One of the most misunderstood accounting concepts in the ecommerce and reselling space involves how to deduct your inventory costs. What is cost of goods sold? How do I calculate it?
I get these questions often from resellers. I’ve also frequented forums on eBay, Amazon, and Etsy to read the back-and-forth among fellow sellers trying to educate each other with sometimes misguided advice.
Not everyone is interested in a technical explanation, so before I dive into the detail, I’ll get right to it:
Before 2018, to the question of “can I deduct my inventory when I purchase it,” I would have answered with a solid “no.”
But the Tax Cuts and Jobs Act (TCJA) of 2017 changed all that. That being the case, I changed my answer about whether or not you could deduct inventory when purchased to a solid “it sure looks that way.”
However, more recently in January 2021 the IRS issued final regulations to answer questions raised by the TCJA. Some are saying that they are shutting down the cash-basis inventory party we had been enjoying during 2018-2020 (deducting inventory when purchased), but I’m not so sure about that. My updated answer about immediately deducting inventory is now “maybe, it depends.”
Read on if you like details.
By the way, if you need a simple way to track your inventory and cost of goods sold, check out my free inventory tracking spreadsheets:
New Rules for Deducting Inventory
Historically, the guidance indicated that if your business had inventory, you were required to use the accrual method of accounting (explained below) for tax purposes unless your gross receipts (essentially your sales) were below a certain level.
If you were below that threshold, you could use the cash method of accounting for everything except your inventory. The TCJA seems to change that.
In a nutshell, the TCJA says that small business taxpayers (basically any business with sales under $25 million) can account for inventory for tax purposes either:
- as non-incidental materials and supplies (this is not new and is described below…hint: it doesn’t do you much good) *OR*
- as conforms to the taxpayer’s method of accounting
The TCJA raised the threshold to $25 million (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.
Pretty clear? Read on for some context.
Cash method vs. Accrual method
We first need to make the distinction between a cash-basis business and an accrual-basis business. People get anxious when they hear words like “accrual method” or “cash method,” but the idea is simple. The difference between these two methods is in the timing.
Cash-basis
A business that is on a cash basis recognizes (or “counts”) revenue when cash is received from a customer. It would recognize expenses when cash is actually spent.
Accrual-basis
With the accrual basis of accounting, you recognize revenue when it is earned. You recognize expenses when they are incurred–which is often at a different time from when the payment is made. If you make use of accounts payable or accounts receivable, you probably have an accrual-based business.
The Inventory Rules Before TCJA (pre 2018)
Most small businesses use the cash method for simplicity. Businesses with inventory, however, were generally required to account for the inventory on an accrual basis.
What this means is that you could only deduct the cost of the inventory when you sold inventory, not when you purchased it.
Were this not the case, it would be very easy to manipulate business earnings for any given year. If I wanted to reduce my profit to lower my taxes, all I’d have to is purchase a bunch of inventory before the end of the year. The IRS isn’t usually a fan of that type of accounting which doesn’t clearly reflect income.
What was confusing was that the IRS provided parameters of businesses who were exempt from accounting for inventory using the accrual method. The main stipulation is that such businesses need to have less than $1 million average gross receipts. (TCJA increases this threshold to $25 million.)
If you qualified for the alternative treatment, which included most small businesses, you were not required to account for your inventory using the accrual method.
But hold on!
That didn’t necessarily mean you could use the cash-basis method for inventory either.
What it allowed you to do was account for “inventoriable items as materials and supplies that are not incidental”.
Pretty straightforward, right?
I kid. This is what the IRS had to say about it:
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 following [$1 million or less of average annual gross receipts] taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental.
People interpreted that to mean that if they made less than $1 million in sales they didn’t have to track inventory, but that wasn’t the case.
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
Try to say that 3 times fast.
“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 guidance states that “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.
Yes you read that correctly.
This means that all materials and supplies that are directly used to produce your goods must be accounted for:
- In the year you provided them as finished goods to customers, or
- In the year you originally paid for the material
Whichever is later.
So if you fall below the threshold and want to treat your inventory as non-incidental materials and supplies, knock yourself out.
Most businesses I’m familiar with 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. I don’t know of many retailers that actually do this, so the whole option is basically a big “thanks for nothing IRS,” at least for us online sellers.
TCJA: “Taxpayer’s method of accounting”
The TCJA language gave you the option to report your inventory on your taxes using the “method of accounting used in the taxpayers books and records prepared in accordance with the taxpayer’s accounting procedures.”
One of the big questions people started asking was What is meant by the “taxpayer’s method of accounting? and What is meant by “books and records”?
I know what many of you are thinking: “What if I don’t even have a method of accounting?”
Or what if your method of accounting is all wrong?
Let’s take it one step further: What if your method of accounting subtracts 20% from all sales…increases purchases by 50%…rounds up to the nearest $10…and adds $1.00 just for fun?
According to TCJA, since that’s your “method of accounting,” can you just use those same numbers for your tax reporting?
According to the IRS tax attorney I called for clarification on this, yep.
I’m trying to make a point here. The IRS is obviously not okay with fraudulent tax returns. I’m simply demonstrating the ambiguity introduced by the TCJA with respect to inventory accounting for tax purposes.
If your method of accounting involves throwing all your receipts in a shoebox, then incorporating all of those receipts into your tax return at year end, you could argue you were operating within the bounds of the TCJA.
There is nothing, according to the IRS tax attorney I spoke with, that says you couldn’t do so.
Clearly reflect income
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.
I would be inclined to argue that since the IRS favors clearly reflecting income, the taxpayer’s method of accounting should only deduct inventory when sold.
However, the TCJA wording 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 finally published final regulations on the TCJA in January of 2021, which you can knock yourself out with here.
The new guidance gave us further direction about the instances in which a small business taxpayer could deviate from the traditional accounting method for inventory. Again, those instances, introduced by the TCJA of 2017 included:
- Classifying your inventory as nonincidental materials and supplies (NIMS). Remember we don’t care about this one because it typically doesn’t change anything, see above.
- Accounting for your inventory on your tax return in the same way as you treat it on your applicable financial statement. Most of us don’t have “applicable financial statements.”
- Or using the method of accounting used in the taxpayers books and records prepared in accordance with the taxpayer’s accounting procedures. This is the one we care about!
One thing the new guidance did was tell us what qualified as your “books and records prepared in accordance with the taxpayer’s accounting procedures.”
The IRS confirmed books and records to mean “the totality of the taxpayer’s documents and electronically-stored data.
Before this guidance, many believed that if a taxpayer business owner’s accounting procedures included immediately deducting inventory on the business books, that that’s all you needed to be able to qualify for using the cash method for inventory on your taxes. And that’s essentially what the tax attorney I talked to at the IRS at the time told me. He said until the IRS came out with more guidance, you pretty much had to draw your own interpretation.
But in the new guidance, the IRS is saying that if you account for your inventory in a certain way on ANY of your books or records, not just your bookkeeping books or financial statements, that that might count as “keeping and inventory” and therefore you’d have to show an inventory on your taxes, basically meaning that you’d have to use the traditional accrual method for inventory.
So I was starting to think that resellers would pretty much be disqualified from using the cash method for inventory because most of us do have some type of records that have information about our inventory, whether it’s the actual active inventory listings we’ve posted online, spreadsheets we use to keep track of our inventory, inventory count records, and so on.
My take
In some of the examples they give in the new guidance, they talk about doing physical inventory counts, and how that might impact whether or not you are considered to be “keeping an inventory”.
Just counting your inventory quantities for storage or reordering purposes does not appear to disqualify you from using the cash method. But allocating costs to the inventory, or valuing the inventory, or making representations about the cost of the inventory on hand, all signify to the IRS that you are “keeping and inventory” and is therefore part of the accounting used in your books and records, and therefore must also be taken into consideration on your tax return, meaning that you need to use the accrual method for inventory, or deduct it when sold.
So even if in your official bookkeeping you deduct your inventory when purchased, the fact that you have other records where you show your inventory costs qualifies as “keeping an inventory” and supersedes what you are doing on your bookkeeping books and requires you to use the accrual method for inventory on your taxes.
So this is the bottom line, and again this is my interpretation: If you aren’t valuing your inventory, or in other words, if you aren’t determining your ending inventory cost balance and it isn’t 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.
My Recommendation
For my own personal online selling business, I have always used, and will continue to use the accrual method for inventory. Doing it this way gives me the best insights into how my business is performing, which to me is much more valuable than any time I might save save by accounting for inventory on a cash basis.
This is the method I recommend if you are growing and care about having good insights into your numbers, and then the question of cash-basis inventory becomes irrelevant.
Thank you, I appreciate your clarification of this misunderstood tooic.
I am still confused ha. I am a small business owner. Do you offer any consulting services?
Hi, I think when you sell a custom order, like on Etsy, this is where this comes into play:
“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. I’ve don’t know of many businesses that actually do this (none actually), so the whole option is basically a big “thanks for nothing IRS.””
Yes, exactly, thanks a lot IRS!
Would dropshipping fall in to this category as well? I’m looking in to the concept. Right now I thrift for goods to sell on eBay.
Yes once you purchase the goods from the thrift they are considered inventory. So you will treat them as such.
Hello, thank you for the detailed info. I have a small business. It’s on the cash acctg system. I bought some equipment under $2500 that I might rent out or sell in the future, but for now it’s packed away. How can I easily and correctly report this on my tax return?
Thank you
You would just put it under supplies or create an “other expense” category called equipment<$2500. Technically you'll need to check a box somewhere to elect the deminimis safe harbor which allows you to deduct assets below that threshold without depreciating them.
I have been forced by supply disruptions to vastly increase my inventory to stay in business. I use accrual accounting. I will have pay taxes on this massive inventory increase and that will be a huge burden.
How about a company buying and paying for materials in 2024
but materials are not received until January 2025 – are these materials deductible?
Is there a good resource for small crafters/manufacturers that goes into how to determine the “value” for inventory purposes of something you make? For resellers it’s a lot easier but I make items from primarily wood. Sometimes there’s a knot in a board I buy or something like that which is going to affect how many items I make from it. Is that something I need to track or just estimate? They’re handcrafted items and sometimes one isn’t up to my standards and I choose not to sell it. Is that damaged goods or something else?
Yes you would either just deduct those as supplies or damaged goods. It all usually goes to your cost of goods sold anyway. Check out the articles on Craftybase. That might be exactly what you are looking for.
Awesome thanks for the resource. Been reading everything I can to get my hobby ready for ‘business’ in 2018 and I’m definitely at the point of being beyond confused. Doesn’t help that I’m trying to simultaneously use Quickbooks, but I don’t have the ultra high-end versions that appear to make manufacturing tracking (such as assembled products) easier to track, nor do I feel I should need it for a hobby that made <$500 last year and might just barely double it this year.
I am left completely perplexed by one thing. The IRS inventory exemption is supposedly to make it easier for small businesses by lightening the reporting requirements. But if you're still expected to track how much of a product you buy you've used in actually sold items.. I can't see how anyone could do that without a fairly robust inventory tracking system. I mean calculating the 'cost' of your items when you may be buying raw materials at different times for different prices and different projects seems FAR more complicated than merely having a spreadsheet of what materials you have on hand. It kind of feels like "okay you can use cash accounting, except for the part of your business where you actually make money". Am I missing some major benefit?
Maybe we both are, because it doesn’t make much sense to me either…or any other CPAs I know for that matter. As a small business though, put forth your best effort, but don’t go overkill on the accounting. Generally as long as your numbers are reasonable, you won’t have trouble from the IRS.
Thanks Mark! Will be seeing a CPA but I feel a lot more comfortable knowing what questions to ask going in. Craftybase was indeed exactly what I needed and am slowly but surely getting my inventory put in.
I’m left with one question that perhaps others who find their way to your blog might also have. How much granularity do you think the IRS would expect from a small business tracking inventory. For example if I make pendants and buy a variety of different necklace cords, with varying length, material, color, clasp, and of course price, would it be enough to track this under a “necklace cords” line and allow Craftbase to calculate a rolling average of all of the ones in the inventory, or should it be broken up into individual items?
I think you’d be fine with a general line. No reason to go overkill. You might want to check out my FB group: https://www.facebook.com/groups/accountingforsellers/
Dan: I have been and am now in the same situation as you are. What I have done in my database is to create a recipe module which for each product I make whether the item is custom made for a customer that ordered it or an item that will be for consignment in an Art Gallery or to sell at a Craft Fair. I enter all the components/items such as 6.5 board foot of cherry lumber, 20 dominos, 1 set of drawer slides, .75 pints of clear finish, etc. and at the end for the scrap lumber pile that was waste or non usable lumber another line is entered for the same cherry lumber such as 1.5 board foot as waste. Then when the project is complete I run the batch process which ask for the time it took for each produced product and the quantity of products to produce. Then system will deduct all of the items in the recipe such as the cherry lumber and waste multiplied by the number of products produced from inventory and add the products produced from the recipe back into inventory which uses the cost calculated in the recipe batch from the weighted average costs of the items used to produce the product along with the supplied labor parameters. In the end when each produced product is invoiced/sold the cost of the materials that went into the product are represented as cost of goods sold. This allows costing the waste for produced items and at the same time deducting from inventory.
What program are you using?
Correct me if I’m wrong, but from my reading of the 1040 Sched C instructions, treating purchased inventory as “materials and supplies that are not incidental” means that only items that sell in the same year they are bought (the filing year) can be written off as COGS. There’s no provision for carrying unsold items forward, which would be tracking inventory, anyway, thus defeating the purpose).
You are not wrong. It seems to completely defeat the purchase.
Great insights! One question, can I record income on an accrual basis while recording shipping supplies on a cash basis? Or should I try to determine the proportionate cost of shipping supplies used each year?
No, inventory is really the only piece that can be different from everything else.
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, inventory purchased on terms in the last month of the year will be reported on the following year’s COGS, allowing typically, the last month of the year to sell inventory on hand.
So for instance, if you run a restaurant and buy a tank of soda syrup on Nov 30 with 30 day terms, you’ll pay by Dec 30 and that cost will be reported on that year’s return. The syrup will likely be used up before year’s end, so the entire cost will be deductable. If you reorder syrup on Dec 20, the cost will be paid the following year and thus contribute to COGS for the following year, 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.
But I don’t see the provision having any benefit to businesses that carry significant inventory year-over-year like long-tail resellers. 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 might benefit.
Perhaps worth mentioning here are credit sales- companies which carry receivables. It seems to me the benefit would be delaying paying tax on the “profit” from these sales until you receive the cash. Yes, you can’t deduct your payments until sold but you don’t pay tax on sales until collected.
That is a good point Charles. There seem to be some who could use these rules to their benefit, but for most of us it either doesn’t apply and just confuses.
How about a company buying and paying for materials in 2024
but materials are not received until January 2025 – are these materials deductible?
These are not items that are resold rather used as Equipment in providing services
Hi George – This would not be governed by these wacky inventory rules in that case. It would just depend on if the company was overall cash basis or accrual basis. If cash, then you would deduct when purchased. However, if we’re talking about equipment and not just supplies, you might need to capitalize the items as fixed assets, meaning you record them as assets on your books and depreciate (deduct) them over time.
All I can say is Oh boy!!! Can I do the following?:
1. I am keeping track of beginning and ending year inventory for my COGS. (And reporting to IRS)
2. I am not deducting the cost supplies that are used in the making of my Home Decor Products unless it is a special order and I buy everything and ship it out, not using what has already been inventoried.
. . So can I use the Cash Based method of accounting as long as my records are good and I track inventory very carefully? I sell on Etsy and E-Bay. I don’t have receivables, I receive money when item is sold. I don’t have payables, I pay for items at time of purchase.
Sounds like you are on the right track Betsy!
My problem is that didn’t keep a log of exactly how much I paid for specific items that were sold in 2017. I have receipts but no way of recovering all the information that would be needed. Am I just S.O.L.? #firstyearresellerprobs
I would at least use an educated guess. You’re only s.o.l. if the IRS calls you on it and does not accept whatever documentation you can provide. The worst they would do is partially disallow the deduction. That would be a very rare case though, so it is definitely worth a shot.
Yes it is tricky, with FBAmazon books sales, for me at least. I buy ton of books, so when I buy 20 books of the same title, all for different prices, 10 of them sell in the same year, 10 are left, how do I calculate cost of inventory on hand? Do I just take the top 10 priced ones that I had purchased? Why not 10 lowest priced, IRS might ask, right?
Thank you so much. This has made Schedule C understandable so I can converse about it with my CPA and keep accurate records from here on out.
Always happy to facilitate CPA conversations!
Even if your business satisfies the gross receipts test to be a qualifying small business tax payer, you cannot use the cash basis for income tax purposes if your business is manufacturing or a retail trade business. Per IRS Pub. 538, an eligible business (to be a qualifying small business taxpayer) “is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. You have an eligible business if you meet any of the following requirements.
1. Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following NAICS subsector codes:
a. NAICS codes 211 and 212 (mining activities).
b. NAICS codes 31-33 (manufacturing).
c. NAICS code 42 (wholesale trade).
d. NAICS codes 44-45 (retail trade)……….”
That is a good point as far as inventory is concerned for retail. I could’ve saved some time just pointing to that section of 538. To be clear for my retail readers, you can’t use the cash basis for inventory, but that’s not to say you can’t use it for the noninventory areas of your business (hybrid).
This is really interesting, thank you for explaining the cash vs accrual method of accounting for inventory purposes. Since you referenced retail, I thought I would jump in. I am a new online retail business and qualify as a small business taxpayer. I bought wholesale inventory of $10,000 in November and December 2017 and have not yet sold that inventory. From what I understand, I cannot expense the $10,000 in 2017 and have to wait until that inventory sells in order to expense it even though I am, otherwise, a cash basis taxpayer? Therefore, the $10,000 would not be listed under COGS on my 1120S?
That is correct Sarah! The 10,000 will be part of your beginning inventory, just waiting for their time to be deducted.
So a question I am confusing myself about…on my schedule C under section 3 “purchases” does that mean ALL inventory purchased that year, even if it did not sell?..I sell only on EBAY, I purchase items to sell and keep my info on spreadsheets. I keep a log of all purchased items and their cost breakdowns. I keep track of my costs of goods as they sell and are paid for. I will have remaining unsold inventory at the end of the tax year. So I do a count of the remaining unsold items and their individual costs and put that number in as my ending inventory? I have a total of my actual Cost of my items that sold.
So is how I am doing this considered cost our accrual? h&r block checked cash on my return last year.
Yes all purchases, whether sold or not. The form is set up to calculate your cost of goods sold by adding purchases to your beginning inventory and subtracting your ending inventory. This is the accrual method for inventory.
Mark,
Is it possible that ecommerce sellers still qualify if they meet the exception for “A qualifying taxpayer under Revenue Procedure 2001-10 on page 272” if their gross receipts are low enough?
I don’t know for sure, but I assume that the “business taxpayer” language in RP 2018-40 supersedes 2001-10.
IRS Pub 538 has been revised for 2019 to reflect this new less stringent definition of qualifying small taxpayer:
“You qualify as a small business taxpayer if you Have average annual gross receipts of $25 million or less (indexed for inflation) for the 3 prior tax years, and
Are not a tax shelter (as defined in section 448(d)(3)).”
No mention of excluded NAICS codes.
Thanks for the confirmation, good to know I’m understanding this somewhat!
I just found this from google search. I think you are very knowledgeable in this matter and I will really appreciate your reply. I retail purchased items. (Average sale of $200,000 or less per year). I list and keep record of all my purchases for that year keeping track of all purchased items, cost and date of purchases. This act as part of the beginning inventory. I make estimate of remaining inventory. Am I required to keep a list of that remaining inventory that is reported in that tax year. Am I required by IRS to keep a record of the remaining inventory. As far as I have the record of all purchases, will I run into any problem with IRS if I don’t keep a record of the remaining inventory that is reported. I look forward to reply.
Well done explanation! Hell of lot of help to me! Thanks so much for your wonderful website!
So technically can you check box “Cash method” (If less than 1M) and same time can you report COGS ?
Yes, exactly. That’s what I do.
Thank you so much
Hi Mark, just wanted to follow-up on this point.
As per following the tax payer’s method – cash method, do you believe we then just recognize COGS when we pay for them and expense it right away?
Thank you very much for your post/comments I found them really helpful, the best post i can find on this topic! Have a great day
Correct, if you are treating inventory using the cash method, goods purchased for resale would be immediately classified as cost of goods sold.
What do mean by “immediately classified as cost of goods sold”? Can the purchased inventory to be expensed in the year of purchase even if it was not sold???
Correct! This is a more widely available option as of 2018.
I have started a business and I need to convert my personal collectibles to the business(LLC). How do I do this? Do I just estimate worth and donate as equity? What does this do to taxes? Then when I sell an item for more than I donated? How does that effect taxes? What if I sell for less then I donated? I have thousands of items and I don’t want to create a tracking nightmare. Is it possible for me to
1) Donate as equity with best possible guess on what I paid? Some of these items were purchased many years ago without reciept
2) Consider the inventory value as the original donated value
3) Consider profit or loss as items are sold
then just keep doing this? I am assuming my taxable profit would be the difference between what I donated and what it was sold for. So if I donated $10 item to the LLC and it later sold for $15 it would be $5 profit or $5 loss if it sold for $5.
Any of this make any sense?
It will definitely require some judgement on your part given that there are so many ways to value collectibles. There is retail value, wholesale value, insurance value, auction value, etc. You will generally want to value the cost (not the selling price) of the item using a general rule known as “the lower of cost or market.” In other words, you will assign the cost as the lower of either your original cost or the item’s market value. The market value can be difficult to estimate or very subjective. The higher the “cost” you assign, the less tax you’ll owe. As long as you can show that you made a reasonable effort to accurately cost the items, you shouldn’t have any issue.
“Oh, great, something else to be overwhelmed about!” 😉
As a non-profit Arts Council that owns a theater used for live performances…
1) Would pre-production licensing payments for plays and deposits securing a musician’s performance be considered as purchasing “inventory”?
2) Since popcorn and candy sales are not really our main product, but incidental to it, would we still have to go with the accrual basis for that inventory?
3) If I’m understanding (ANY of) this correctly, fees paid to musicians and dramatic licensing companies shouldn’t be listed as expenses, but as COGS? And, if that’s correct, credit card fees and ticketing fees should also be considered as part of that event’s/production’s/“product’s” COGS, as well, right?
(Questions board presidents ask when treasures quit and accountants retire and move away at the same time…)
Thanks for any and all assistance; you’ve already put me way ahead of where I was!
Hi Eric – I don’t specialize in performing arts, but I think I can confidently say that licensing payments have nothing to do with inventory. On the concession sales, I’d have to research to double check, but even if it were technically required, I know many CPAs who would deduct as incurred just because they are incidental to your main service. This article applies mainly to retail businesses, so actually fees paid to musicians and licensing companies would not be listed as COGS. Hope that helps.
That absolutely does help, Mark; thank you so much!
Okay so I am going to start up an online thrift store and since it will just be me using an ebay store front I am going with the self employed route.
Here is where I am getting confused about cost of goods..I buy things in cash usually (through craig’s list) so I don’t have receipts. Should I just keep my own records of what I pay in cash and hope I don’t get audited?
Exactly, except for hoping you don’t get audited. Keeping your own records if you are not provided receipts is totally acceptable.
Hello Sir, I am treating inventory using the cash method and wanted to write off all the inventory purchased this year. When filling my return, The accountant put the COGS in the supplies section of my schedule C and told me that it would be a red flag if we put it in the COGS without a beginning and an ending inventory.
I wanted your opinion after reading this article. I am unsure if I should leave the total in the supplies section or move it to COGS without Beg or ending. What do you recommend?
Another opinion would be to use my actual ending inv. I have a rough estimate, but I’d rather not track inventory moving forward due to time constrain. Thank you for your help.
The whole point of the IRS having you list your beginning and ending inventory balances is so you can calculate COGS, but many business track their cost of goods sold independent of their beginning & ending inventory balances. In that case, they’ll often enter their total COGS on the purchases line and show a beginning & ending inventory balance of zero. That’s what I call the lazy accountant COGS method. It’s still accrual inventory, they just aren’t filling in some of the data. I’ve never seen this trigger an audit, and if it did, once the IRS saw the result was the same everything would be fine. This is not, however the scenario you are describing.
You are talking about entering your purchases on the purchases line (rather than actual cogs) and also list beginning and ending inventory as zero, which is the cash method for inventory. I haven’t talked it about it much yet, but the IRS recently released guidance that narrowed the ambiguity about our options to even use this method, and it looks like they are closing the door on it. So I would probably come up with a way to estimated your ending inventory each period so you can use the regular accrual method for inventory.
Thank you for your response, sir.
Please point me to the information you have seen where the IRS recently released guidance that narrowed the ambiguity about our options to even use this method, and it looks like they are closing the door on it. We started our resell business in 2019 and treated purchases as cost of goods sold. We have not filed out 2020 tax return. Do we need to amend 2019?
I have started a candy shop, and I sell a lot of very small, very inexpensive things. Do I have to keep inventory of each small piece of candy? what if i’m selling mixed bulk by the bagload? Can I expense the purchase of each order of candy when I buy it or do I have to calculate the profit on each candy bar (bought at different times at different prices) and expense cost of goods sold when I sell it? I carry a shop full of inventory, but its very small right now, as is my revenue. my total space is only a couple of hundred square feet, and so far my revenue is on track to be less than 10,000 yearly for that part of my business (it’s also a video arcade, so most of my revenue is entrance fees)
If the candy sales are on incidental to the primary business activity, the IRS is usually okay with just expensing (deducting) the purchases as incurred. If you are going to keep an inventory, you should look into keeping a periodic inventory system. That basically entails counting your inventory and calculating your cost of goods sold that way. You can read more about it here: https://www.accountingtools.com/articles/2017/5/13/periodic-inventory-system
But I want to understand why we don’t expense it when bought the inventory as all other expenses I.e salaries
Because purchasing inventory is merely exchanging exchange one asset for another. Conversely, other expenditures such as wages, utilities, fuel, etc are not going to later enable you to exchange them for cash (or cash equivalents).
Thanks so much for trying to help all of us!
Right now, as a hobby, I collect, buy, and sell antique sewing buttons from the late 1800s.
I might buy a collection that has 1000 buttons. Every single button is unique, believe it or not. And I might sell them from anywhere of $1 to $5 each.
Are you saying that since I am selling “retail” that I would need to have an inventory spreadsheet with every single button listed individually? Or can my inventory just be my gross purchases lumped together?
I’ve scoured the internet for hours and am so confused.
I wish there was an answer to this. I sell musical instrument parts that I pick up for variable costs depending on bulk discounts or clearance sales. One time I purchase I might buy 100 pieces for $35 and the next time it is 50 pieces for $26. How would I possibly attribute the correct Cost for the same product on 150 of those items?
It doesn’t matter that the buttons are all unique. I would simply count each collection purchased as a separate lot, and then find the average cost of each button in that particular lot, either by piece or by weight. Of course, you would need a way to attribute each button to its respective lot whenever it sells.
Thank you for this article but I still don’t find my answer anywhere on the Internet. I am an IT consultant. Most of my income are from services that are timed-based. But quite often, I am in a situation where I must buy specific computer components or other related items for my clients. I do or do not make a profit out of these items but I definitely do not lose money. That depends on the client’s status, favor thing.
Now, I do not have an inventory. Every single thing I buy for a client end up in its hands. I DO track all my expenses. I store bills and keep track of dates of purchases and all. Considering this situation, my common sense tells me I MUST add these items in my expenses, otherwise my income vs. expense will be completely falsified. But:
**Under what category do I add them?**
Surely I cannot add them as business expenses? How can I categorize them afterward? What should this category be named? Inventory? Even though I do not have an inventory?
Oh please help me. I spent hours on the Internet with no answers yet. Thank you!
How do you charge your customers for these supplies? Do you separately itemize or are they included in your hourly fee? Or what?
It sounds like you go out and buy the parts when needed and are using them right away, so I would just expense them as supplies. Even if the IRS likes another category better, they are not going to put up a fuss because it all nets out the same.
§ 1.162-3 Materials and supplies.
(a)In general –
(1)Non-incidental materials and supplies. Except as provided in paragraphs (d), (e), and (f) of this section, amounts paid to acquire or produce materials and supplies (as defined in paragraph (c) of this section) are deductible in the taxable year in which the materials and supplies are first used in the taxpayer’s operations or are consumed in the taxpayer’s operations.
This doesn’t seem to jive with what your saying, no?
Nvm boss I see it’s explained in Rev proc 2001-10, thanks for your help!
Reading all that stuff can make you go crazy!
Great info, thanks much! Just want to clarify to make sure I understand and do it correctly. Gross sales < $1 million and I have both inventory of manufactured goods and purchased goods to resell. The way I read it, I can still do cash basis, as long as I only deduct COGS at the time I sell the goods and keep track of beginning and ending inventory. For example, if I purchase a $10 finished good to resell at $20, I don't record the $10 expense for COGS until I sell the item, then I record both a revenue of $20 and a $10 expense. Where I'm a bit confused is what schedule C line I record this expense on? I have been reporting it on Line 36 (Purchases). Additionally, for the manufactured items, I have been recording labor on Line 37 and cost of raw materials on Line 36, so I'm confused by the statement to record these COGS expenses under Line 38 (Materials and Supplies)? Thanks much! Mike
Bingo! The way the schedule C works is that it calculates your cost of goods sold for you by using your beginning inventory cost PLUS your purchases during the year MINUS your ending inventory cost balance. That equals your cost of goods sold, which works out the same as the accounting you used in your example.
There has been a new guidance provided by the IRS that supposedly now allows for deducting your inventory costs and the use of the cash method where previously it couldn’t be done. Your take on this?
Accounting for inventories
Current law: Businesses required to use an inventory method (if the production, purchase or sale of merchandize is a material income-producing factor to the business) must also use the accrual method of accounting. The exception is if its average gross receipts are not more than $1 million (or $10 million for businesses in certain industries), it may account for inventory as non-incidental materials and supplies.
TCJA impact: The bill would increase the gross receipts exception so that businesses with average gross receipts of $25 million or less would be permitted to use the cash method of accounting even if the business has inventories and, therefore, may account for inventory as non-incidental materials and supplies or using its method of accounting reflected on its financial statements.
https://bakertilly.com/insights/tax-reform-bill-modifies-and-simplifies-accounting-methods-for-small-busine/
This is the big question! The current law is what is detailed in this post. Businesses in general should use accrual accounting for tax purposes. But if your gross receipts are less than a certain amount, you can use the cash method, except for inventories, which you can account for as non-incidental materials and supplies–this means you can deduct the inventory “when used or paid, whichever is later.” It doesn’t help most online sellers.
The new TCJA law does 2 things:
1. It increases the gross receipts limit to $25 million, which will allow more businesses to account for inventory as non-incidental materials and supplies. That does not mean a business can expense inventory upon purchase. So this is really a moot point for online sellers and retailers in general.
OR
2. It allows “small business taxpayers” to use a method of accounting for inventory items “conforming to the taxpayer’s method of accounting reflected in its applicable financial statements” or “its books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.”
My first question on this is–Can you apply the same definition of “small business taxpayers” referenced in TCJA as is described in Publication 334? If so, neither 1 nor 2 would apply to online sellers, because retail is on the list (Pub 538) of ineligible business activities. But if that’s not the case…
Then what does “taxpayer’s accounting procedures” mean? That is extremely vague. Many small business taxpayers don’t even have accounting procedures. Or what if they have incorrect or fraudulent accounting procedures? Does that mean they can just do whatever they want when it comes to reporting on their taxes? I doubt it. I know that several of the big firms have requested further guidance on this. But I have not yet seen that guidance. So until then, I’m assuming there is no applicable change.
And on a final note, even if it does change, using the accrual method for inventory will always give you a better view into your own profitability, so that’s what I will encourage my clients to do regardless.
Mark
I am a CPA with small business clients—that is, the have substantially under $25,000,000 in annual sales. Their accounts’ payable is usually greater than their accounts payable. A client, who maintains significant amounts of inventory and maintains books on the accrual basis, had me almost convinced that under the 2018 tax law changes he could change his method of accounting to cash basis and thereby eliminate reporting inventory. After review I told him that for all intensive purposes he had to continue same method of accounting and still report inventory, since a change would only accelerate income (accounts payable exceeds accounts receivable). The only change for anyone in this situation would be that he no longer has to capitalize section 263a costs (overhead, etc.). Is my understanding correct?? Many thanks
I think it’s still definitely a gray area. If his “method of accounting” was a complete cash basis, according to the TCJA wording he could argue eliminating his inventory. I personally wouldn’t feel comfortable with that given the uncertainty, but I do think he has an argument.
Thank you for your response.
There was a guidence issued in August
https://www.irs.gov/newsroom/irs-issues-guidance-on-small-business-accounting-method-changes-under-tax-cuts-and-jobs-act
And also I heard that one was issued recently, about 2 weeks ago, but I can’t seem to find it.
I recently called the contact number in that RP and grilled the guy with questions. I’ve updated the post with my conclusions.
Great information! I have a small company (<$1M) that sprays and treats lawns with chemicals. We provide/sell a service and do not categorize the chemicals we purchase on invoices. Chemicals go in a big tank, mix the potion, and spray many lawns from the tank. We keep some chemicals on hand, but the cost is pretty small and I have not been inventorying anything (1.5 years old). We report Cash Basis and obviously want to keep income close to zero for our beginning years building up the business. We are looking at purchasing $2-3k of chemicals before the end of the year that would not be sprayed until the subsequent year. Do I need to inventory this with these new rules; it seems to go against the clearly reflect income principal. Additionally, does it matter if you take possession of the product, or is that strictly accrual method?
Thanks!
Hi Mark, hopefully you can help me on this one. I’ve had a small handmade business for many years and at one point had a CPA helping me with my taxes. She said that I didn’t need to report my inventory amounts, but just put the COGS amount on Schedule C.
I’ve kept an inventory with Craftybase for a few years, so I do have the numbers if audited. I’m wondering if there is a way to report my inventory numbers now on Schedule C. I’ve always thought it was a little odd not to show how I came up with the COGS. So, my question is, how to do that? Would I put $0 for the beginning inventory because it was $0 last year? And then add in the inventory I had at the beginning of the year (I have a few thousand dollars of inventory at this point) to the purchases from this year on Line 36? Then, go from there with the calculation of COGS? Or do I report my actual beginning inventory and put a note in to explain why it’s different than ending inventory last year? Trying to stay away from any red flags even though I know I have the numbers if I get asked about it. Thanks for your help.
I would start with inventory as zero. If you haven’t already deducted the inventory you have on hand, I would include that as purchases. Then when you fill out the COGS section on your Schedule C, the formula of beginning inventory + Purchases – Ending inventory will give you the correct cost of goods sold for the year.
Thanks, Mark. That’s what I thinking, but wanted to get your thoughts on it. I’ll feel better about it now.
I have a client that qualifies as a small business but manufactures a product. Each unit sells for $100K. The customer wants an invoice before the end of the year since they are accrual but they won’t pay until January. As a cash basis taxpayer, my client won’t report the income until received in January but she has to purchase the materials in December to start the job. The materials will be around $40K. Does she have to report this as ending inventory or should she expense it under the new rules?
Based on the new language, I would say she can’t expense it. In order to not account for inventory on your taxes, it also has to be “conforming to the taxpayer’s method of accounting.” So unless their books are cash basis, I don’t believe they could deduct the inventory purchase.
i don’t know, ,,,my head is spinning reading & re-reading the statute……”taxpayer’s method of accounting for inventory…”
is there a statutory definition of inventory? goods on hand?
appears to me that if you were switch from accrual to cash basis, your inventory is adjusted for amounts paid….so you can’t write-off inventory on change of accounting method from accrual to cash…..if you did then you wouldn’t have a method to account for your inventory…(hmmmmm) i enjoy the conversation ,,,,thanx for the comments
From my research, I am afraid that this “Small Business Taxpayer” exemption is not applicable toward us in the online business of reselling. As stated on the IRS website the inventory exemption applies to, “a qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.” I read into the procedure and found that under Section 4, a qualifying small business taxpayer must meet one of three tests. The first test requires the taxpayer’s NAICS code must be eligible. Ineligible is stated “retail trade within the meaning of NAICS codes 44 and 45.” These codes include non-retail stores such as electronic shopping and mail order houses which online reselling falls under. Of the other two tests (one must be passed to be eligible), each requires either a service is being sold, or the business must involve fabrication or modification of the property being sold. E-commerce stores that simply buy and resell their merchandise to customers would, under this verbiage, not be eligible for the small business taxpayer exemption. Please let me know your thoughts on these fine print terms.
Links:
https://www.irs.gov/publications/p334#en_US_2017_publink1000313270
https://www.irs.gov/pub/irs-irbs/irb02-18.pdf
You are correct that an online businesses would not qualify as a “qualifying small business taxpayer” because the business activity is not listed as an eligible business in Pub 538. But an online business would qualify as a “qualifying taxpayer,” meaning that before TCJA you would qualify to account your inventory as nonincidental materials and supplies.
According to the IRS tax attorney I spoke with whose contact info is listed in in RP 2018-40, the “small business taxpayer” definition in the TCJA language is totally unrelated the the “qualifying small business taxpayer” definition in the prior RPs you referenced and doesn’t appear to exclude retail.
Hey Mark,
I have a small business selling on eBay
This is my first year selling on eBay but second year of business.
I am basically starting with no inventory and have made a few bulk purchases this year to sell on eBay. I would like to use cash-basis accounting for simplicity sake as I’m still determining which products are best to sell and I have an assortment of products and no fixed pricing (collectibles and antiques).
If I use cash basis and made everything non-incidental supplies I would effectively claim all my inventory purchases as expenses for this calendar year correct? i.e. cost of good sold even though the products haven’t all been sold yet?
Mostly yes. What you mean is cash basis for inventory. Treating it as non-incidental supplies wouldn’t have the same effect. According to TCJA, if your method of accounting does not use inventory (aka cash basis inventory), than you can use the same treatment on your taxes.
Hi there – I sell vintage clothing and accessories both online and through a showroom location/vintage shows – i am a small business. My inventory is in the $200k range but my gross receipts are much less than $1million. I have been using the cash basis of accounting and my concern is that I really should be using the accrual method. What is the dollar amount of inventory in 2017 that legally dictates whether a business owner like me would be required to use the accrual method? and has that figure changed for 2018 and moving forward. I have searched the IRS website and it is very hard to understand. Thank you – this blog has been tremendously helpful.
That threshold has changed with the Tax Cuts and Jobs Act. It’s now $25 million 🙂 My recommendation is to use a hybrid method. Cash basis for everything except for inventory for simplicity and profitability tracking purposes.
thanks Mark – this post is very thorough. With your recommendation to use a hybrid method – cash basis for everything except inventory – what box do you recommend checking for the overall accounting method on the tax return, ‘accrual’ ‘cash’ or ‘other’? I lean towards ‘other’, but with the ambiguity & complexity of inventory accounting and what came out of the TCJA, I see how one could also feel comfortable checking the ‘cash’ box while using a hybrid approach for inventory.
In my experience most CPAs just select cash, since the accrual method for inventory is assumed and built into the form.
Thank you so much for this post and your website! They’re super helpful.
I have a quick question for you, if you don’t mind.
I’m a teeny tiny business selling handmade things. For the past few years, I’ve been using a cash based inventory and claiming my supplies as I buy them. I’m now seeing that’s not the best idea.
Is it possible for me to switch over to an accrual system of inventory (I think that’s what it’s called), where I use COGS and deduct supplies as I sell things? Do I need to go back and refile taxes, or can I just keep inventory that way moving forward?
I hope I’m making some sense. Thank you so much for your time!
Yes the IRS does allow you to change methods, and the beginning of the year is a great time to do so. Technically you get approval from the IRS with form 3115, but with small reselling business I know many who don’t think the changes are material enough to bother with the form.
I have a medical practice client with gross receipts in excess of $25 million per year. They are adding a pharmacy to their practice which will now of course have to maintain inventory. Prior to this, they have never had inventory on their books. I am a bit confused as to if now they have inventory and don’t meed the small business exemption if this would now require the entire company’s books to be accounted for and reported on their tax return under the accrual method?… Or does the accrual method only apply to the inventory itself?
The client is organized as an S-corp by the way.
I am curious what you think about how this intersects with the Tangible Repair Regulations from 2013. If you look at the definition of incidental materials and supplies, it includes any “non-inventory” item that is below $200. If I am a qualifying small business taxpayer and treat things as “non-incidental materials and supplies” then that is “non-inventory” so anything under that $200 threshold would be converted to incidental materials and supplies and therefore expensed right away. Wouldn’t this allow someone to keep their books on accrual basis, but use the cash method of accounting (fully) as long as all their items are under $200 each (assuming they meet all the other tests to be a qualifying small business taxpayer)?
What about things that would be considered shop supplies (paper towels, rubber gloves used to stain items) and also items that can’t be readily tracked like thread for our big machine (we don’t buy excessive amounts), stain (use about 20 bottles a year), or dye (maybe 5 large bottles a year). Would these items need to be accounted for in raw materials/inventory (which would eventually end up in COGs) or can we just expense it somehow? Perhaps as supplies?
Regarding this: “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.
By “used” doesn’t it mean I can deduct it when I use the materials in my production? So if I buy raw materials in year 1 and use them into making finished goods in year 1, but the sales happen in year 2, I can deduct the materials in year 1. No?
Some are saying you can use DMSH to write off if under $2500. Thoughts?
I have been researching for weeks and I stumbled upon this site, it has been by far the most helpful. The questions I can’t find answers to are:
we own a convenience store and coffee shop, under one S corp, we carry inventory, our NAICS code is 44-45, am I eligible to switch to cash method?
if so, the inventory that I bought years ago, would that become an expense this year, even though it may have been purchased 2 years ago
lastly, if I choose to stay with accrual this year, may I change to cash in the following years?
Big thank you for your help
I have a question regarding a manufacturing company. Since part of the cost of the inventory includes, among other things, depreciation on manufacturing equipment, is that included in the COGS for tax purposes. I know it is for accounting purposes but is it for tax as well? Does that mean that we don’t file a form 4562 and take depreciation for these manufacturing assets? I’ve been looking to find this answer and can’t seem to find anything definitive. Any help would be greatly appreciated!
Hello,
We are a new business that is mainly an eBay reseller and we purchase lots of surplus or bulk jobsite inventory . Most of the items we buy are typically lotted together by the trailer-load and have almost unlimited variations. Conditions range from junk, some repairable, some used, some new. To actually do an individual inventory would be impractical and to track actual cost on each item is not accurately possible as the stuff is sold at one “lot” price. Some items we sell are higher dollar tools and can actually place a dollar amount to it based on what we individually paid for it. With that being said, our eBay sales are typically around 100k or less. Inventory purchases for resale are usually between 30-40k per year .
Someone in a previous post wrote
“If I use cash basis and made everything non-incidental supplies I would effectively claim all my inventory purchases as expenses for this calendar year correct? i.e. cost of good sold even though the products haven’t all been sold yet?”
We have a similar situation to that eBay reseller and wondering if this (cash accounting) is the simplest way to treat the inventory for tax purposes.
i second this question
Third this question
Correct, if you use cash basis for inventory, then you would deduct all inventory purchases when purchased regardless of when sold.
This has been very helpful.
Mark, I found your piece very insightful. As a CPA myself, I am also anxious to see some guidance from the IRS regarding the interpretation of the TCJA’s relevant language “taxpayer’s books and records”, “method of accounting” and “taxpayer’s accounting procedures.” Certainly one possible interpretation (and an unfavorable one) of these requirements is that an otherwise qualifying taxpayer could not deduct inventory on its tax return even if it prepared internal-use-only financial statements that accounted for inventory. However, one counter-argument might be that since the overall thrust and intent of these small business provisions was to promote, encourage and facilitate the use of cash basis accounting by small businesses, the negative interpretation I just suggested could be viewed as too restrictive. In any case, we’ll just have to wait to see what stance the IRS ultimately adopts.
Thanks John! I agree, the conservative thing to do would be to continue to use the accrual method for inventory, which is what I recommend to my small business clients, but I do tell them that there is ambiguity with the new tax laws and that they’ll probably be fine if they do cash.
Hi, thanks for the post!
I have a question. I buy antique stuff from people for cash. Let’s say I bought it for $50 and sold it for $100. Besides the fact that I can deduct gas(for example I drove somewhere to pick it up) I can also deduct the original $50 that I paid for it, correct? But if i pay cash on hands, and I have no receipt to prove that I spent $50 how do I deal with that?
Many thanks!
Hi John – Good question! This is a common occurrence, and the best thing to do is to create your own “receipt.” Many sellers who make frequent cash purchases keep a log where they record the relevant information such as the date, item description, purchase price, location, etc. If it is a significant purchase, getting a signature from the seller can’t hurt either. Additional supporting documentation would be mileage you have recorded elsewhere to the location. There is no exact set of documentation you need, so the more you have, the stronger your case.
Thank you very much Mark! ????????
Thanks for the post Mark. Question for you…. I had a new client bring me an 1120S that was prepared by another preparer for me to review. The new client is retailer that sells landscaping materials. They buy products (rock, gravel, mulch, etc) and resell it to customers and local contractors. They have historically used the accrual method for inventory only and their sales are under $1M. They have always been a cash basis filer for tax purposes (again, except for inventory). Given the new automatic change #235 “Inventory exception for a small business taxpayer (section 471)”, the preparer did the following:
On the 1125A COGS schedule, the beginning inventory (2017 ending) was $150,000.
Current year purchases were $235,000.
Ending inventory was left blank.
They took the sum of the ending ’17 inventory and the ’18 purchases and applied the COGS against income.
To me, this significantly overstates purchases. In fact, I dont see how these could be considered “not incidental” either. They buy and sell. No manufacturing involved.
Additionally, they produce correct financial statements monthly, showing the accrual method for inventory transactions only.
This blows my mind. What are your thoughts? As you cant imagine, by doing this – expenses are overstated and the K1 net ordinary income is a huge loss. This doesnt reflect the income actually received.
If the $235K is actually what was purchased during the year, this would be the correct catch-up treatment to switch from accrual to cash. You are correct that these are not “non-incidental materials and supplies.” So unless their current cash-basis inventory tax treatment conforms to their method of accounting, which it sounds like it doesn’t, than it doesn’t sound like they have solid grounds for switching to cash for tax purposes. The IRS would likely never know about it, so maybe they are willing to roll that dice.
Hi Mark, I just wanted to ask your insight on “non-incidental materials and supplies.”
Greatly appreciated your feedback before in the reply.
If you have some time to spare, could you kindly review my question below:
Say you pass the gross receipt test and can treat the inventory as “non-incidental materials and supplies.”
How would you go about recording this journal entry? Is NIM&S asset line under balance sheet?
As per NIM&S being deducted in the year it is used or paid, whichever is later.
Then would you enter a temporary journal entry for the initial expense in the NIM&S line and flow out it to COGS when the product is sold?
Thank you for your time again.
That sounds like the correct treatment to me, although I’ve never dealt with that specifically in practice.
We started out internet retail business in 2004 – very small. in 2018 we had gross sales of $6500/month. this year we have a run rate of $24000/month. My issue is we have always deducted inventory purchases as cost of goods sold.
I realize this is wrong and I would like to rectify with the IRS and get back on track with the proper method. Is there a way to do that without breaking my bank all at once?
Mike
Hey Michael – Historically it wouldn’t have technically been correct, but as of 2018, you could continue to do so if your books also reflect that same accounting treatment. But if you do make the switch, you would file Form 3115, which can be attached to your tax return.
Hey Michael – Historically it wouldn’t have technically been correct, but as of 2018, you could continue to do so if your books also reflect that same accounting treatment. But if you do make the switch, you would file Form 3115, which can be attached to your tax return.
For this year say I go to a store and buy 20 items that cost $200 total. I write on my white board for January under cost of goods $200. When I list the items for sale on ebay, under custom sku I put what I paid for each item. Say I then sell a shirt for $35 and paid $15 for it, I write on the white board under cost of goods sold $15. At the end of the month I add up all of my cost of goods and minus my cost of goods sold. As if this were my only purchase for the month would leave me with $185 in inventory to start feb. I just put all of my receipts into a folder. Would this be ok? Not itemizing every item that is left in my inventory and just having the total of cost of goods
Hi Tom! If I am understanding you correctly that seems fine. The only thing I would change just for clarity is referring to the unsold cost of goods as “Inventory” and then when is sells as “cost of goods sold” like you’re doing.
Thanks for the clarification Mark!
I have been researching this for my wife’s retail business for a year now.
As a CPA, I had the same feeling and had come to the same confusing conclusion as you.
There is an exception but it does us no good since we have to deduct inventory once “used or consumed”. haha.
I’m glad you posted this so I now know its not just me, and I feel you helped the topic seem a little more clear to me or at least I have a second opinion backing up my own thoughts.
Thanks David I’m glad it helped!
Hi Mark, Thanks for posting this article. I found it very helpful. If I have been using the cash method for a sole proprietorship buying/selling retail items for approx 10 years now, with complete ignorance to the accrual method, would you recommend switching to the accrual method at this point because it may be more appropriate for my type of business? Or would it be more appropriate to keep using the cash method since that has been the method used for a long period of time already?
Hi John – If that’s been working for you and you feel good about it, there’s nothing wrong with sticking with it. In many cases, the accrual method for inventory can give you better insight into your profitability. If you did switch, technically you have to report that to the IRS using form 3115.
Mark, great info, thanks for posting this. I will be launching a t-shirt e-commerce business very soon using the cash method of accounting along with the accrual method for inventory, like you recommend. My question is this: I purchased much of my inventory (blank t-shirts and heat transfers) last year, before I was in business. Would I still need to state my beginning inventory for this year as zero? (I’ve read that every new business should.) If so, how would I account for the inventory purchased last year so that it could be applied to COGS this year? Thanks so much.
To avoid confusion I would probably put beginning inventory as zero and enter those initial shirts as purchases. It will have the same effect.
Thank you for the great information… here is my question and wonder if you could take a look
client buys and sells cosmetic machines. Gross revenue of about $600k. they have been using the cash basis for tax purposes and do keep accrual books for financials. Here is the interesting part. They buy the machines from a related company that bills them for it, but they don’t have to pay the bill until they turn a profit which could be a couple of years. Can they still deduct the COGS for the cost of the machines they sold even though technically the bill for it has not been paid.
Thank you very much for the good information.
I run a small Etsy shop selling photography prints and also sell several prints a year at local art shows (sales of under $1,000 a year so far). I am currently filing as using the cash method of accounting. I also keep good records of beginning and ending inventory as well as materials purchased throughout the year to determine an accurate value for cost of goods sold so as to only deduct inventory costs once products have sold.
My questions is the following. On Schedule C am I able to list starting Inventory (Line 35), Purchases (Line 36) and Ending Inventory (Line 41) to determine COGS for line 4 … or am I not able to show these inventory line items since I am filing using the cash method of accounting? It is confusing since many of the references state that if you maintain inventory you must use the accrual method … however, all I am really doing is providing an accurate breakdown on how I am treating my inventory as non-incidental materials and supplies, only deducting them in the year they are used. All materials costs and product sales are still accounted for using the cash method, recording sales once money is received and purchases once materials are paid for …
Thanks for your insight
John, your explanation of inventory is the absolute best one I’ve been able to find! I am an artist/painter who makes an average of only $5,000 a year. I usually do my taxes with pencil & paper. This year when trying TurboTax, they ask about inventory. Some of my research makes me think I can just stop including inventory at all on my taxes and simply list earnings and expenses. Is this true? It would be so much easier! If not, how on earth should I figure my inventory? I had been counting only unused materials on hand (paint, paper, canvases, etc), NOT all my unsold paintings. Should I have been counting those unsold paintings and prints? If so, ARGGGH! Thanks a million. (or should I say a $5,000)
Can I amend my 2018 tax return from accrual to cash and get back the tax money I paid? We had purchased large amounts of inventory in 2018 because we opened a new retail location, but it really added towards our gross income during tax time. We practically had to pay our entire personal income for that year to the IRS because the inventory percentage inflated total gross income altogether. I told the IRS, “look, it’s not like I can buy groceries with my inventory. We didn’t even come close to making this much.” Thoughts? Any feedback greatly appreciated. Thank you so much!!
You could definitely do that! Technically that is done through completing a Form 3115 as part of the amendment, which isn’t the world’s most straightforward form.
Thank you Mark for responding. So basically I would send an amended tax return along with the 3115 for year 2018 to IRS. Assuming everything is done accurately, there is a chance the IRS will agree, reprocess my 2018 return, and send me back the money I paid in taxes for the non-expensed inventory? I want to make sure I understand correctly.
Also, we want to switch CPAs, any advice on what three things I should prioritize when interviewing CPAs? I feel like our current one just doesn’t do a good job looking out for our business interests.
Please know I appreicate all the information provided! Thank you!
Yes, they should reprocess and send you back the difference.
You just want someone who has your best interests in mind and who works for you and not the IRS, someone you work well or get along with, and someone who knows their stuff 🙂
Thank you so much! You have been so helpful!
Mark, what are your thoughts on this? Looks like it further supports the cash basis accounting model.
This is from another blog.
Footnote 465 of JCT (Joint Committee on Taxation) Blue Book on the Tax Reform Act) states if you meet the $25M gross receipts exception and use the de minimis safe harbor election of Treas. Reg. sec. 1.263(a)–1(f), you can expense “inventory” items when paid. You would have to reflect this same method of accounting for an applicable financial statement for the $5,000 threshold or record these as expenses on the books/records for the $500 (now $2,500) threshold when there are not applicable financial statements. PLAIN ENGLISH: If you meet the $25M exception, make the election and are consistent between your treatment on tax returns and with your financial records, you should be able to expense inventory items when payment is made rather than waiting until it is sold.
Please note: This is a relatively new concept. The IRS has provided very little guidance on this matter and, at their discretion, could deny this method of accounting for inventory in the future.
Keep in mind the following: You will most likely have to file a Form 3115, as this is a change in accounting method. This will include change to overall cash method of accounting (Change 233) and exception from requirement to account for inventories under IRC Sec. 471 (Change 235).
Taxpayers need to realize that this accelerates expensing the purchasing costs and is not creating a new deduction, so the effects of this could swing from year to year, depending on level of inventory.
JCT is written by the Congressional Staff that assist lawmakers in crafting the statutes. Please note that the JCT is listed as having substantial authority under Reg Sec. 1.6662-4(d)(3)(iii) for purposes of penalty avoidance, in the event that this becomes otherwise differently addressed by the Internal Revenue Code, Treasury Regulation, etc.
Below is Footnote 465 from the JCT.
Footnote 465 – Consistent with prior and present law, a deduction is generally permitted for the cost of non-incidental materials and supplies in the taxable year in which they are first used or are consumed in the taxpayer’s operations. See Treas. Reg. sec. 1.162–3(a)(1). As the provision allows a taxpayer to treat inventories as non-incidental materials and supplies, a taxpayer may also be able to elect to deduct such non-incidental materials and supplies in the taxable year the amount is paid under the de minimis safe harbor election of Treas. Reg. sec. 1.263(a)–1(f).
Under such election, a taxpayer with an applicable financial statement that has written accounting procedures in place that treat as an expense amounts paid for property costing less than a specified dollar amount may deduct amounts paid for non-incidental materials and supplies at the time of payment if the amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice). In addition, a taxpayer without an applicable financial statement that has accounting procedures in place that treat as an expense amounts paid for property costing less than a specified dollar amount may deduct amounts paid for nonincidental materials and supplies at the time of payment if the amount paid for the property does not exceed $500 per invoice (or per item as substantiated by the invoice).
However, in either case, the taxpayer is not eligible to deduct inventory treated as non-incidental materials and supplies under this provision under the de minimis safe harbor election unless the taxpayer is also treating the amounts paid for such items as an expense in its applicable financial statement or its books and records, if the taxpayer does not have an applicable financial statement (i.e., the taxpayer is not eligible to apply the de minimis safe harbor if the amounts paid for such items are treated as inventory for financial reporting purposes). See Treas. Reg. Sec. 1.263(a)–1(f)(1)(i)(C) and (ii)(C). If a taxpayer elects to apply the de minimis safe harbor, the taxpayer must apply such safe harbor to all materials and supplies that otherwise meet the requirements of Treas. Reg. sec. 1.263(a)–1(f).
Hello,
I am French and would like to start an LLC (or else if more suitable) for my Amazon business.
My initial investment will be € 30k and I do not intend to take any income for the 3 first years of activity which means that I’ll re-invest everything (mainly inventory).
I will continue to live in France and I won’t have any office or employee in the US.
What taxes will I have to pay in the US and France?
Thank you.
I understand that the de-minimus safe harbor of items costing less than $2,500 can be expensed.
Can you address that? What is your opinion on that? I imagine most small businesses have items costing less than $2,500 per item.
I think it’s great and encourage my clients to take full advantage of it. And you are correct, the majority of small business assets qualify.
Can I use average monthly inventory for the fiscal year on my tax return as inventory valuation, rather than 12/31 actual? We are seasonal and all my good are in stock in December, but my monthly inventory average better reflects out annual expenses and payables.
It depends what you mean. If you are using some type of average costing throughout the year, that will impact what your 12/31 ending inventory number is. So I think it’s a yes in that sense.
Hello! this is my first year to have this business and I need to understand any updates you have about using cash method. Can I just total up all my expenses of purchases of items I sell and then count the income minus purchases and other expenses such as shippingI …Doing it all on a Schedule C for a sole proprietor? Do I need to deal with inventory carrying over? I know this string of emails started a few years ago.
Yes you can do that now 🙂 It’s using the cash method specifically for your inventory. No need to carry over inventory in that case.
OK, so I’ve read through the article and comments and thank you for your insights, Mark. I apologize if the following has been covered and I missed it, but lets say a taxpayer decides to interpret the new TCJA “taxpayer’s method of accounting” verbiage to mean that he, as a qualifying taxpayer can expense out inventory that hasn’t sold yet and reap the immediate tax benefits. Since this is not officially being tracked as “inventory” in a traditional IRS COGS manner, what wording should he use on Schedule C to describe the expense (I assume it needs to be written in). In this particular case it’s collectibles purchased through a variety of venues for the purpose of eventually being sold on eBay and other places on line. Would he term the expense “Materials and Supplies” or “Inventory” or “Goods” or “Cost of Goods Sold”? Some of the collectibles purchased in the given year may or may not have been sold in the year purchased, but most of it will sell a year or more down the road. The intent here is 100% to follow the spirit of the law and pay appropriate taxes on income, when it finally actually occurs, and yes, given this “taxpayer’s method of accounting” (which is documented by the way) it does indeed mean that the tax pain will be much greater in the future when the items actually sell, though for now it means losses and tax breaks. I’ll also just say, regarding the freedom the TCJA brings, that we already know that many startups are going to lose money out of the gate for a few years anyway, and many of them need to be able to reap the tax benefits to survive those bumpy first steps, no matter WHAT the early expenses are…tools, rent, etc. or inventory.
I’m sure there are some out there who get really specific and technical with this, but what I do, and what I see most others to is simple list the items as Purchases in the COGS section, leaving beginning and ending inventory blank.
you’re exactly correct. as a small business owner, many can’t survive if you don’t reap the benefit of tax deductions in the year of the expense. Typically that refund gets put back into the business for marketing/advertising/new products. Mark’s answer is gold.
Hi! Ive been selling for 3 years now and every year I input zeros for begining and ending inventory. I have trouble keeping track of inventory I bought in the past years lol so I just input what I spent in the current year as my cost of goods. Have I been screwing up? Lol either way I will be purchasing your tax academy. Appreciate all of your videos.
I have a follow-up question which I think many of today’s online sellers experience: If personal items become inventory, how should the cost basis of these be calculated?
The lower of the original cost or the market value. The market value can be a pretty wide range so I tend to go with the original cost or your best estimate of it.
I have a similar question as James. I sell items on eBay and most of the time they are items I had or find in the house and no longer want or need. Occasionally (like just a few items per year) I have something I bought that is still new and I sell it. From reading this article and reading the IRS documentation I think the cash method would make sense for this and then deducting the amount paid for some items if they sell that year and if they are things purchased. Are you allowed to have “0” inventory when you do the Schedule C? Also if you have personal items like James mentioned, do you have to take some money off for the deduction if it is a used item vs. new?
Yes if using the cash method for inventory, you would list zero on the beginning and ending inventory lines. And you can deduct personal items converted to and sold as business inventory.
Thanks for your response!
I was told this is ok to do from another cpa but he doesn’t specialize in online sales. So I just wanted to clarify with someone who specializes in online sales lol. Thank you for your time.
I have a question regarding COGS spreadsheet. Do I need a new spreadsheet each new year or do I just change the year on previous sheet. Thank you.
I’ve been using the cash method and putting 0 for beginning and ending inventory for 2 years already. I put the total amount I spent on inventory for the year (whether it sold or not) in the Cost of Purchases section. Is there a benefit to switching to accrual and counting beginning and inventory if I haven’t before?
If there is a benefit, how should I go about switching to accrual for this tax season? Because the 2020 beginning inventory value would be inaccurate (since I had 0 last year as 2019 ending inventory) which throws off the COGS.
The main benefit of accrual for inventory that I see is that it matches up the inventory expense to the revenue that it belongs to, so you have more accurate and consistent profit & loss statements. But if your buying and selling patterns are fairly consistent, it might not make that much of a difference. To switch, you technically need to file form 3115 (a nightmare of a form by the way) and make what’s called a section 481(a) adjustment. That will basically back out the deduction you already took for inventory you still have on hand.
Hi Mark,
I have a decently sized handmade bag business (sole proprietor LLC) I’ve been running for about 10 years now. For the past few years I’ve deducted inventory supply purchases in the year purchased, and I’ve also ran an inventory amount for finished items unsold at the end of the year, but have not included the unused supplies as part of this inventory. My fabric stash is now worth about 20k and clearly I don’t sew through it all in a year, so I’m growing concerned I may have been making a mistake with taxes on it, despite having a decent CPA in years past (who I’ve sadly lost this year due to moving).
From reading this and other sites, it sounds like I need to not deduct inventory purchases immediately anymore, but instead should switch to the accrual method and use my inventory amount from end of 2019 with end of year 2020 to generate cost of goods sold for inventory purchase deduction this year? Do I need to file the Form 3115 to tell the IRS I’m changing methods if I’ve been doing what I think is a hybrid of cash/accrual? Will switching greatly increase my taxes owed due to “profits” appearing to go up (even though the money has mostly gone back into inventory supplies)? I’ve sold more goods this year than any of my previous years, and I no longer have education tax credits this year to cover any oweing, so I’m a bit scared of appearing to have made a huge profit.
Thank you for this article!! It is definitely the best and most clarifying one I have seen by far. I sell trading cards on ebay. It is exceptionally hard to account for inventory when I buy a case of a product, then open it and sell individual cards over time. Also, the value of the cards fluctuate greatly depending on the market. The accountants I have talked to about this usually don’t seem to understand the business and also talk down to me about it, which isn’t helpful. I am trying to arm myself with as much knowledge of how I want to run and account for my own business before talking to another accountant. So, I really appreciate your plain spoken explanation of these IRS rules!!
The final IRS regulations on this issue have been released back in January and they clearly state that you CAN’T expense your inventory until it is sold.
I don’t know why this was not discussed here earlier, since these regulations have now been out for 3 months, but here you go:
Federal Register/ Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations
https://www.govinfo.gov/content/pkg/FR-2021-01-05/pdf/2020-28888.pdf
Start on Pg. 257
The Treasury Department and the IRS read the repeated use of the word ‘‘inventory’’ to mean that Congress intended that inventory property remains inventory property while relieving taxpayers from the general inventory rules of section 471(a). To reduce confusion about the nature of property treated as non-incidental materials and supplies under section 471(c)(1)(B)(i), these final regulations refer to the method under that provision of the Code as the ‘‘section 471(c) NIMS inventory method.’’
“Simplification does not indicate that the nature of the property was changed by the TCJA, or that the intent of Congress was to provide immediate expensing of inventory costs.”
i. Definition of the Term ‘‘Used or Consumed’’ The preamble to the proposed regulations provides that the Treasury Department and IRS interpret section 471(c)(1)(B)(i) as generally codifying the administrative guidance existing at the time of its enactment (that is, Revenue Procedure 2001–10 (2001–2 IRB 272) and Revenue Procedure 2002–28 (2002– 18 IRB 815)) and making that method available to significantly more taxpayers. Accordingly, the proposed regulations provided that items of inventory treated as materials and supplies under section 471(c) are used or consumed in the taxable year in which the taxpayer provides the item to a customer, and the cost of such item is recovered in that taxable year or the taxable year in which the taxpayer pays for or incurs such cost, whichever is later.
ii. De Minimis Safe Harbor Under § 1.263(a)–1(f)
The de minimis safe harbor, which is a regulatory election rather than a statutory one, does not apply to inventory.
So here you go, since this is one of the post popular blog posts on the interest with regard to this issue, I think Mr. CPA should update it to put a nail in this topic.
Good luck
It’s really not so cut and dry. The way it reads is if you’re below $26M in revenue then you can use cash or accrual or hybrid. It all depends on how you want to do your accounting as long as you treat your income and expenses the same method. Example: I get an order for $2,000 of product on December 28th but don’t receive the money until January 6th. Then that income is not counted until the next year. Same if i purchase raw materials on December 20th and don’t get charged until January, i can count that expense in the next year because it didn’t get taken out of my account until the next year. When i sell the item, ALL of the sales is considered income, so unless i have deductions its all considered taxable.
With accrual, it doesn’t matter when you get expenses because you can’t write them off until your product sells, whether it’s 2 weeks down the road or 2 years. Accrual is not small business friendly because it ties up your “losses” and you don’t get it back in taxes to grow your business. For bigger businesses accrual is favorable because they have higher turnover and are able to hold assets in warehousing/storage etc for minimal costs.
I’ll stick to cash.
Here is a good summary that is easy to understand. Also, according to this summary, it doesn’t technically apply until 2021 tax year. So if you have been on cash basis, and have been deducting inventory as an expense for the last few years, looks like you might be able to get away with it for 2020, curious what Mark would say.
“Accounting for inventories. The final regulations clarify the inventory rules for small businesses. IRC Section 471(c) allows taxpayers meeting the gross receipts test to treat inventories as nonincidental materials and supplies (Section 471(c) NIMS). The final regulations require the capitalization of all direct material costs for property produced or acquired for resale, but they do not include the provision under the proposed regulations that would require small businesses to also capitalize their direct labor costs.
The final regulations also clarify that inventories accounted for as Section 471(c) NIMS are not eligible for immediate deduction under the de minimis safe harbor rule under IRC Section 1.263(a)-1(f). However, if inventories are expensed under a taxpayer’s books, the inventories might be eligible for a corresponding deduction for tax under one of the other small-business inventory methods.
In addition, the final regulations provide simplifying inventory costing methods allowing taxpayers meeting the gross receipts test to use either their AFS (AFS Section 471(c)), or books and records if they do not have an AFS (non-AFS Section 471(c)) to determine the value of inventories. The regulations also provide examples clarifying that taxpayers might need to adjust their book inventory amounts if they use a different overall method for tax purposes.
Effective date. Generally, these rules are applicable to taxable years beginning on or after Jan. 5, 2021. For calendar year taxpayers, the first year that these rules apply is the 2022 tax year. However, taxpayers generally may apply the rules in the final regulations to taxable years beginning after Dec. 31, 2017, and before Jan. 5, 2021, if they are applied in their entirety and in a consistent manner.” https://www.crowe.com/insights/tax-news-highlights/final-regulations-on-the-small-business-taxpayer-exception
So how do direct sellers fit here? I am so confused as to whether I have to account for inventory or not. Even the year or two I hired an accountant, one year I did and the next year he advised I didn’t have to. When I purchase product from my company, I am paid commission on those ‘purchases’. If some of those purchases are to be held for sale to my customers, is that then defined as inventory? I have always operated under the ‘cash basis’ on my Schedule C. I am well under the limits stated above. I just want to be sure my bookkeeping is accurate and my tax filings don’t get flagged.
Is anyone monitoring this site for comments?
Yes 🙂
Thank you for the above explanation – I have a question, for my 2019 return I kept inventory on the books. Can I now expense it in 2020 even though I had inventory on my tax return in 2019?
I’m still confused by this. For someone who is self employed and does nails and lashes, do the products purchased to provide those services need to be counted as inventory (nail tips, lashes, etc.)? Can they not go to a regular expense account such as “nail and lash supplies”? If they have to go to COGs though, but if I’m not required to track inventory, how does that work on part III of Schedule C?
Mark, such a good article, thank you! I am pretty confused about how to classify my COGS. In my case, I am classified under NAICS 236110 Residential Building Construction. This business was just created in NOV 2021. In December, I purchased land, paid insurance and fees associated with the same. I am building a residential dwelling, which all add to the COGS. As soon as it is finished, it will be sold. In the spirit of starting small and being less encumbered by accrual methodology, I would like to use the cash basis for 2021. Obviously, the ‘good’ has not been sold, and so ending 2021, my inventory could be the same as the COGS. But, I will not have receivables related to the sale; once money is in hand, I’ll deliver the keys so to speak. Is it possible to use the cash method for this, or am I stuck with accural? Thanks!!
I am just starting to sell more items online(Lego to be exact). I dont know what i need to do when it comes to taxes? Just started up in February of 2022 so trying to get ahead of tax issues for next year. Will i need to claim this as earned income as it is not my job as i work full time. I buy legos locally or i go to stores to purchase them. I then use the parts and resell them in my online store at a specific website. The payments then go to paypal. But then i have expenses of shipping, paypal fees, bricklink fees, cost of getting product to add to my store, shipping supplies, storage supplies for the parts and fuel to take the orders to be shipped via post office. So im not sure exactly what i need to do going forward as far as claiming as income or not. any help would be greatly appreciated.
I sell color street nails as an independent sales consultant with a 1099-nec. We make commission from sales and are not supposed to buy inventory to have on hand but we do so clients can get items that sell out quickly. I grossly overbought and stopped selling the product. Can I deduct the “inventory” I purchased at cost as supplies or am I stuck calling it inventory on my taxes? I sold 1336 and purchased 5273. My 1099 commission wages were 1215 and it is killing my return as inventory.
By at cost I mean retail price
I am late getting my business license and state business set up for this year, but I have bought supplies to make handmade items with. Can I still deduct them this year? I also built a shed to make these things in, which I will amortize. If I get all the permits, etc. done in January, can I deduct them in 2022?
You don’t necessarily need the business license for the IRS to consider you a business. If you were actively selling or “open for business” then you can count the deductions toward 2022. If you were not open yet, then those deductions would go toward 2023.
I have an S Corp, actually 2 S Corps one is a service business I’ve had since 2002. I just started reselling last year. I LOVE Cash method of accounting, but what about the 1125A? If I’m not claiming when sold do I skip this form or put zeros? Are you taking clients? My CPA retired and I’ve been doing them myself, hahaha. I’d be happy to pay for consultation if questions are beyond the scope of this forum. Also, probably should have you do them anyway if you have openings. I do have thorough Excel Spreadsheets. Fyi, been following you on YouTube. Thanks much!!! Michelle
You would enter zeros for the beginning and ending balances, and you would enter your purchases on the purchases line. That would yield a COGS number the same as the purchases. And that’s it! Just shoot me an email – mark@notyourdadscpa.com
So, last year I heard about the threshold for the 1099k changing, so I decided to go in all deep on my eBay store- I resell items. Last year I thought I was doing the hard part of spreadsheeting each individual sale documenting what my original cost of purchase was, and adding it together with eBay fees/shipping costs.
Then this year, I took a look at the schedule C and I see everything about the beginning inventory/end inventory. Many of the items I resold came from a year prior to 2022- I think I’d have a very difficult time trying to ascertain what my ending inventory was even if I reflecting my starting inventory as 0.
So I want to avoid inventory all together, which to my understanding, I could opt to do so as a qualifying small business owner. Is this the NIMS method listed above? If so, do I state I don’t have an inventory and file my COGS elsewhere?
So if i run a shopify account and made an inventory purchase before end of year and did not reflect this on my shopify account until the new year then i can still use cash basis? I started the business December 12th 2022 with personally owned items and im hoping to use the cost of startup to help reduce my tax liability for 2022.
I also do not sell the product as it is purchased, it gets opened and items get sold separately as part of a live stream. Can this impact how the “inventory” would be classified?
This article was very helpful despite my continued lack of understanding!
If the business was “open for business” in December then yes, as part of the cash method for inventory you could deduct that purchase.
I just want to thank you for taking the time to write this and respond to questions.
I own a firm as well, and even with two decades of experience, this IRS verbiage is not always delivered clear enough for me. It has the capability of humbling me quickly!!
My favorite phrase I tell people is, “Accounting is not black and white.” So.. I died laughing when I read your example of “Taxpayer’s Method of Accounting.” 🙂
I recently had a new farming business client come in which has a hybrid method of accounting & it involves inventory. The publications weren’t clear on this complex business structure in relation to the inventory and tax reporting (I’ve scraped them all 10 times lol).
I hesitated on hitting send, without first devoting even more research time (or signing up for a PhD in order to interpret the new publications better, which at this point seemed like a faster option than the analysis-paralysis LOL).
I found your page today. Hallelujah! With reading all of your thoughts, it seems we both had the same take on the issues and my confidence in my gray-area accounting solutions has been restored.
Thanks for the excellent read, my friend. Credit is certainly due for your time! I love to read financial perspective, so I will definitely be back to look at other articles!
Thanks so much Miranda! Very kind, and I’m so glad it helped.
Hey Mark.
Thanks for putting this together.
If I wanted to go along with expensing inventory under § 1.471-1(b)(6), would you say I need to file a change in accounting method? Or is this a valid method if done from the inception of the business.
This is assuming I followed all other code guidance (never kept inventory on any forms of records or books, never used inventory value with lenders, etc.)
Yes it would be valid with no additional documentation required if done from inception.
Well, its 2023… what is everyone doing on this topic these days. My client is a reseller. She buys random things, random places and resells it for random prices. Surprisingly, (NOT!) she didn’t keep an inventory. I spent a lot of time trying to have her remember things she bought from where online, using her PayPal and what that may have been for and what she thinks she sold them for — all to find this and have been stuck on it for 2 days. I don’t want to do accrual. Cash is where my heart is on this, but I still feel uncomfortable on the what I am doing here despite reading the answers. In the article the creator said they will forever use accrual, then in the posts said “thats what I do” referring to cash method… so I think I lost something somewhere.
Would I A.) Just record all her purchases of the items she bought this year against sales and THATS IT – use “Cash” accounting.
B.) Use cash method and still only deduct COGS as what was actually sold this year based on what we came up with (so a portion of what she spend on goods.
C.) Something I am not thinking of… 🙂
Just do cash inventory! Deduct purchases and be done with it. I do this with many of my clients, especially those who care more about the simplicity of their books and don’t have great records. But if she wants to do accrual, then you’d just need her to estimate her ending inventory, and then you can back into the COGS with that. It’s not perfect, but it’s better than nothing.
I do not understand how sellers can determine profit on goods sold if they cannot keep track of their cost of those goods sold, for fear of triggering accrual accounting.
Hi Mark,
First of all, thank you very much for this easy to read and understand article. I am a CPA and have been looking for an answer for last few days. I came across this article and I think I have an answer now. I would like to confirm my understandings.
A single-member LLC client started an online jewelry business in 2023. Orders are taken in US and items are shipped from overseas. The client has small amount of inventory on hand. Gross revenue was less than $200k which will increase as the business grows however, not expected to grow beyond $25M. Client doesn’t do valuation or allocate cost to inventory. Therefore, it’s my understanding that they can use cash method for overall accounting as well as for inventory. Would you mind confirming it?
Also, separate from inventory, do you know if and what kind of foreign reporting the client needs to do for making the payments to vendor overseas?
Thanks again!
Vandana
Many of my purchases are for selling in a short to medium length time – anywhere from less than a year to less than two years. A significant portion of my purchases, on the other hand, are purchases of large quantities to enable my suppliers, with the intention that I will sell significantly fewer than the entire purchase. For my own purposes, I divide my purchase price for the entire lot by the expected short term sales and use that when determining whether my expected market price will be sufficient to make an economic profit. Continuing sales after I break even are entirely profit except for transaction costs.
I keep an dollars and cents inventory of sorts by using a standard percentage of sales (by average, not by item) as a cost of goods sold.
Is that adequate?
I am adding some new products after purchasing some very established trade names. I am well into what most people would consider retirement years. Whereas the previous items were meant to support me during my semi retirement, the new ones are to build my business for sale when I decide to stop working or when the business outgrows my energy level. Do I need to convert to GAP in order to sell the business at its best price?
Thank you
Hi Bill – Practially I would say that is adequate as long as you are consistent and have a documented & logical methodology.