When it comes to how inventory is taxed, there are three ways that the IRS allows businesses to value their inventory. These methods are known as the cost method, the lower of cost or market method, and the retail inventory method.
- Cost: This is the most commonly used method for valuing inventory. It involves simply valuing the inventory at the original purchase cost plus any applicable fees. It is based on the actual cost to acquire the inventory and does not reflect any fluctuations in market value or sale price. This method is most appropriate for businesses that do not have to worry about significant fluctuations in market value throughout the year.
- Lower of Cost or Market: This method is typically used when there is a significant risk of inventory becoming obsolete or its value fluctuating over time. When using this method, the original purchase cost of each item is compared to its market value based on a specific valuation date each year. The lower of the two values is taken as the inventory value for tax purposes.
- Retail Inventory Method: The retail inventory method is the most commonly used by retail businesses. This method is based on sales prices and the costs associated with goods sold. It does not take into account any fluctuations in inherent market value or cost. To calculate the cost of inventory with this method, the average markup percentage is subtracted from the retail prices for goods sold.
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Two main methods of keeping track of inventory are generally used: First in, First out method (FIFO) and Last-in, First-out Method (LIFO). Each method has its own rules and considerations when determining cost basis. They also each have unique and important implications for a company's financials, tax liability, and reported profits. Thus, businesses must carefully consider which method is the most appropriate for their particular needs.
First In First Out Method (FIFO)
The FIFO method assumes that the first items purchased are the first ones sold, and the cost basis is determined by calculating the average cost of the oldest items in inventory. General inflation and rising prices generally mean that the older inventory prices being used for inventory valuation are lower than the most recent inventory purchase prices. This can lead to lower expenses which typically results in higher profits reported on financial statements. However, it may also result in a higher tax liability since more income is being reported.
This method is commonly used by companies that sell perishable, limited, or rapidly deteriorating items such as groceries. The assumption here is that the first items to be produced or purchased are the first ones to be sold. For example, the oldest milk cartons in a grocery store may be pushed to the front of the shelf in front of the newer ones. This helps to ensure that the older items are sold first, thus keeping them from going bad or becoming obsolete before they can be sold.
Last In First Out Method (LIFO)
The LIFO method is the opposite of FIFO and assumes that the items purchased most recently are being sold first. This means that the more recent purchases (usually more expensive) are expensed first when calculating COGS. For example, company XYZ bought ten widgets for $10 each on Monday and then purchased ten more for $15 each on Tuesday. Fifteen widgets were sold on Wednesday. Even though the widgets could have been sold from either purchase, the LIFO method assumes that the ten purchased on Tuesday are the first ones out of the inventory. Thus, ten widgets would be expensed at $15 each and the other five at $10 each. It can be seen how this method can result in a lower taxable income for the business since more expensive items are expensed first.
The LIFO method is commonly used by companies that purchase and sell products whose cost increases over time, such as raw materials or fuel. This method helps to avoid the undervaluation of inventory due to inflation and generally results in higher expenses being reported which, in turn, lowers the amount of taxable income. Conversely, during times of falling prices (deflationary environment), this method often results in lower expenses being reported leading to increased net income and higher taxable income.
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The Uniform Capitalization Rules (UNICAP) are a set of regulations issued by the Internal Revenue Service that require businesses to capitalize certain expenses related to the production or resale of goods. Under UNICAP, businesses must capitalize both direct and indirect costs associated with production or resale. Direct costs are those that can be directly attributed to the manufacturing of a product, such as materials and labor. Indirect costs are those that must be allocated across multiple products or services, such as overhead and marketing expenses. The process of capitalization involves converting expenses into assets by recording them in the company's balance sheet. This results in the expenses being spread over several taxable periods, instead of all in one period, through the processes of depreciation or amortization.
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The IRS requires that businesses use either the FIFO, LIFO, or weighted-average methods to keep track of their inventory and report it on their taxes. Additionally, businesses are required to accurately account for their inventory and utilize an accrual method of accounting for all sales and purchases. The IRS also states that businesses should measure the value of their inventory at the beginning and end of the taxable year. The method used for measuring the value of inventory for each period must remain consistent throughout the year as well as between years.
There are some stated types of items that are required to be recognized as inventory when calculating inventory value. These include:
- Finished products
- Works in progress
- Raw materials
- Merchandise or stock in trade
- Supplies that become a physical part of items intended for sale
It is also worth noting that the IRS states that containers of liquid, such as drums and barrels, should be considered part of the inventory when their contents are intended for sale. In cases where they have been transferred to customers, they do not need to be counted as inventory.
Example of Inventory Taxes in Small Business
It can be helpful to explore an example of inventory taxes for a small business. This will help to further illuminate the complexities of accounting for and valuing inventory for end-of-year inventory tax.
Company XYZ is a small furniture manufacturing company. It produces wooden chairs and tables, which it then sells to customers in its retail stores and online. At the beginning of its fiscal year, Company XYZ measures the value of its inventory at $50,000. Throughout the year, it invests an additional $100,000 in inventory. At the end of the fiscal year, its inventory value is $120,000.
Company XYZ uses the FIFO method to value its inventory for tax purposes. In essence, this means that it calculates the value of its inventory by assuming that the first items purchased are the first items sold. Therefore, it values the inventory for the fiscal year at $50,000 + $100,000 = $150,000. Of this amount, $120,000 is its ending inventory value, while the remaining $30,000 represents the cost of goods sold. This can be deducted from revenue to calculate company XYZ's taxable income. If the company's revenue was $150,000 for the year, its taxable income would be $150,000 - $30,000 = $120,000.
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The accurate valuation and reporting of inventory is a critical part of complying with tax regulations and avoiding costly penalties. There are three ways the Internal Revenue Service (IRS) allows businesses to value their inventory for tax purposes: cost, lower of cost or market, and retail inventory methods. The cost method simply uses the original cost of an item plus any applicable fees. The lower of cost or market method uses the current market value if that is lower than the original cost. Finally, the retail inventory method involves subtracting the average markup percentage from the retail cost. Additionally, businesses must use either First in First out (FIFO), Last in First out (LIFO), or weighted-average methods to track their inventory.
FIFO assumes that the first items purchased are sold before any subsequent purchases, while LIFO assumes that the most recent purchases are sold first. For companies that sell products whose product costs increase over time, the LIFO method is often used due to its ability to accurately reflect the costs associated with selling those items. The IRS requires that items such as raw materials, finished products, and works in progress should all be considered a part of a company's inventory. Additionally, the IRS states that when determining inventory value, the value should be measured at the beginning of the year and at the end of the year. A final IRS requirement worth noting relates to the Uniform Capitalization Rules (UNICAP). These regulations require that businesses capitalize both direct and indirect costs associated with the production of goods and services when valuing their inventory.
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Video Transcript
Cell Phones and Inventory
For this lesson, we will use the example of a cell phone store where inventory is constantly changing. New inventory is regularly coming out for new phones and their accessories, and past inventory becomes old and outdated quickly. But how do you account for the inventory that is sold and inventory that cannot be sold?
Inventory and Taxes
Inventory should be valued at the purchase cost. In general, items that cannot be sold or have become worthless can be taken out of the inventory come tax time. By doing this, the loss is reflected as a higher cost of goods sold on the tax return. Essentially, you have the cost of the item, but not the revenue for the sale. This will mean that there are more deductions against your total income from sales, in turn lowering your profit that is subject to taxation.
There are three ways in which you can value your inventory that the IRS will accept. The first is cost. Simply state the value of the item at your purchase price plus any applicable fees. This is the most common of the three valuation methods, and therefore is used most often. Next is lower of cost or market. With this method you would compare the cost of each item with the market value on a valuation date of each year. You would then report whichever number is the lower of the two. Finally, there's retail. This method is less common. Here, you would take the retail value of the item and subtract the mark-up percentage of that item to determine the cost.
The FIFO and LIFO Methods of Inventory
But what happens when you cannot specifically identify the cost of items in your inventory or the items are mixed in with other goods? Here, two methods can be used: the First In First Out Method (FIFO) and the Last In First Out Method (LIFO). The FIFO method means that the oldest inventory is recorded as being the first sold. LIFO is another method, but is more of a valuation method. It assumes that inventory that was last to be acquired is the first to be sold.
Choosing which method to use is determined by what type of goods you sell. If you have products whose cost increases over time, then using the LIFO method will result in a lower taxable income for your business. The LIFO method assumes that a business will sell more of the newest product than the oldest product. This is true of a cell phone store, where a customer will always want the newest phones or accessories that are available. However, if you need to maintain strong financials, then the FIFO system may be best. This method is commonly used by retailers. For example, a grocery store will try to sell the food that is the oldest first, before they have to throw it out.
There is no advantage to having a large inventory that is not necessary for business. Thus, there is no tax advantage to keeping a large amount of inventory in order to get a tax deduction. The purchase of inventory is not tax deductible until the items are sold or are considered worthless and removed from inventory. For a cell phone store, this would be the worst possible scenario as you are stuck with too much inventory that will most likely never be sold.
Uniform Capitalization Rules
The Uniform Capitalization Rules (UNICAP) state that you must capitalize the direct cost and the indirect cost for production or resale. This method states that you include these costs as property you produce or acquire for resale. You do not claim them as a current deduction. The manner in which you recover the cost is through depreciation, when the property is sold, or when it's disposed of due to end of life.
The IRS and Inventory Taxation
The Internal Revenue Service (IRS) states that you must account for inventory in any business and that an accrual method of accounting should be used for all purchases and sales of goods. The IRS also states that to determine the value of your inventory you must value the inventory at the beginning and end of the year. The IRS also requires that there be a method for valuing these items. However, the rules for valuing inventory are not the same for all businesses. The practices used must be consistent from year to year and must show an income.
While the IRS does not set a specific method for accounting for inventory, it does require that certain items be included in the accounting of inventory. These items are:
- Merchandise or stock in trade
- Raw materials
- Work in progress
- Finished products
- Supplies that physically become a part of the item intended for sale
Furthermore, the IRS states that containers for liquids should be included in the inventory calculation. However, if they have transferred to the customer, they are not to be included in the calculation.
Determining the value of inventory at the beginning and end of the year can be tricky. Following our example of the cell phone store, the best way to determine the value is by age and product type. Do you have inventory for a cell phone that was replaced by a newer model in that year? If so, its value is close to nothing. Unlike cars and houses, phones and accessories do not hold their value over time. Once a newer model comes out, the older version is considered obsolete.
Lesson Summary
In this lesson we've learned that inventory should be valued at the purchase cost for taxation purposes. In general, items that cannot be sold or are considered worthless can be taken out of the inventory come tax time. We also reviewed the three ways in which you can value inventory: cost, lower of cost or market, or retail. We also looked at the FIFO and LIFO methods of inventory accounting as well as UNICAP. All of these methods are dependent upon the type of business as well as the preference of the business.
Lastly, we took a look at how the IRS wants inventory accounted for. The IRS states that you must account for inventory in any business, and an accrual method of accounting should be used for all purchases and sales of goods. While the IRS has a requirement for how inventory is to be accounted for, it does recognize that each business is different and that certain categories of businesses will have different methods for inventory accounting.
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