Inventory & Taxes: Definition & Examples

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  • 0:00 Cell Phones and Inventory
  • 0:23 Inventory and Taxes
  • 1:27 FIFO & LIFO Methods of…
  • 3:00 Uniform Capitalization Rules
  • 3:23 The IRS & Inventory Taxation
  • 4:51 Lesson Summary
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Lesson Transcript
Instructor: Lee Davis

Lee has a BA in Political Science; and my MA is in Political Science with a concentration in International Relations.

This lesson will cover how inventory is to be accounted for come tax time. We will look at the most common methods for accounting for inventory and see how the IRS would like the accounting of inventory done. We will also take a look at what you do with end-of-life inventory.

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 New inventory is regularly coming out for new phones and their accessories, and past inventory becomes old and outdated quickly.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.

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