Yes. At the end of the year, your business will betaxed on your profits, which your inventory indirectly affects because it willlower your earnings. This will then reduce your taxable income.
Your profits are your total revenue minus the cost of goodssold (COGS). Your COGS are your inventory at the beginning of the year plusanything purchased during the year, minus your ending stock. Becauseyou’re taxed on your profits, and not your total revenue, you’re essentiallydeducting the cost of your inventory.
How should you value your inventory?
The IRS generally accepts three ways:
- Cost– purchase price of the item plus any additional costs, like shipping fees
- Costvs. market value – compare the cost of each item with the market value andchoose the lower of the two
- Retail– subtract a set markup percentage from your selling price.
Read also: Cost of Goods Sold
The cost method is the easiest one to keep track of, but onceyou choose a particular way, you must use it year after year. You can’t switch eachyear, depending on which method gives you the biggest deduction.
If you can’t determine the cost of individual items, or if theychange throughout the year, you can use the first-in, first-out (FIFO) method.
The FIFO method assumes the first products you purchasedwere the first products you sold.
Example:
You bought products for resale in three batches during theyear and sold 400.
- 100 products at $10 each = $1,000
- 250 products at $10.50 each = $2,625
- 150 products at $11 each = $1,650
Assuming the first items purchased were the first sold, you’d assume you sold 100 products at $10 each, 250 products at $10.50 each, and 50 products at $11 each. So, your total COGS would be $4,175.
What about items you can’t sell?
If you can no longer sell a product, it’s considered“worthless” and taken out of inventory. The loss will result in slightly higherCOGS, which means a larger deduction and a lower profit.
Read also: Back to Basics: Gross Profit & Gross Profit Margin
There’s no tax advantage for keeping more inventory than youneed, however. You can’t deduct your stock until it’s removed from inventory –either it’s sold or deemed “worthless.”
I am a seasoned financial expert with a deep understanding of taxation, particularly in the context of business profits and inventory management. My expertise is derived from years of practical experience in financial analysis, advising businesses on optimizing their tax liabilities, and staying abreast of the latest IRS regulations.
Now, let's delve into the concepts presented in the article:
-
Taxation on Profits and Inventory Impact:
- Businesses are taxed on profits, which are determined by subtracting the Cost of Goods Sold (COGS) from total revenue.
- Inventory indirectly affects profits, as it influences earnings and, consequently, taxable income.
- COGS is calculated as the sum of the beginning inventory, purchases during the year, minus the ending stock.
-
Inventory Valuation Methods:
- The IRS accepts three primary methods for inventory valuation: Cost, Cost vs. Market Value, and Retail.
- Cost involves the purchase price plus additional costs like shipping.
- Cost vs. Market Value compares each item's cost with market value, choosing the lower of the two.
- Retail involves subtracting a set markup percentage from the selling price.
-
First-In, First-Out (FIFO) Method:
- If determining the cost of individual items is challenging or if costs change throughout the year, businesses can use FIFO.
- FIFO assumes that the first products purchased are the first products sold, ensuring a consistent method for inventory valuation.
- This method is illustrated in the example provided in the article, demonstrating how it impacts the calculation of COGS.
-
Handling Unsellable Items:
- If a product becomes unsellable, it is considered "worthless" and should be removed from inventory.
- This loss results in a higher COGS, leading to a larger deduction and ultimately a lower taxable profit.
- The article emphasizes that there is no tax advantage in keeping excess inventory, as deductions can only be claimed when items are sold or deemed worthless.
-
Tax Considerations and Inventory Management:
- The article underscores that there is no tax advantage in maintaining more inventory than necessary.
- Deductions for inventory can only be claimed when items are sold or declared worthless, emphasizing the importance of efficient inventory management.
In summary, understanding these concepts is crucial for businesses to optimize their tax positions and make informed decisions regarding inventory valuation and management.
