and filed for an extension. We got your book but we're confused about how to calculate inventory. It's not that bad doing the calculations if you use a tax software program (we've used TurboTax Home and Business). But even if you use software, you'll still need to know your cost of goods (COGS) for the year. The IRS explains how to figure it out on its website by walking you through lines 35 through 42 of Schedule C. Here's a summary:

• Line 35: Beginning of year inventory. If this is your first year of operations, beginning inventory would be zero. If it's not your first year, this amount should be identical to the prior year's closing inventory. (If it isn't, you must explain why to the IRS.) Include the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the crafts, but only those that were part of inventory at the beginning of the year. The IRS provides an explanation on valuing inventories (scroll down to "Inventories"). 
• Line 36: What did you purchase this year? Here you provide the cost of all merchandise you purchased during the year. Include the costs of all materials you purchased in the year that were necessary to manufacture your crafts. Subtract the cost of any items withdrawn for personal use.
• Line 37: Labor costs. Calculate labor costs — the amounts paid to employees for making your crafts. Do not include any amounts paid to yourself. (If you have employees that are not involved in manufacturing items for sale, their labor costs will be deducted elsewhere on the tax return and are not included in the cost of goods sold.)
• Line 38: Other manufacturing supplies. If you need glues, chemicals or other crafts supplies to manufacture your goods for sale, list the amount paid for these supplies.
• Line 39: Packaging costs. If you manufacture goods for sale, you can list additional costs such as containers and packages that are part of the manufactured product, costs of freight to bring in supplies, and overhead expenses — for example, rent, heat, light, power, insurance, depreciation, taxes, and maintenance — that are direct and necessary manufacturing expenses.
• Line 40: Total lines 35 through 39. This represents the total cost of inventory that your business held in the year.
• Line 41: End of year inventory. On Line 41, you enter the value of the inventory unsold at the end of the year. Keep in mind that the value of the remaining inventory is not the price you plan to sell it for; it is the amount you paid for it. This amount will become your beginning inventory for the next year — that is the number you will use on Line 35 of the following year's tax return. Note that most businesses do a "physical" inventory at the end of the year; that is, actually count and record the type and number of each remaining inventory item. The results of this work will provide the basis for the year-end inventory calculation. Physical inventories also allow you to inspect and discard inventory if it is damaged or of no value, thereby "writing it off" of year-end inventory and increasing the costs of your 'goods sold' deduction. A physical count also will alert you to items missing from your inventory.
• Line 42: COGS deduction. On Line 42, you subtract the amount listed on line 41 (ending inventory) from line 40 (all inventory costs). The result is the amount you claim as your COGS deduction.

For more information on inventories, see the Cost of Goods Sold section in Chapter 7 of IRS Publication 334, Tax Guide for Small Businesses, and IRS Publication 538, Accounting Periods and Methods.
By the way ... Some cities also have a tax on business inventory. This is another reason why some retail businesses have inventory sales -- to reduce their stock before the tax date.