By Dean Alexander
June 6, 2012. Let us first define what an inventory is. This seemingly academic issue may have an impact on your tax liability and may or may not survive in audit depending on how to treat inventory. The simplest definition of an inventory is as follows: Inventory is all the goods or materials you buy with the intention of selling them.
The definition of inventory may seem to be a mercurial issue. What is inventory to one may not be so to another. To elaborate, inventory is usually thought of as non-capital items. For example, the hamburger at MacDonald’s is an inventory item. They buy the meat, grill it and then resell it. The meat enters cost of goods sold among other things. The machines that the store has to grill the meat are not inventory. They are capital items. Same thing for the desk of the manager at McDonald’s. So meat is an inventory item but desks are not. Right? Not quite.
Take a business which sells furniture. The desks on display are what? They are in this case inventory because they were purchased to be sold. What about the desks in the office of the store’s manager? Is it inventory or is it a capital item? It is a capital item. So one desk is inventory and another is a capital item in the same store? That is exactly what I am saying. So the criteria are not how bulky the object is but rather what business we are in and the intention of buying to sell.
This is one tax problem we must find a tax resolution for. In order to survive an IRS audit, items that should be classified as inventory should be done properly. Your CPA or possibly your tax attorney may provide you with needed tax help in this regard.
The next challenge of the inventory tax resolution regarding inventory is how to price it. The general rule is the lower of cost or market. But we run into another tax problem which is: How do we define cost? You may buy several batches of inventory, each batch having a different unit price. When we withdraw some of the material to work on, what price should we attach to that material? Is it the first batch, the second or any other way?
The two most famous methods are First in First out FIFO and the other is Last in First out. Which way you choose will have significant ramifications on your cost of goods sold and the profit and also on the value of what is left of the inventory in your warehouse. The IRS will not allow you to switch from one method to another if they catch you doing so in a tax audit.
If you do not want to be chasing a future tax problem with potential tax debt to IRS and following collection actions short of an agreement with the IRS such as offer in compromise, you must first decide what an inventory is and then how to price it.
Summary: The tax resolution of inventory definition and pricing could solve a potential tax problem and IRS audits.