Why claiming materials as expenses is a really bad idea for a craft business
As a handmade seller, one of the first things to realise is that you are not just a retailer of your goods - you are also a manufacturer of them.
Why does this matter? Well for starters, it changes everything about the way you need to report your end of year revenue and expenses to the IRS. The taxman expects you to be reporting your direct material costs as part of your COGS ("Cost of Goods Sold"). This is to be reported on your annual Schedule C form.
Claiming your material expenses directly as a "supply" rather than COGS can also be really tax inefficient so there are more advantages to this approach than just simply being compliant.
Let's go through an example to illustrate: let's say you open your Etsy shop in 2015. You purchase $10,000 of materials during this year to build your material inventory to ensure that you can handle demand. Sales aren't quite as expected during your first year, so you still have quite a bit of your materials in stock, along with some finished products.
When tax-time rolls around, you complete your return stating a supply expense of $10,000 on sales of $2,000.
Skipping ahead to year 2, sales start to pick up - great news! You make $15,000 in the next year in sales, but only purchase $2,000 in stock due to the excess of materials you already had on hand from year 1.
Claiming the expense of $2,000 on your tax return against the $15,000 means that after one of your biggest deduction categories have been applied you still have $13,000 in pure business income that will be taxed.
Here, you should already be seeing the issue: as you have claimed your materials as a deduction in the year you purchased them, you have lost the ability to claim and offset against their eventual sale later down the track.
Let's look at the COGS approach now for the same situation. For the sake of simplicity, we'll use a guideline of COGS being 45% of your sale price (it's however a little more involved than a simple percentage calculation: see here for more detail on how to calculate your COGS)
In year one, as sales were relatively low your COGS will also be low - remember that your COGS can never be higher than what you have sold. On your sales of $2,000, you will claim COGS of $900.
In year two, your $15,000 in sales will be offset by a COGS deduction of $8,250. Comparing to the direct expense example above, you have been able to claim $4,750 more in deductions in your second year.
Tracking your material expenditure as COGS as you can see in the diagram above means that you always have a direct relationship between your revenue and your expenses - as your revenue increases, the cost of manufacture increases (you make and sell more products). This means that you are always claiming a constant amount of expenses against your revenue and can estimate your liabilities with much more confidence going forward.