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.
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.
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.
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.
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.