Publication 334
Tax Guide for Small Business

(For Individuals Who Use Schedule C or C-EZ)

For use in preparing 2002 Returns

7. Figuring Gross Profit

Introduction

After you have figured the gross receipts from your business (chapter 5) and the cost of goods sold (chapter 6), you are ready to figure your gross profit. You must determine gross profit before you can deduct any business expenses. These expenses are discussed in chapter 8.

If you are filing Schedule C-EZ, your gross profit is your gross receipts plus certain other amounts, explained later under Additions to Gross Profit.

Businesses that sell products.   If you are filing Schedule C, figure your gross profit by first figuring your net receipts. Figure net receipts on Schedule C by subtracting any returns and allowances (line 2) from gross receipts (line 1). Returns and allowances include cash or credit refunds you make to customers, rebates, and other allowances off the actual sales price.

Next, subtract the cost of goods sold (line 4) from net receipts (line 3). The result is the gross profit from your business.

Businesses that sell services.   You do not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for your business. Your gross profit is the same as your net receipts (gross receipts minus any refunds, rebates, or other allowances). Most professions and businesses that sell services rather than products can figure gross profit directly from net receipts in this way.

Illustration.   This illustration of the gross profit section of the income statement of a retail business shows how gross profit is figured.

The cost of goods sold for this business is figured as follows:

Items To Check

Consider the following items before figuring your gross profit.

Gross receipts.   At the end of each business day, make sure your records balance with your actual cash and credit receipts for the day. You may find it helpful to use cash registers to keep track of receipts. You should also use a proper invoicing system and keep a separate bank account for your business.

Sales tax collected.   Check to make sure your records show the correct sales tax collected.

If you collect state and local sales taxes imposed on you as the seller of goods or services from the buyer, you must include the amount collected in gross receipts.

If you are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments, you generally do not include these amounts in income. For more information, see the Schedule C instructions.

Inventory at beginning of year.   Compare this figure with last year's ending inventory. The two amounts should usually be the same.

Purchases.   If you take any inventory items for your personal use - use them yourself, provide them to your family, or give them as personal gifts, etc. - be sure to remove them from the cost of goods sold. For details on how to adjust cost of goods sold, see Merchandise withdrawn from sale in chapter 6.

Inventory at end of year.   Check to make sure your procedures for taking inventory are adequate. These procedures should ensure all items have been included in inventory and proper pricing techniques have been used.

Use inventory forms and adding machine tapes as the only evidence for your inventory. Inventory forms are available at office supply stores. These forms have columns for recording the description, quantity, unit price, and value of each inventory item. Each page has space to record who made the physical count, who priced the items, who made the extensions, and who proofread the calculations. These forms will help satisfy you that the total inventory is accurate. They will also provide you with a permanent record to support its validity.

Inventories are discussed in chapter 2.

Testing Gross
Profit Accuracy

If you are in a retail or wholesale business, you can check the accuracy of your gross profit figure. First, divide gross profit by net receipts. The resulting percentage measures the average spread between the merchandise cost of goods sold and the selling price.

Next, compare this percentage to your markup policy. Little or no difference between these two percentages shows that your gross profit figure is accurate. A large difference between these percentages may show that you did not accurately figure sales, purchases, inventory, or other items of cost. You should determine the reason for the difference.

Example.   Joe Able operates a retail business. On the average, he marks up his merchandise so that he will realize a gross profit of 331/3% on its sales. The net receipts (gross receipts minus returns and allowances) shown on his income statement is $300,000. His cost of goods sold is $200,000. This results in a gross profit of $100,000 ($300,000 - $200,000). To test the accuracy of this year's results, Joe divides gross profit ($100,000) by net receipts ($300,000). The resulting 331/3% confirms his markup percentage of 331/3%.

Additions to Gross Profit

If your business has income from a source other than its regular business operations, enter the income on line 6 of Schedule C and add it to gross profit. The result is gross business income. If you use Schedule C-EZ, include the income on line 1 of the schedule. Some examples include income from an interest-bearing checking account, income from scrap sales, and amounts recovered from bad debts.

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