Income Tax Implications of Recording a CD
Author: Brad Howland
First Posted: July, 2002
If you record a CD, don't try to expense all the costs in one year!
Let's suppose that you record a demo CD and incur expenses for audio editing, manufacturing, and so on. You might be tempted to write off all the costs on your income tax return for the year, in the hopes of receiving a nice, fat tax deduction. Don't do it! This is one of the most common mistakes musicians make, and it's an easy target for the auditor.
Your CD is a product, which means that you are no longer simply in the business of providing services for pay. Now you are a merchandising company, and must keep track of your "inventory" of CD's from year to year. You write off the cost of producing those CD's as you sell them. This deduction is called "The Cost of Goods Sold," and here's how it works.
Suppose that you start the first year with an opening inventory of zero. During the year you incur costs of $5,000 to produce 500 CD's, but make no sales during the year. Your closing inventory at the end of the year is $5,000, and your cost per CD is $10.
In the second year you sell 100 CD's at $20 each. You include $2,000 of income in the total sales line of your business statement (the same line you report all your freelance income on). Your closing inventory is the opening inventory of 500 CD's 100 CD's sold = 400 CD's, and 400 × $10 = $4,000. Subtract the closing inventory from the opening inventory, and you have $5,000 $4,000 = $1,000 Costs of Goods Sold. This is your allowable deduction for the year.
As you can see, it is extremely important to have an accurate count of the number of CD's left in inventory at the end of the year, so every Dec. 31 you need to add them up. This is why, in the old days, you would see many retail businesses close shop near the end of the year for inventory valuation purposes. Nowadays modern, point-of-sale terminals allow most businesses to get an accurate picture of inventory and cost of goods sold as the sales are made. Of course, as a small manufacturer you probably don't have this luxury, so make your accountant happy and count your CD's!
The example I gave above is simple, but what would happen if you had more than one CD in stock? How would you value their cost? There are four different inventory valuation methods in use: Specific Identification, Average Cost, First-In First-Out, and Last-In First-Out. The methods you are allowed to use for income tax reporting differ between the US and Canada, so I won't go into them here. The situation for visual artists in Canada is further complicated by the fact that they can make a special election to value their inventory at nil. You should discuss these scenarios with a professional tax preparer.
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