If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

The following are types of expenses that go into figuring cost of goods sold.

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.

For more information, see the following sources.

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.

You can elect to deduct or amortize certain business start-up costs. See chapters 7 and 8.

To help you distinguish between capital and deductible expenses, different examples are given below.

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and generally is not deductible. See chapter 4 for information on deducting interest and the allocation rules.

Recovery of amount deducted (tax benefit rule).   If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. If you have a recovery in a later year, include the recovered amount in income in that year. However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income.

  For more information on recoveries and the tax benefit rule, see Publication 525.

Payments in kind.   If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. You cannot deduct the cost of your own labor.

  Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. If these costs are included in the cost of goods sold, do not deduct them as a business expense.

Limits on losses.   If your deductions for an investment or business activity are more than the income it brings in, you have a loss. There may be limits on how much of the loss you can deduct.

Not-for-profit limits.   If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. See Not-for-Profit Activities, later.

At-risk limits.   Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. You are at risk in any activity for the following. For more information, see Publication 925.

Passive activities.   Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. In general, deductions for losses from passive activities only offset income from passive activities. You cannot use any excess deductions to offset other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. Suspended passive losses are fully deductible in the year you completely dispose of the activity. For more information, see Publication 925.

Net operating loss.   If your deductions are more than your income for the year, you may have a “net operating loss.” You can use a net operating loss to lower your taxes in other years. See Publication 536 for more information.

  See Publication 542 for information about net operating losses of corporations.

Cash method.   Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them.

Accrual method.   Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.

Economic performance.   You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

Prepayment.   You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Contested liability.   Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. See Contested Liability in Publication 538 for more information.

Related person.   Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. Your deduction is allowed when the amount is includible in income by the related cash method payee. See Related Persons in Publication 538.

Presumption of profit.   An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.

  If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death.

  If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.

Using the presumption later.   If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.

  You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.

  The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.

  Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.

  

You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity.

If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).