Karen Ann Keegan - Page 10

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            during the taxable year 1994 in the amount of $489 ($4,578 less                           
            2.  Cost of Goods Sold                                                                    
                  Respondent disallowed the cost of goods sold which                                  
            petitioner claimed on Schedules C of her returns for the taxable                          
            years 19946 and 1995.                                                                     
                  In disallowing the cost of goods sold claimed by petitioner                         
            for 1995, respondent did not contest petitioner's                                         
            characterization of the items in question as costs of goods sold                          
            rather than as claims for deductible expenses under section 162.                          
            The cost of goods sold is subtracted from gross receipts for                              
            purposes of determining gross income, whereas business expenses                           
            are deducted from gross income.  Hahn v. Commissioner, 30 T.C.                            
            195, 197 (1958), affd. per curiam 271 F.2d 739 (5th Cir. 1959).                           
            In effect, cost of goods sold, unlike business expenses, is                               
            excluded from gross income.  Section 1.61-3(a), Income Tax Regs.,                         
            provides that "In a manufacturing, merchandising, or mining                               
            business, 'gross income' means the total sales, less the cost of                          
            goods sold".                                                                              

                  6  We do not consider respondent's adjustment to cost of                            
            goods sold for 1994.  Any allowance by the Court would result in                          
            an increase in petitioner's expenditures, which would have the                            
            effect of increasing income under the source and application of                           
            funds analysis.  Since we have fully addressed respondent's                               
            reconstruction of petitioner's income for 1994, we see no reason                          
            to address separately respondent's adjustment with respect to                             
            costs of goods sold for 1994.                                                             

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