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[Vraille Darkfang]

Inventory - Manufacturing Tax Tips

An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales.

To figure taxable income, you must value your inventory at the beginning and end of each tax year. To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items.

The rules for valuing inventory cannot be the same for all kinds of businesses. The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.

Items Generally Included in Inventory

Include the following items when accounting for your inventory.

Merchandise or stock in trade
Raw materials
Work in process
Finished products
Supplies that physically become a part of the item intended for sale
Containers such as kegs, bottles, and cases, regardless of whether they are on hand or returnable, should be included in inventory if title has not passed to the buyer of the contents. If title has passed to the buyer, exclude the containers from inventory.

Valuing Inventory

The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is very important. Generally there are two methods for valuing inventory. These methods are cost or lower of cost or market.

Cost Method

To properly value your inventory using the cost method, you must include all direct and indirect costs associated with it. The following rules apply:

For merchandise on hand at the beginning of the tax year, cost means the inventory price of the goods
For merchandise purchased during the year, cost means the invoice price less appropriate discounts plus transportation or other charges incurred in acquiring the goods. It can include other costs that have to be capitalized under the uniform capitalization rules
For merchandise produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform capitalization rules
A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You must reduce the cost of inventory by a trade (or quantity) discount
A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose whether or not to deduct cash discounts, but you must treat them the same from year to year. If you do not deduct cash discounts from inventory costs, you must include them in gross income.

If you cannot specifically identify the cost of your inventory, you must use either the FIFO or LIFO methods.

Lower of Cost or Market Method

Under the Lower of Cost or Market Method, compare the market value of each item on hand on the inventory date with its cost and use the lower value as its inventory value. This method applies to the following:

Goods purchased and on hand
The basic elements of cost (direct materials, direct labor, and an allocable share of indirect costs) of goods being manufactured and finished goods on hand
This method does not apply to the following and must be inventoried at cost:

Goods on hand or being manufactured for delivery at a fixed price on a firm sales contract (that is, not legally subject to cancellation by either you or the buyer)
Goods accounted for under the LIFO method
Uniform Capitalization Rules (UNICAP)

Under the Uniform Capitalization Rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities subject to the rules. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

APPENDIX

Merchandise

Include the following merchandise in inventory:

Purchased merchandise if title has passed to you, even if the merchandise is in transit or you do not have physical possession for another reason
Goods under contract for sale that you have not yet segregated and applied to the contract
Goods out on consignment
Goods held for sale in display rooms, merchandise mart rooms, or booths located away from your place of business
Do not include the following merchandise in inventory:

Goods you have sold, but only if title has passed to the buyer
Goods consigned to you
Goods ordered for future delivery if you do not yet have title
Assets - Do not include in inventory assets such as:

Land, buildings, and equipment used in your business
Notes, accounts receivable, and similar assets
Supplies that do not physically become part of the item intended for sale
Work in Process

The three elements of work-in-process consist of:

Direct Materials - Materials that become an integral part of the finished product, are consumed in the manufacturing process and are identified with specific units or processes
Direct Labor - Labor which can be associated with particular units. Labor includes basic compensation, overtime pay, vacation and holiday pay, sick leave pay, and payroll taxes
Indirect Costs - Costs necessary for production other than direct production costs. Indirect costs include variable and fixed overhead. They may be classified as to type for identification with various activities and to facilitate groupings for determining unit costs. Under prior law, manufacturers were required to comply with the full absorption rules under Section 1.471-11 of the Regulations. The full absorption rules provided three categories of indirect costs associated with production activities
References/Related Topics

Tax Tips - Manufacturing
IRC Section 471 - Inventory
IRC Section 472 - LIFO
IRC Section 263A - UNICAP
Note: This page contains one or more references to the Internal Revenue Code (IRC), Treasury Regulations, court cases, or other official tax guidance. References to these legal authorities are included for the convenience of those who would like to read the technical reference material. To access the applicable IRC sections, Treasury Regulations, or other official tax guidance, visit the Tax Code, Regulations, and Official Guidance page. To access any Tax Court case opinions issued after September 24, 1995, visit the Opinions Search page of the United States Tax Court

So, do you have to pay Taxes on Inventory or not?

The lesson here is "Be prepared to pay a Tax Accountant as the Speak Language IRS requires around 50 Skill Points to be able to figure out exactly what the heck the above actually means".

 

[Doug Sundseth]

Your example works...just remember though that when the retailer ordered the original stock he/she thought that would sell as well. Being able to identify the stuff that 'will actually sell' is the hard part, not the decision to flog the dead stuff at below what you paid for it...at least it was for me.

Thanks,
Rich

No argument there; the ends of fads can be particularly painful. If you keep making the wrong decisions, there's not much you can do. But not selling merchandise doesn't do much for the bottom line either.

 

[Fifth Element]

*sigh*

I've said this so many times, but the FLGS does not have the ability to deep discount those books. For most of them, the price generally reflects what they truly paid for it. Paid. Money is gone. The books can't be returned for credit and reissued to them as remainders. If they mark the books down, it's money out of their pockets. And if the customers don't want them now, they aren't losing anything. Someday, someone will buy them.

Economics lesson: "Sunk cost"

The amount paid for inventory, if it cannot be returned for credit, is a sunk cost. It cannot be taken back or changed. It is therefore irrelevant in determining future actions. You price your product in a way to maximize profit, bearing in mind the costs of financing the inventory.

If you keep prices high, the product sites on the shelf. If you cut prices, you might technically take a loss on that inventory, but you have money that you otherwise would not, and can use it to pay bills, or purchase inventory that will sell at full price.

 

[Fifth Element]

So, do you have to pay Taxes on Inventory or not?

The lesson here is "Be prepared to pay a Tax Accountant as the Speak Language IRS requires around 50 Skill Points to be able to figure out exactly what the heck the above actually means".

This passage says nothing about paying tax on inventory. It discusses valuing inventory, which is necessary to compute profit.

Cost of sales (ie, what it cost you to buy/produce the inventory you sold during the year) is calculated as the cost of your opening inventory, plus any inventory costs added during the year, minus the cost of your closing inventory.

Which is to say, you cannot calculate your profit if you don't know the cost of your inventory. That's what the IRS was discussing. It does not address taxing inventory directly.

In Canada, we do not have a tax on inventory. Inventory costing affects the calculation of profit, and profits are taxed. There may be an inventory tax in the US; I'm not a US tax expert. (I am a Canadian tax expert).

 

[Delta]

In Canada, we do not have a tax on inventory. Inventory costing affects the calculation of profit, and profits are taxed. There may be an inventory tax in the US; I'm not a US tax expert. (I am a Canadian tax expert).

No, there's definitely no tax on inventory in the US. Again, taxes are paid on profit, and there's no profit on unsold inventory.

As you can see in this particular debate, above, I've posted the exact lines on the forms where sold inventory actually reduces your taxes by the cost of goods sold. TheAuldGrump, for example, doesn't actually have any references or form entries to back up the counter-claims.

 

[JoeGKushner]

Economics lesson: "Sunk cost"

The amount paid for inventory, if it cannot be returned for credit, is a sunk cost. It cannot be taken back or changed. It is therefore irrelevant in determining future actions. You price your product in a way to maximize profit, bearing in mind the costs of financing the inventory.

If you keep prices high, the product sites on the shelf. If you cut prices, you might technically take a loss on that inventory, but you have money that you otherwise would not, and can use it to pay bills, or purchase inventory that will sell at full price.

Not to mention that traditionally, a $ is weaker the longer something sits on the shelf. That $30 book, if it came out two years down the road, may be $40, or broken up into multiple smaller books, or general inflation, etc...

 

[Fifth Element]

Not to mention that traditionally, a $ is weaker the longer something sits on the shelf. That $30 book, if it came out two years down the road, may be $40, or broken up into multiple smaller books, or general inflation, etc...

True. Another way to look at is that you've had to finance that inventory while it sits on the shelf - that is, you need to come up with the money to pay for that inventory in stock. Depending on the rate at which you can borrow money, that inventory might cost you anywhere from 5-15% per year. A $30 book sitting on a shelf for 3 years at a 10% finance rate equals a cost of $40 (or $39.93 to be precise, compounding the interest annually).

 

[Crothian]

We had the Ohio Gameday at a great store near Dayton. They had I think three book selves of discounted stuff. Most of it seemed to be half price or less. Then they had about 10 boxes of items prices at 2$ that I never got a chance to look through. I found almost a dozen books I've been looking for there. I was really happy with the way they have things.

 

[Fifth Element]

Errr, the point of reducing the price before tax time is to get it out of inventory for tax time - not a reduction in apparent value (which is indeed a dodge, at least if you mark it back up after tax time) but an inventory reduction - it gets taxed on what was actually paid.

Generally the point of a year-end sale is to liquidate inventory, in part so you don't have to include it in the physical count (which can be expensive in terms of time and labour), and in part to move old inventory that's not selling at full price.

Accounting profit is based on the historical cost of the inventory, so for tax purposes you don't get to claim a loss on inventory that has lost value until you actually dispose of it. This can also be a reason to cut prices before your year-end, but it has nothing to do with reducing the value of inventory you have on hand; it has to do with reducing profit, because profit is the thing that's taxed.

 

[bento]

We had the Ohio Gameday at a great store near Dayton. They had I think three book selves of discounted stuff. Most of it seemed to be half price or less. Then they had about 10 boxes of items prices at 2$ that I never got a chance to look through. I found almost a dozen books I've been looking for there. I was really happy with the way they have things.

That's another reason to eventually mark something down. Maybe the original MSRP was too high for the market. I know there's many times I look at an item and think "hey - I'd buy that if it were $X cheaper."