Cost of Goods Sold — Form 1125-A & Inventory

Any C-corp that sells physical products — retail, wholesale, manufacturing, or e-commerce — must file Form 1125-A to compute Cost of Goods Sold. The completed Line 8 of Form 1125-A flows directly to Line 2 of Form 1120.

Pure service corps (law firms, consulting shops, software SaaS) skip this form. But mixed-model corps (say, a law firm that sells its own workbook) technically need it for the product portion.

The corp must also maintain inventory records. Under Rev. Proc. 2018-40 and the §471 regulations, most 'small business taxpayers' (avg annual gross receipts under $30 million for the 3 prior years, indexed) can elect to treat inventory as 'non-incidental materials and supplies' — meaning they can deduct inventory when they buy it, not when they sell it. This is a huge simplification for small product corps.

Cost of Goods Sold on Form 1125-A follows this exact formula:

Line 1 — Beginning inventory (must equal prior year's ending inventory)
+ Line 2 — Purchases (goods bought for resale, net of any returns to suppliers)
+ Line 3 — Cost of labor (production labor only — office/admin labor does NOT go here)
+ Line 4 — Additional §263A costs (indirect costs capitalized into inventory — see next section)
+ Line 5 — Other costs (freight-in, storage, packaging materials, factory utilities allocable to production)
= Line 6 — Total
− Line 7 — Ending inventory (physical count × cost method)
= Line 8 — COGS

Line 8 flows to Form 1120 Line 2. Ending inventory must tie to the balance sheet (Schedule L, Line 3) — a mismatch is a common IRS red flag.

§263A (a rule from the Tax Reform Act of 1986) requires many taxpayers to capitalize into inventory not just direct product costs but ALSO indirect costs that benefit production or purchasing — think of it as 'burden allocation.'

Indirect costs that get scooped up: purchasing department salaries, warehousing (for produced inventory), depreciation on production equipment, factory rent, quality control, and a slice of general management time.

This creates real math problems for corps because you're moving costs OUT of the deduction column and INTO the inventory column. That reduces this year's deduction but increases COGS when the inventory later sells.

Big relief: The TCJA created a 'small business taxpayer' exception. If the corp's average annual gross receipts for the prior 3 years are under $30 million (indexed — check the current-year figure), it is completely exempt from §263A. Most small preparers will never touch §263A because their clients fall under this exception. Know it exists, know the threshold, and know how to check the average calculation. If your corp is over the threshold, you probably need a manufacturing-tax specialist involved.

At the bottom of Form 1125-A, Line 9 asks the corp to identify its inventory valuation method:

(a) Cost — Simple: inventory is valued at what the corp paid for it (or made it for).
(b) Lower of cost or market (LCM) — Value at cost, but if market value has dropped below cost, use market. Rare in practice.
(c) Other — Specific identification, retail method, etc.

Line 9c asks if the corp uses LIFO (last-in, first-out). If yes, Form 970 must be attached in the first LIFO year and LIFO conformity requires the same method on financial statements — a major consideration for corps with bank loans. Most small corps use FIFO (first-in, first-out) or specific ID, which are simpler and result in higher taxable income in inflationary times but avoid the LIFO paperwork burden.

Line 9d: 'Was there a writedown of subnormal goods?' — checking this box tells the IRS the corp reduced inventory value below cost. Line 9e-f cover changes in method (Form 3115 required).