It’s audit season and I just got back from meeting with the IRS.   So far this season, I’ve worked with two different artists and they both were contacted about the same thing:  Cost of Goods Sold. 

If you go to the IRS website and research what they’re looking for, you’re not going to find much information.  I did find an old IRS audit guideline for artists from back in the 90’s, but that didn’t address Cost of Goods Sold for artists either.  

In a normal business, Cost of Goods Sold would be what you pay for the stuff you sell.  For example:  say you own a teddy bear store.  You pay $5 for each bear and then you turn around and sell the bear for $10.  You start the year with 100 bears in your inventory, you buy 500 more bears to sell, and you end the year with 50 bears in your inventory.   Let’s do the math:

Beginning inventory:     $500  (100 bears times $5 each)

Purchases:                      $2,500 (500 bears times $5 that you paid for each new bear)

Ending inventory:          $    250  (because you have 50 bears left times the $5)

Cost of Goods sold:       $2,250  (this is the confusing one:  you take the 500 and add the 2500—that’s all the bears that you’ve purchased to sell, right?  That equals $3000.  Then you subtract the ending inventory 250 (because you didn’t sell those) and you’re left with $2,250—that’s your Cost of Goods Sold.)

But if you’re an artist, you don’t have a bunch of identical $5 bears.   How do you even begin to value your artwork?  Here’s the thing—most artists should not be doing a Cost of Goods Sold report on their taxes.  Let me repeat that:  Most artists should NOT be doing a Cost of Goods Sold report on their taxes. 

Think about your art.  If each piece is a unique work, where the value of the piece is mostly due to your labor as opposed to the materials that you put into the work, then generally you’re fine just writing off your expenses as “expenses” rather than listing your materials as a Cost of Goods Sold.

So at what point do you “cross over” from just recording your expenses to actually keeping inventory?  I asked that at the IRS the other day.  “It’s really hard to say,” was the answer I got.  Even for an IRS agent with years of experience, this was a tough question.  If you’re mass producing works-for example you’ve produced a limited edition of numbered prints, well then that’s a case where you should be taking inventory.  Still—your purchases are only the products that you sell.  For example:  you pay $2,000 to have 100 prints produced which you then hand number and sign.  You sell 70 of the prints for $100 each.

Your Beginning inventory:  $0  (up until now, all of your art was unique.  You never did COGS before)

Purchases:  $2000  (because that’s what you paid for them)

Ending inventory:  $600  (You have 30 prints left and they cost you $20 each because 2000 divided by 100 equals 20.)

Cost of Goods Sold:  $1400  (You started with $0, you added $2000 in purchases.  To get the Cost of Goods Sold you subtract the ending inventory of $600 and you get $1400.)

Is this making sense?  Art and Accounting don’t go together well, but you need to know this stuff.  (And I’ve worked with enough artists by now to know that you’re way better at math than you let on.)

But what about the 70 prints I sold for $100 each?  That goes in the front of your schedule C, $7000 under gross receipts on line 1.

Cost of Goods Sold will go on line 4.

You’ll take your Gross Receipts minus your Cost of Goods Sold to get your Gross Income.  In this example, you’d take the $7,000 – $1,400  to get $5,600.

But once again, let me make this clear—as a professional artist, you shouldn’t be using Cost of Goods Sold unless you are producing a significant amount of work and you have a way of determining the cost and a way of counting the work.  For example:  A painter could count canvasses, but it would be almost impossible to count paint.  Canvas could be a COGS but paint would be a regular expense.  A potter might be able to count pounds of clay, but the tools and glazes might need to be a regular expense.

If you choose to count your inventory, it’s important to value items at what they cost and not what you are selling them for.  Let’s go back to our example about the prints.  You paid $20 apiece for them so your ending inventory of 30 prints is worth $600.  If you value your inventory at what you want to sell the prints for ($100 apiece) then your ending inventory will be $3000—that’s more than you spent on the prints to begin with.  If you did that on your tax return, your COGS would come out as negative $1000 and your income would go up to $8,000 instead of the $7000 that you actually made.  Valuing your inventory at the “retail” price will really mess you up, so don’t do that.

Remember, as an artist your business situation is as unique as your art.  Don’t let your packaged software intimidate you into using Cost of Goods Sold when you shouldn’t.  If you’re thinking that you produce enough that you should be taking inventory, spend the money to get help from a professional so that you get started on the right track.  It’s much cheaper than an audit.