In the world of small business accounting, few topics are as misunderstood as Cost of Goods Sold (COGS). A quick Google search or a glance at simplified online guides can lead business owners to inaccurate conclusions—particularly those in service-based industries. Let’s set the record straight.

COGS Is Not a Deductible Expense

One of the most common misconceptions is that COGS is simply a deductible business expense. This is technically incorrect.

COGS is not reported as a deduction on your tax return. Instead, it is a reduction to gross receipts. This distinction matters because COGS affects how gross income is calculated, which in turn impacts taxable income in a different way than ordinary deductions do.

Service Businesses Do Not Have COGS

Another error we often see is the notion that COGS includes all direct costs associated with producing or selling a product or service. While that may sound reasonable, it doesn’t align with IRS guidance.

COGS applies only to tangible products, not services. For example, a hairdresser cannot claim the cost of electricity for running clippers or the use of scissors and shampoo as COGS. Likewise, a marketing firm that uses paper and envelopes to distribute information isn’t selling those materials—they’re using them to deliver a service. These are operating expenses, not costs of goods sold.

Businesses that provide services—like consulting, marketing, or design—typically do not report COGS unless they are also selling physical products.

When COGS Does Apply

In contrast, businesses that produce or resell physical products generally do report COGS and may be required to maintain inventory. For instance, if your business involves printing and selling physical marketing materials to clients, then those materials are part of what you’re selling. In that case, COGS and inventory tracking likely apply.

Why Does This Matter?

Beyond correct financial reporting, misclassifying expenses as COGS can have real consequences—especially when it comes to IRS audit risk. One critical example involves the statute of limitations for tax assessments.

If a business omits more than 25% of its gross income on a tax return, the IRS has six years—not the standard three—to assess additional tax. This is commonly misunderstood, especially by service-based businesses that incorrectly report or inflate cost of goods sold.

Here’s how this becomes a problem: For service businesses, gross income is typically equal to gross receipts, since they don’t have COGS. If a business improperly deducts expenses as COGS, it effectively reduces reported gross income. If the reduction is large enough—say, over 25%—this could trigger the extended statute of limitations.

Misuse doesn’t just distort financials—it can extend your audit exposure by years.

Final Thoughts

If you’re unsure whether your business should be reporting COGS, the key question is whether you’re selling a tangible product. If you’re only using materials and supplies as part of providing a service, those costs belong elsewhere on your tax return.

Understanding this distinction can help you avoid misreporting income and expenses—something the IRS pays close attention to. As always, consult with a qualified tax professional to make sure your reporting aligns with your actual business activities.