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“A Newbies Guide to the IRS Exception to Inventory Tracking and Accrual-Basis Accounting”
Disclaimer: I am not an accountant and this is not tax or accounting advice!
(See IRS Pub 334, “Tax Guide for Small Business” for details of the provisions discussed in this post)
Into the weeds…
The IRS generally requires sellers who maintain inventory of stuff to sell to keep track of the inventory and use accrual-basis accounting. But they provide an exception for small sellers (probably all of us would qualify) whereby these sellers can:
1. Use cash-basis accounting, and
2. Treat purchased inventory as “materials and supplies that are not incidental” instead of tracking inventory year-over-year.If you’ve already filed a 1040 using accrual-basis accounting, and/or reported inventory on Sched C, Part III, you’d have to file a form to get IRS permission to change accounting method, so this provision is moot for most sellers, but for those in their first year (like me), you have to make a choice: Cash vs Accrual, Inventory vs “Inventoriable items as materials and supplies that are not incidental”.
What the provision to treat “inventoriable items as materials and supplies that are not incidental” means in practice, is that the cost of inventory purchased in a given year is reported (1040 Schedule C, Part III) and the fraction of that inventory (purchased that same year–the year you’re filing for) which is unsold at year’s end is subtracted as year-end inventory. The result is your COGS deduction for the year. To put it in mathy terms:
COGS = (cost basis of year “X” purchases) – (cost basis of unsold year “X” purchases).
Note: This method of accounting for inventory does not allow for inventory purchased in previous years and sold in the reporting year to be deducted as COGS–there’s no provision for carrying inventory over from previous years or for carrying over to subsequent years! But that apparently is the tradeoff–you are freed from the burden of tracking inventory year-over-year, but you don’t get to deduct COGS on inventory that doesn’t sell the same year you purchase it.
Unfortunately, the IRS, in it’s wisdom doesn’t provide any clues (even in the tax code) as to why they adopted the provision and who it might benefit.
The scenerio where the provision to treat purchased inventory as “materials and supplies that are not incidental” makes sense to me is the small restaurant or store that buys on terms. Businesses like those, with high sell-through rates, will sell virtually all their inventory by year’s end, so most of the cost basis will be deductable as COGS. Using cost-basis accounting, the cost of inventory purchased “on terms” in the last month of the year will be paid the following year and reported on the following year’s COGS.
So for instance, if you run a restaurant and bought a tank of soda syrup on Nov 30, 2017 with 30 day terms, you’ll pay by Dec 30 and that cost will be reported on your 2017 return. The syrup will likely be used up before year’s end, so the entire cost will be deductable in 2017. If you reordered syrup on Dec 20, on 30 day terms, the cost will be paid in Jan 2018 and, under cash-basis accounting rules, thus contribute to COGS for 2018, even if you take delivery before Jan 1.
The same would apply for any high-turnover inventory, and must offer some accounting benefit to that kind of business, although you’d still have to account for the cost-basis of your sales, so some kind of inventory tracking is required.
But I don’t see the provision having any benefit to businesses that carry significant inventory year-over-year and pay for items at the time of purchase, like long-tail resellers. Under the provision, items that don’t sell the same year they’re purchased lose all deductable COGS value!
Bottom line: accrual accounting and inventory tracking are probably the way to go for most small, long-tail resellers.
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OK, this is a long-overdue correction:
Details in IRS Pub 538 lead me to believe that under the IRS exception for using cash-basis accounting, COGS for inventory treated as “materials and supplies that are not incidental” can, in fact, be deducted in years after the original purchase.
Frankly, after extensive research in the IRS publications and underlying code on this exception, I remain unclear on the correct implementation, and do not, myself, use the exception. As I’ve stated before, I’m not an accountant, so please don’t base your tax accounting system on my posts!
FYI: Actual CPA person Mark Tew has written fairly extensively on this topic at his website notyourdadscpa.com
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This is why I never specialized in taxes. I do our own tax work, but that is all.
I read Mark Tew’s post on this, and I will conclude that using the accrual method for inventory is right for reselling. It is right for 99.44% of all businesses.
Who that .56% the IRS is carving out for in the cash case…I have no idea…
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