Sole proprietors who deliver services rather than sell products from a shelf can still claim cost of goods sold on Schedule C when they have no inventory, and doing so lowers both income tax and self-employment tax. You report direct materials and direct labor on Part III, enter zero for beginning and ending inventory, and the total on Line 42 carries to Line 4 of Part I. The mechanics are simple once you know which costs belong in Part III and which belong with your operating expenses in Part II.
What Counts as a Direct Cost Without Inventory
The physical-incorporation test is the cleanest way to sort your costs. If something you bought becomes part of what the customer receives, it’s a direct cost. A plumber’s copper fittings, an HVAC technician’s replacement compressor, a contractor’s lumber and drywall all disappear into the finished job and belong in Part III.
Direct labor qualifies too. Wages you pay employees who physically perform the service count, along with their payroll taxes and reasonable fringe benefits. Payments to subcontractors doing hands-on production work on a specific job also go here. What doesn’t belong: amounts paid to yourself (the form explicitly excludes this), administrative staff wages, or employee time spent on non-production tasks like bookkeeping.
A working rule: if the cost would not have existed without a specific revenue-generating job, it’s likely a direct cost. A framer’s wages on a remodel qualify. The office manager’s wages don’t, even if she placed the lumber order.
Tools and equipment that last beyond the current year can’t be expensed as COGS. Those get capitalized and depreciated on Form 4562. Under the de minimis safe harbor election, you can expense tangible property costing $2,500 or less per item ($5,000 if you have audited financial statements) without capitalizing it, but those expensed items still sit in Part II as operating expenses rather than in COGS.
Why You Can Skip Formal Inventory Accounting
The IRS generally requires businesses that produce or purchase merchandise to maintain inventories, but most service sole proprietors qualify for an exception. If your average annual gross receipts over the prior three tax years are $31 million or less (indexed annually for inflation) and you aren’t a tax shelter, you’re a small business taxpayer and can skip formal inventory accounting.
Under this exception, you treat materials as non-incidental supplies, deductible in the year you use or consume them. You don’t track beginning and ending inventory values or apply a valuation method. For a contractor who buys materials and installs them the same week, this simply matches how the business already operates.
If you previously used an accrual method with formal inventory tracking and want to switch, file Form 3115 to request the accounting method change. The IRS treats this as an automatic change for qualifying small business taxpayers, but the form is still required. If you’ve always operated this way, no filing is needed; just be consistent year to year.
Filling Out Part III Line by Line
Part III is titled “Cost of Goods Sold,” and even businesses without traditional inventory use it. Here is what each line asks for as a no-inventory filer:
- Line 33: Inventory valuation method. You can leave this blank or check “Cost”; it won’t affect your calculation.
- Line 34: Whether there was any change in determining quantities, costs, or valuations. Check “No.”
- Line 35: Inventory at beginning of year. Enter zero.
- Line 36: Purchases less cost of items withdrawn for personal use. Enter your total direct material costs — every part, fitting, and supply you bought for jobs during the year.
- Line 37: Cost of labor (not including amounts paid to yourself). Enter wages to employees who did direct production work, plus subcontractor payments tied to specific jobs.
- Line 38: Materials and supplies not already included on Line 36.
- Line 39: Other direct costs, such as freight on materials or equipment rental for a specific job.
- Line 40: The sum of Lines 35 through 39.
- Line 41: Inventory at end of year. Enter zero.
- Line 42: Line 40 minus Line 41. This carries to Line 4 of Part I.
Because both inventory lines are zero, Line 42 equals Line 40. Your annual direct purchases plus direct labor is your COGS. That figure gets subtracted from gross receipts on Line 1 to produce gross profit on Line 5, before you touch operating expenses in Part II.
Separating Direct Costs From Operating Expenses
The Part III versus Part II decision matters more than most filers realize. COGS determines your gross profit margin, and the IRS benchmarks that margin against industry averages. A plumbing business showing a 15% gross margin when the industry runs at 45% will draw attention, since that gap suggests either underreported revenue or inflated direct costs.
Return to the test: did the cost become part of what the customer received? The copper pipe a plumber installs is COGS. The plumber’s liability insurance is an operating expense. The specialized fitting that goes into the wall is COGS. The van that carried it there is an operating expense or a depreciation item.
Vehicle mileage sits in a gray area, but in practice most sole proprietors deduct all business mileage on Line 9 of Part II. For 2026, the standard mileage rate is 72.5 cents per mile. Splitting mileage between COGS and operating expenses by trip purpose is technically more accurate but rarely changes the bottom-line tax result, since both reduce net profit. Utilities work the same way: if you can’t practically meter production versus office use, putting the full bill on Line 25 is the common approach and auditors don’t typically push back. Office supplies like printer paper, ink, and postage always go on Line 18 of Part II.
Records That Support Your Numbers
With no beginning or ending inventory to reconcile, your recordkeeping focuses on proving that every dollar on Lines 36 through 39 was a legitimate direct cost. Keep receipts and invoices showing the vendor, purchase date, item description, and amount. A receipt reading “supplies — $347” won’t survive an audit. You want “24 sheets 4×8 CDX plywood, $347, Home Depot, 3/15/2026.”
For direct labor, maintain time logs or job-costing reports tying hours to specific jobs. If you pay an employee $25 per hour and she spent 30 hours on the Johnson kitchen remodel and 10 hours organizing the shop, only the 30 production hours belong on Line 37. The rest is an operating expense. Failing to segregate hours risks having the entire labor cost reclassified during an audit.
Watch materials purchased before December 31 but not used until the following year. A small amount, like a box of electrical connectors on your truck, is fine to deduct in the purchase year. If you bought $8,000 in flooring for a January project, that cost technically belongs in the year you use it. This matters most for cash-method taxpayers with projects that straddle the calendar year.
Keep records supporting any item on your return until the statute of limitations expires. Usually that’s three years from the filing date. If you underreport income by more than 25% of your gross receipts, the window extends to six years. For depreciated property, keep records until three years after you dispose of the asset.
How COGS Affects Your Total Tax
COGS reduces self-employment tax as well as income tax, and for many sole proprietors the SE tax savings matter more. Your net profit from Schedule C Line 31 flows to Schedule SE, where it becomes the base for the 15.3% self-employment tax (12.4% Social Security plus 2.9% Medicare). Every dollar of legitimate COGS lowers that base.
Take a contractor with $150,000 in gross receipts and $40,000 in direct material and labor properly reported as COGS. Gross profit drops to $110,000 before operating expenses. After Part II deductions, both the income tax base and the SE tax base are substantially lower than if COGS had been skipped.
COGS also affects the qualified business income deduction under Section 199A, which can be worth up to 20% of qualified business income calculated from Schedule C net profit. Higher COGS means lower net profit and a slightly smaller QBI deduction, but the income tax and SE tax savings from the COGS deduction outweigh that reduction.
1099-NEC Filing When You Pay Subcontractors
When subcontractor labor lands on Line 37, a separate reporting obligation kicks in. For payments made in 2026, you must file Form 1099-NEC for any subcontractor you paid $2,000 or more during the calendar year. That threshold rose from $600 under legislation effective for tax years beginning after 2025.
Furnish the 1099-NEC to the subcontractor by January 31 of the following year. File with the IRS by February 28 on paper or March 31 electronically. Missing these deadlines triggers per-form penalties that grow the longer you wait:
- Filed within 30 days of the due date: $60 per form
- Filed after 30 days but by August 1: $130 per form
- Filed after August 1 or not filed at all: $340 per form
- Intentional disregard: $680 per form with no maximum cap
Penalties apply separately for failing to file with the IRS and for failing to furnish the statement to the subcontractor, so exposure doubles if you miss both. A contractor who paid five subcontractors and filed nothing could face $3,400 or more in penalties before any tax on the underlying income. Collect a W-9 from every subcontractor before paying them, and use accounting software that flags 1099-eligible payments.
Projects That Cross the Calendar Year
Long-term projects that start in one tax year and finish in the next create a cost-matching problem. IRC Section 460 generally requires the percentage-of-completion method, but small contractors whose average annual gross receipts fall below the $25 million threshold (indexed for inflation) are exempt. Most sole proprietors clear that exemption easily.
If you do, you can use the completed-contract method, recognizing all revenue and costs when the project finishes, or another method that clearly reflects income. Apply your choice consistently every year. Switching methods without IRS permission through Form 3115 can trigger Section 481 adjustments that accelerate income into the transition year.
Practically, if you have a $30,000 remodel that starts in November and finishes in February, match costs to the period where you recognize the revenue. If you bill on completion and use the cash method, both income and expenses land in the completion year. Deducting material costs in December while deferring revenue to February is the mismatch auditors look for.