Definition — Cost of Goods Sold

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Image source: Wikimedia Commons, public domain

Image source: Wikimedia Commons, public domain

If your business manufactures or buys products for resale, you’re probably familiar with cost of goods sold. You might even know the formula for figuring these direct expenses–Beginning Inventory + Inventory Purchases – Ending Inventory = Cost of Goods Sold—and that you can subtract the cost of goods sold from your gross receipts on your tax return to determine your gross income.

Do you also know that last statement means cost of goods sold is not treated as a deduction under the tax code? If not, you may wonder what difference the classification makes. After all, you get to use cost of goods sold to reduce your income no matter what the expenses are called.

But the definition does matter because certain limitations on deductions, such as the “ordinary and necessary” requirement (section 162) don’t apply to cost of goods sold. Neither does the rule denying a deduction for kickbacks or illegal payments (section 162(c)), or the strict substantiation rules for expenses such as meals and entertainment (section 274). Note you still have to maintain records and be able to support amounts you claim.

Here are three situations where the question is whether an item is an ordinary and necessary business expense or a reduction of gross receipts in determining gross income.

1.

A milk producer paid allowances, discounts, or rebates to certain purchasers of its milk, in willful violation of a state law fixing the price of milk. The allowances, which reduced the purchase price of the milk, were made with full knowledge of the company’s officers and directors. These officers knew that competitors of the company were making similar allowances and they believed it necessary for their company to do the same in order to maintain its competitive position in the industry.

The taxpayer deducted the allowances. The IRS said the allowances were not deductible, in part because they were illegal under state law.

What do you think?

or

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The case: Pittsburgh Milk Co.

2.

A manufacturer of draperies paid kickbacks to employees of the manufacturers of mobile homes that purchased the draperies. The company deducted the kickbacks, saying they were ordinary and necessary business expenses.

The IRS said the payments were nondeductible because they were made in order to secure the business of the employer-manufacturers and thus were common kickbacks, not ordinary business expenses.

The court agreed the payments were not deductible as business expenses, then went on to consider whether they should be deductible as rebates paid in consideration for the recipient-employees giving their employers’ business to the taxpayer.

What do you think?

Were the payments “rebates” and therefore excludable from gross income (or deductible) under the theory that only the actual consideration paid for the purchase is income?

For the or for the

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The case: United Draperies, Inc.

3.

A manufacturer of prescription drugs paid (legal) Medicaid rebates directly to state Medicaid agencies pursuant to a Rebate Agreement.

The five-step transaction worked like this: (1) The manufacturer sold a prescription drug to a wholesaler; (2) the wholesaler sold the drug to a retail pharmacy; (3) the pharmacy dispensed the drug to an individual Medicaid beneficiary, and then filed a reimbursement claim with a state Medicaid agency; (4) the state agency approved the claim and then reimbursed the pharmacy for the cost of the drug plus a dispensing fee; and (5) the manufacturer paid a Medicaid Rebate to the state agency pursuant to the Rebate Agreement.

What do you think?

or

For a full explanation, hover your mouse over the link below.

The ruling: Rev. Rul. 2008-26

Extra credit.

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Right answer!
Sorry, wrong answer :(

The allowances were adjustments to the price of milk.

The test to be applied, as in the interpretation of most business transactions, is: What did the parties really intend, and for what purpose or consideration was the allowance actually made?

Where, as here, the intention and purpose of the allowance was to provide a formula for adjusting a specified gross price to an agreed net price, and where the making of such adjustment was not contingent upon any subsequent performance or consideration from the purchaser, then, regardless of the time or manner of the adjustment, the net selling price agreed upon must be given recognition for income tax purposes.

We hold that the allowances here involved should be applied to reduce the corporation’s gross sales, so as to reflect the actual agreed prices for which the milk was sold.

Sorry, wrong answer :(
Right answer!
For the IRS.

In the instant case, the taxpayer’s agreement to pay rebates was made with employees of its customers and was independent of its agreement with its purchasers fixing the selling price of the products sold.

These amounts were paid for a consideration separate from the selling price of its products, namely these employees sending the business of their employers to the taxpayer, and the amounts received from these employers in consideration for the taxpayer’s products sold is properly includable in the taxpayer’s gross income.

Right answer!
Sorry, wrong answer :(
The rebates were adjustments to the sales price.

The Medicaid Rebate is paid by the manufacturer to the state agency pursuant to the terms of the Rebate Agreement. Under the purpose and intent test of the Pittsburgh Milk case, the Medicaid rebate is a factor used in setting the actual selling price, negotiated and agreed to before the sale to the wholesaler takes place.

Medicaid rebates that a pharmaceutical manufacturer pays to state Medicaid agencies are adjustments to the sales price in calculating gross receipts. This holding is limited to Medicaid rebates that a pharmaceutical manufacturer pays pursuant to the Medicaid Rebate Program established by the Omnibus Budget Reconciliation Act of 1990.

Medical marijuana sales.

Code section 280E prohibits deductions or credits related to expenditures in connection with the sale of illegal drugs.

However, “to preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision” (from the Senate Finance Committee Report 97-494 (Volume I).

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