Schedule C Part III: Cost of Goods Sold Explained for Freelancers and Product Sellers (2026 Guide)

Published: May 25, 2026 · Reading time: 9 min

TL;DR: Part III of Schedule C (Lines 33–42) computes Cost of Goods Sold (COGS) for anyone who sells products: Beginning Inventory + Purchases + Cost of Labor + Materials & Supplies + Other Costs − Ending Inventory. The result lands on Line 4 and is subtracted from gross receipts to get gross profit — before any Part II operating expenses. Pure service freelancers skip Part III entirely. Under IRC §471(c), small-business taxpayers (gross receipts at or below $31 million for 2026) can treat inventory as non-incidental materials and supplies and avoid formal inventory accounting. COGS is not the same as Line 22 supplies or Line 11 contract labor — no item appears twice. Because COGS lowers gross income, it cuts both income tax and the 15.3% self-employment tax.

If you sell physical products — handmade goods on Etsy, retail arbitrage on Amazon, prints, apparel, food, or anything you buy or build and resell — the most important section of your Schedule C isn't Part II. It's Part III, Cost of Goods Sold. Get it wrong and you either overpay tax or hand the IRS an audit thread to pull. This guide walks every line for 2026.

What Cost of Goods Sold Actually Is

COGS is the direct cost of the products you sold during the year — what you paid to acquire or produce them. The key word is sold. If you bought 1,000 units and sold 600, only the cost of those 600 units is deductible this year. The other 400 sit on your balance sheet as ending inventory (Line 41) and roll into next year.

This matching principle is why product sellers can't just deduct everything they spent on inventory. The IRS wants the cost recognized in the same year as the related sale, so your deduction tracks the goods out the door, not the cash out the bank.

How COGS Flows Into Your Profit

Part III feeds the top of Schedule C:

Only after gross income do your Part II operating expenses (advertising, car, home office, etc.) come off. So COGS reduces the figure that ultimately drives both income tax and the 15.3% self-employment tax on Line 31 net profit. For a deeper map of the whole form, see our Schedule C line-by-line guide.

Walking Part III Line by Line (Lines 33–42)

Line 33 — Method used to value closing inventory

Check Cost, Lower of cost or market, or Other. Most freelancers use cost. Lower of cost or market lets you write down inventory whose value has fallen below what you paid.

Line 34 — Did you change your method?

A "yes" generally means you filed (or need to file) Form 3115 for a change in accounting method. Keep it consistent year to year.

Line 35 — Inventory at beginning of year

This must equal last year's Line 41 (ending inventory). In your first year of business it's usually $0.

Line 36 — Purchases less items withdrawn for personal use

What you paid for goods bought for resale or raw materials. Subtract the cost of anything you took for personal use (the candle you kept, the shirt you wore).

Line 37 — Cost of labor

Wages paid to other people who physically produce your goods. Critically, never include your own draw — a sole proprietor's own labor is never deductible. And labor counted here does not also go on Line 26 wages or Line 11 contract labor; production labor belongs in COGS.

Line 38 — Materials and supplies

Items that become part of the finished product — wax, wicks, fabric, beads, packaging that ships with the product. This is the line most often confused with Part II Line 22; the distinction is below.

Line 39 — Other costs

Direct costs of getting goods ready for sale: freight-in (what you pay to receive inventory), import duties, and direct factory overhead.

Line 40 — Add Lines 35 through 39

The total cost of goods available for sale during the year.

Line 41 — Inventory at end of year

Physically count and value what's left on your shelves at year-end, using your Line 33 method. This is the cost of goods you did not sell.

Line 42 — Cost of goods sold

Line 40 − Line 41. This is your COGS. It carries to Line 4.

The §471(c) Small-Business Exemption: Most Freelancers Don't Need Formal Inventory

Here's the rule that saves side-hustle sellers a mountain of bookkeeping. Under IRC §471(c), added by the Tax Cuts and Jobs Act, a small-business taxpayer — one whose average annual gross receipts for the prior three years are at or below the §448(c) threshold ($31 million for 2026) — may:

1. Treat inventory as non-incidental materials and supplies (deduct the cost in the year the item is sold or used), or
2. Follow its books and records (deduct inventory the way your accounting software already does).

For nearly every freelancer this means you can skip a formal year-end inventory valuation and instead expense each item's cost when it sells. Treas. Reg. §1.471-1(b) spells out the mechanics. This pairs naturally with the cash method of accounting most solo sellers use — see our cash vs accrual guide.

You still report a COGS figure; §471(c) just simplifies how you arrive at it. And §471(c) is an election tied to your method of accounting, so be consistent.

COGS vs Operating Expenses: The No-Double-Dip Rule

The single biggest Part III mistake is deducting the same cost twice — once in COGS and again as a Part II operating expense. The IRS matches these, and a maker who expenses raw materials in both Line 38 and Line 22 is writing an audit invitation.

When in doubt, ask: does this cost become part of the product a customer receives? If yes, it's COGS. If it's overhead or selling cost, it's Part II. Our how to categorize Schedule C expenses guide and Etsy seller expense guide drill into the edge cases.

Worked Example: An Etsy Candle Maker

Maria sells hand-poured candles. Her 2026 numbers:

• Beginning inventory (Line 35): $0 (first full year)
• Purchases of wax, wicks, jars, fragrance (Line 36): $8,200
• Part-time pourer she pays as a 1099 contractor (Line 37): $1,500
• Labels and product boxes that ship with each candle (Line 38): $900
• Freight-in on bulk wax (Line 39): $300
• Line 40 total available: $10,900
• Ending inventory of unsold candles + raw materials (Line 41): $2,400
• Line 42 COGS: $10,900 − $2,400 = $8,500

Maria's gross receipts were $24,000. Gross profit (Line 5) = $24,000 − $8,500 = $15,500. Her packing tape, shipping postage, Etsy fees, home studio, and mileage are all separate Part II deductions that come off after this. The $2,400 still on her shelves becomes next year's Line 35.

Common Part III Mistakes That Trigger Review

• Deducting all purchases regardless of sales. Unsold inventory is an asset, not a current deduction. Only sold goods reduce income.
• Double-counting raw materials in both COGS and Line 22.
• Putting your own labor on Line 37. A sole proprietor's time is never deductible.
• Mismatched beginning/ending inventory. Line 35 must equal last year's Line 41. A jump with no explanation is a flag.
• Treating shipping you charge customers as a reduction of COGS. That's income on Line 1; outbound postage is a Part II expense.

Keep your supplier invoices, a simple inventory log, and your marketplace settlement reports. Under IRC §6001 and Treas. Reg. §1.6001-1, you must be able to substantiate every figure. A receipt-capture tool that tags each purchase to COGS vs supplies as you buy makes year-end a non-event.

Authoritative References

• IRS Schedule C Instructions (Part III, Cost of Goods Sold)
• IRS Publication 334 — Tax Guide for Small Business
• IRC §471 — General rule for inventories
• IRC §448(c) — Gross receipts test
• Treas. Reg. §1.471-1 — Need for inventories

Track COGS and Supplies Without the Year-End Scramble

CentSense auto-tags every receipt to the right place — raw materials to Cost of Goods Sold, packing and overhead to Part II supplies — so Part III practically fills itself at tax time. The Solo plan ($5/month) gives you unlimited AI receipt scanning with Schedule C categorization, mileage at the 2026 IRS rate of $0.725/mile, and a CPA-ready CSV export broken out by line number.

Start free →