One of the most misunderstood accounting concepts in the
ecommerce and reselling space involves how to deduct your inventory costs. Small
business that sell on a digital platform such as eBay, Esty, Shopify, etc. must
contend with rules relating to maintain inventory.
Before 2018, all taxpayers were required to maintain inventory even if they were a cash basis taxpayer.
The Tax Cuts and Jobs Act (TCJA) of 2017 changed the inventory rules for the small business taxpayer.
Recently in January 2021 the IRS issued final regulations to answer questions raised by the TCJA.
New Rules for Deducting Inventory
Under the TCJA a small business taxpayer (basically any business
with sales under $25 million) can account for inventory for tax purposes
either:
1.
as non-incidental materials and
supplies (this is not new and is described below…hint: it doesn't do you much
good), or
2.
as conforms to the taxpayer's method of accounting.
The TCJA raised the threshold to $25 million[1]
(it was $1 million for retailers before 2018) and now allows the small business
taxpayer to report inventory for tax purposes according to his or her method
of accounting.
Cash method vs. Accrual method
The difference between these two methods is timing.
Cash-basis
A business that is on a cash basis recognizes revenue when
cash or a cash equivalent is received from a customer. It recognized expenses (deduction)
when the cost item is paid.
Accrual-basis
With the accrual basis of accounting, revenue is recognized when
it is earned. Expenses are recognized when they are
incurred–which is often at a different time from when the payment is made. If a
taxpayer maintains accounts payable or accounts receivable it is likely using
the accrual method.
The Inventory Rules Before TCJA (pre 2018)
Most small businesses use the cash method for simplicity. Notwithstanding
cash basis businesses with inventory were generally required to account for the
inventory on an accrual basis.
Accordingly, a cash basis taxpayer could deduct the cost of the inventory when the inventory was sold, not
when it was purchased.
The IRS regulations provided certain businesses exempt from
accounting for inventory using the accrual method. These were businesses which
had less than $1 million average gross receipts. (the TCJA increases this
threshold to $25 million.)
If the taxpayer qualified for the alternative treatment,
which included most small businesses, it was not required to account for inventory
using the accrual method.
Having said that the taxpayer still had to account for non-incidental
expenses but could deduct currently
“Inventoriable items as materials and supplies that are not
incidental”.
The regulations provided that if you produce, purchase, or
sell merchandise in your business, you must keep an inventory and use the
accrual method for purchases and sales of merchandise. However, the small
business taxpayer [$1 million or less of average annual gross receipts] could use
the cash method of accounting even if they produce, purchase, or sell
merchandise. These taxpayers had to account
for inventoriable items as materials and supplies that are not incidental.
In order to understand how accounting for inventory works we
have to clarify what is meant by accounting for “inventoriable items as
materials and supplies that are not incidental.”
Accounting for inventoriable items as materials and supplies
that are not incidental
“Not incidental” materials are those that required to
manufacture your products. They are essential to the creation and selling of
your product.
“Incidental” materials, on the other hand, are materials
that are not directly involved in the production of your finished product.
The IRS regulations provides that “not incidental” materials and supplies are deductible in the year
they are used or paid, whichever is later.
This means that all materials and supplies that are directly
used to produce your goods must be accounted for:
1.
In the year you provided them as
finished goods to customers, or
2.
In the year you originally paid for
the material
Whichever is later.
Most businesses pay for their goods before selling them. If that’s the case, you were
required to account for your inventory using the accrual method–recognizing the
cost when you sell it (#1).
But if for some reason you don’t pay for your goods until
after you sell them (#2), you can recognize the cost when you pay.
TCJA: “Taxpayer's Method of Accounting”
The TCJA gave the taxpayer the option to report inventory on
using the “method of accounting used in the taxpayers’ books and records
prepared in accordance with the taxpayer's accounting procedures.”
What is meant by the “taxpayer's method of accounting? and What is meant by “books and records”?
A “method of accounting” has
the following characteristics:
• It affects the computation of a
material item;[2]
• It is consistently applied and is
predictable;[3]
• It conforms to generally accepted
accounting principles;[4]
• It clearly reflects income;[5]
and
• It has been adopted.[6]
The IRS defines books as:
“Except as provided in paragraph (b) [of Reg. §1.6001-1], any person subject to
tax under subtitle A of the Code…or any person required to file a return of
information with respect to income, shall keep such permanent books of account
or records, including inventories, as are sufficient to establish the amount of
gross income, deductions, credits, or other matters required to be shown by
such person in any return of such tax or information.[7]”
Clearly Reflects Income
Neither
the Code nor regulations define what clearly reflects income. The concept of “
clear reflection of income” is central to tax accounting; clear reflection of
income is influenced by many factors but not controlled by any one.[8] If
a taxpayer's method of accounting challenged by the Commissioner were to
prevail, the taxpayer must demonstrate that the Commissioner's determination is
arbitrary, capricious, and without a sound basis in fact or law.[9] A
method of accounting which reflects the consistent application of generally
accepted accounting principles in a particular trade or business in accordance
with accepted conditions or practices in that trade or business will ordinarily
be regarded as clearly reflecting income, provided all items of gross income
and expense are treated consistently from year to year.[10]
However, the fact that an accounting method is consistent with GAAP does not,
by itself, satisfy the clear-reflection-of-income standard.[11]
An often-cited
definition is found in Caldwell v. Commissioner,[12]
where the Second Circuit said “clear reflection of income” means that income
should be reflected with as much accuracy as standard methods of
accounting practice permit.[13] The
IRS generally wants to see accounting treatment that “clearly reflects income.”
Historically this has meant that the deduction of the inventory should be
recognized at the same time as the sale.
The TCJA specifically stated that “the taxpayer’s method of accounting for inventory for
such taxable year shall not be treated as failing to clearly reflect
income if such method either 1) treats inventory as
non-incidental materials and supplies or 2) conforms to such taxpayer’s
method of accounting.
Updated Tax Guidance (Jan 2021)
The IRS published final regulations on the TCJA in January
of 2021.
The final regulations clarify in Reg
§1.471-1(b)(6)(i) that costs that are generally required to be
capitalized to inventory under IRC §471(a) but
that the taxpayer is not capitalizing in its books and records are not required
to be capitalized to inventory. The IRS has also determined that, under this
method, such costs are not treated as amounts paid to acquire or produce
tangible property under Reg
§1.263(a)-2 , and therefore, are generally deductible when they are
paid or incurred if such costs may be otherwise deducted or recovered,
notwithstanding Reg
§1.471-1(b)(4) , under another provision of the Code and
regulations.[14]
Additionally, the final regulations
clarify that costs capitalized for the non-AFS IRC §471(c) inventory method are
those costs that are related to the production or resale of the inventory to
which they are capitalized in the taxpayer's books and records. Similar
clarifications have been made in Reg
§1.471-1(b)(5) regarding the AFS IRC §471(c) inventory method.[15]
Hence If you are not valuing your inventory, or in other words, if
you are not determining your ending inventory cost balance and they are not reflected
in your books and records, then it appears that you can use or continue to use
the inventory cash method, which means deducting your inventory when you
purchase it, rather than when you sell it.
But if you are keeping track of your overall inventory
balance, meaning the total cost of everything you have on hand, or making
representations about it, then you’ll need to use the inventory accrual method,
meaning that you’ll deduct your inventory when sold.
It’s good practice to use the accrual method for inventory. Accrual
accounting provides the best information into how a business is performing.
Notwithstanding the changes made by the TCJA and the ability
to deduct costs before the goods are sold, the accrual method is recommended if
your business is growing and it’s important to you to have good information about
your businesses’ performance.
[1] The threshold is adjusted for
inflation. For 2021 it was $26 million.
[2] Reg. §1.446-1(e)(2)(ii)(a) provides
that a material item is any item that concerns the timing of income or
deductions. In Revenue Procedures, the IRS has explained that an item concerns
timing, and is therefore considered a method of accounting, if “the practice
does not permanently affect the taxpayer's lifetime income but does or
could change the taxable year in which income is reported. The term “item” is
used to indicate any recurring incidence of income or expense. Examples
include: real estate taxes, Reg. §1.446-1(e)(2)(iii), Example 2; corporate
officers’ bonuses are items, Connors, Inc. v. Comm’r, 71 T.C. 913
(1979); and employees’ vacation pay, Oberman Mfg. Co. v. Comm’r, 47 T.C.
471 (1967), acq., 1967-2 CB 3, See, e.g., TAM 8201015.
[3] Reg. §1.446-1(e)(2)(ii)(a) states
that “in most instances,” a method of accounting is not established without a
“pattern of consistent treatment” of an item. The “consistency” referred to is
consistent treatment of a particular item over time, not consistency between
the contemporary treatment of different items.
[4] Reg. §1.446-1(a)(2).
[5] IRC §446(b).
[6] As stated in Reg. §1.446-1(a)(2),
“A method of accounting which reflects the consistent application of generally
accepted accounting principles in a particular trade or business in accordance
with accepted conditions or practices in that trade or business will ordinarily
be regarded as clearly reflecting income, provided all items of gross income
and expense are treated consistently from year to year.”
[7] IRC §446(a); Reg. §1.446-1(a).
[8] See
TAM 9603004 (advising that a method of accounting that was permissible by one
taxpayer (using a sliding scale method of depreciation for television film
contract rights) was not permissible by another taxpayer because it did not
clearly reflect income for the other taxpayer).
[9] Ansley-Sheppard-Burgess
Co. v. Comm'r, 104 T.C. 367 (1995). See
Sierracin Corp. v. Comm'r, 90 T.C. 341, 368 (1988). That standard was
described in Sierracin as follows:
Section 446(b) and sections 1.451-3(e), 1.446-1(a)(2), and
1.446-1(b)(1), Income Tax Regs., vest respondent with broad discretion in
determining whether a taxpayer's contracts should be severed so as to clearly
reflect income. “Since the Commissioner has “[m]uch latitude for discretion,”
his interpretation of the statute's clear reflection standard “should not be
interfered with unless clearly unlawful.” Thor Power Tool Co. v. Comm'r, 439
U.S. 522, 532 (1979).
Similarly, under IRC §482, the IRS can distribute,
apportion or allocate gross income, deductions, credits, or allowances between
two or more businesses under common control to prevent tax evasion or for clear
reflection of income.
[10] Reg.
§1.446-1(a)(2).
[11] Thor Power
Tool Co v. Comm'r, 439 U.S. 522, 79-1 USTC ¶9139
(1979).
[12] 202 F.2d 112, 53-1 USTC ¶9218 (2d
Cir. 1953). See also Knight-Ridder Newspapers, Inc. v. United States,
743 F.2d 781 (11th Cir. 1984), where the court found that the IRS did not abuse
its discretion in forcing newspaper corps to change from cash to accrual
method. Newspaper was material part of business requiring use of inventories
which allowed the IRS to require the newspaper company to use the accrual
method. The IRS’s consent to use cash method in earlier year did not bar the
IRS from changing to accrual method during subsequent year in which it was
apparent that cash method did not clearly reflect income.
[13] The problem,
however, is that if taken literally, it would, among other things, virtually
preclude the use of the cash method.
[14] Id.
[15] Id.
Applicable date. The final regulations are applicable for tax years
beginning on or after January 5, 2021.
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