Form 1125-A is where you calculate cost of goods sold and attach it to your business return, and to fill out Form 1125-A you work Part I from the top: start with beginning inventory on Line 1, add purchases, labor, any Section 263A costs, and other costs on Lines 2 through 5, total them on Line 6, subtract ending inventory on Line 7, and land on COGS at Line 8. That figure then flows to Line 2 of Form 1120 (or the corresponding line on Form 1120-S, 1065, 1120-C, or 1120-F).1Internal Revenue Service. Form 1125-A – Cost of Goods Sold Part II adds a set of disclosure questions about how you value inventory. The work that actually determines your numbers happens before you touch the form: choosing a valuation method and sorting your costs correctly between COGS and operating expenses.
Who Has to File This Form
Any entity that reports a COGS deduction attaches Form 1125-A. That covers Form 1120 (C-corporations), Form 1120-S (S-corporations), Form 1065 (partnerships), Form 1120-C (cooperatives), and Form 1120-F (foreign corporations with U.S. income).2Internal Revenue Service. About Form 1125-A, Cost of Goods Sold If your business buys or produces goods for sale and deducts any of those costs, the form applies.
Pick Your Inventory Valuation Method First
You cannot fill in dollar amounts until you know how you are assigning cost to the units you sold versus the units still on the shelf. The choice drives Line 7 (ending inventory) and, by subtraction, Line 8 (COGS).
FIFO
First-in, first-out assumes your oldest inventory sells first, so ending inventory carries the cost of the most recent purchases. When prices rise, FIFO pushes cheaper older costs into COGS and produces higher taxable income.
LIFO
Last-in, first-out reverses that logic: newest inventory is treated as sold first, matching current costs against current revenue and typically reducing taxable income when prices are rising. The trade-off is the LIFO conformity requirement. A corporation electing LIFO for tax must also use LIFO in reports of income to shareholders, creditors, and beneficiaries.3Internal Revenue Service. LIFO Conformity
Average Cost
The average cost method divides the total cost of all goods available for sale by total units and applies that weighted average to both COGS and ending inventory. It works well for fungible goods where tracing individual units is impractical.
Lower of Cost or Market
If inventory has lost value since purchase, you can carry it at the lower of original cost or current market replacement price on the inventory date. Damaged, shop-worn, or otherwise subnormal goods get valued at actual selling price minus direct costs of selling. Under current GAAP rules, the lower-of-cost-or-market write-down is not available if you use LIFO.4Internal Revenue Service. Lower of Cost or Market
Whichever method you pick, apply it consistently. Switching is a change in accounting method, which requires filing Form 3115 and potentially a Section 481(a) adjustment.1Internal Revenue Service. Form 1125-A – Cost of Goods Sold
Sort Your Costs Before You Start Typing
The form is short. The judgment call is deciding which costs belong on it and which stay on the main return as operating expenses.
Direct Costs
Direct costs trace straight to the goods you produced or bought for resale. Purchases go on Line 2 at invoice price, including sales or excise taxes paid on acquisition, reduced by anything the owner withdrew for personal use. Direct labor goes on Line 3: wages of employees who physically work on the product, plus the employer share of payroll taxes and benefits for those workers. Anything else directly tied to production or acquisition (freight-in, direct overhead, supplies consumed in manufacturing) goes on Line 5 with an attached statement listing the components.1Internal Revenue Service. Form 1125-A – Cost of Goods Sold
Indirect Costs and Whether UNICAP Applies
Indirect costs support production without attaching to any single unit: factory rent, equipment depreciation, utilities for production space, supervisory wages, quality control, factory insurance, production-related administrative costs, and equipment maintenance. Under Section 263A, the Uniform Capitalization Rules generally require you to capitalize a share of these into inventory rather than deducting them immediately.5Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses Capitalized amounts sit in ending inventory until the goods sell, at which point they enter COGS. The deduction is delayed, not lost. The capitalized total goes on Line 4.
Not every indirect cost gets pulled into UNICAP. Selling and distribution expenses (marketing, advertising, shipping to customers), Section 174 research and experimental expenditures, Section 179 expensing, Section 165 casualty losses, income-based taxes (including income-based franchise taxes), warranty and product liability costs, on-site storage, and strike-related expenses stay currently deductible as period expenses.6eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs
The Small Business Exemption That Skips Most of This
Section 263A(i) exempts any taxpayer other than a tax shelter from UNICAP if it meets the Section 448(c) gross receipts test. For tax years beginning in 2026, that means average annual gross receipts of $32 million or less for the three preceding tax years.7Internal Revenue Service. Rev. Proc. 2025-32 If you qualify, Line 4 is zero and you can ignore the UNICAP allocation entirely. Section 471(c) also lets qualifying small businesses use a simplified inventory method, either treating inventory as non-incidental materials and supplies or conforming to their financial statement method.8Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
Producers who don’t qualify for the small business exemption but keep total indirect costs at $200,000 or less for the year also don’t have to capitalize additional Section 263A costs into ending inventory.9Internal Revenue Service. Producer’s 263A Computation Above that threshold, most manufacturers use the simplified production method to allocate; resellers use a parallel simplified resale method.
Filling in Part I, Line by Line
With a valuation method chosen and costs sorted, Part I is mechanical.
Line 1 — Beginning inventory. The inventory value on hand at the start of the tax year. It should equal last year’s ending inventory. The one exception: if you changed accounting methods this year, refigure last year’s closing inventory under the new method, enter the adjusted amount, and attach an explanation.1Internal Revenue Service. Form 1125-A – Cost of Goods Sold
Line 2 — Purchases. Cost of raw materials or finished goods bought for resale, reduced by items withdrawn for personal use.
Line 3 — Cost of labor. Direct labor for employees who physically produce or work on the goods. Pure resellers who do no processing or assembly typically leave this blank.
Line 4 — Additional Section 263A costs. The indirect costs UNICAP required you to capitalize. Zero if you qualify for the small business exemption.
Line 5 — Other costs. Remaining production or acquisition costs not on Lines 2 through 4. Attach a detailed statement.1Internal Revenue Service. Form 1125-A – Cost of Goods Sold
Line 6 — Total. Add Lines 1 through 5. This is total goods available for sale.
Line 7 — Ending inventory. Inventory on hand at year-end, valued using your chosen method.
Line 8 — Cost of goods sold. Line 6 minus Line 7. Carry this figure to Line 2 of Form 1120 or the equivalent line on your entity’s return.1Internal Revenue Service. Form 1125-A – Cost of Goods Sold
Part II: The Line 9 Disclosures
Line 9 is a series of checkboxes and yes-or-no questions the IRS uses to spot inconsistencies without opening your books.
Line 9a asks which valuation method you use: cost, lower of cost or market, or another specified method. Line 9b asks whether you wrote down subnormal goods. Lines 9c and 9d cover LIFO: check 9c if you adopted or used LIFO for any goods this year, and on 9d enter closing LIFO inventory and the LIFO reserve (the difference between LIFO and what the value would have been under another method). Line 9e asks whether Section 263A rules apply to property you produced or acquired for resale. Line 9f asks whether you changed how you determine inventory quantities, costs, or valuations between opening and closing inventory; if yes, attach an explanation.
Skipping these or answering in a way that contradicts your Part I numbers is a common audit trigger. Answer every one, and make sure the answers line up with what you put above.
Common Mistakes That Trigger Penalties
Section 6662 imposes a 20% penalty on any underpayment attributable to negligence or a substantial understatement of income tax.10Internal Revenue Service. Accuracy-Related Penalty11Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The COGS errors that most often draw one:
- Capitalizing too few indirect costs under UNICAP, which inflates the current-year deduction.
- Changing valuation methods without filing Form 3115.
- Beginning inventory on Line 1 that doesn’t match the prior year’s Line 7 (with no method-change explanation attached).
- Misclassifying operating expenses as COGS, or the reverse, which distorts gross profit.
- Leaving Line 5 without the required attached statement, or skipping Line 9 disclosures.
The defense is documentation. Every number on Form 1125-A should trace back to invoices, payroll records, and allocation worksheets. If UNICAP applies, keep the absorption ratio computation and supporting schedules with your working papers so the Line 4 figure can be reconstructed on request.