For those businesses who must maintain and manage inventory, it can be a daunting task. Inventory is a process where you purchase goods at cost for the purpose of sales. The complexity comes into how you measure the use of the inventory. For example, consumption in a business, e.g. restaurants; supplies in hair salons, manufacturing and a host of other areas, will require careful documentation and compliance to IRS rules and regulations, Publication 538 (and others), adherence to US Generally Accepted Accounting Principles (US GAAP).
If you run a strict retail business where you buy products to sell only, this should be easy. Are you sure? The short answer is No! You still have to follow all the rules and regulations of inventory management. Let’s take an example using a company that resales antiques and other collectibles as these are popular home based businesses.
You have decided to open your business and start selling on eBay and at flea markets. Your first decision is are you going to be a sole proprietor, partnership, or corporation. Each classification has major tax advantages and disadvantages. The next decision is what entity will I create based on the first decision, i.e., a sole proprietor may want a trade name, a LLC will need to choose to be taxed as a partnership/sole proprietor or a corporation. Of course, there are multiple forms and steps in this. Based on how you setup this area of your company will determine how your income is taxed.
A question to ask yourself is what deductions are allowed, and essentially how much money you will net in your pocket? Let’s not forget that you will need an EIN for some of the choices or you can use your Social Security Number for the Sole Proprietorship. Do you know the pitfalls of using your Social Security Number? How to get an EIN? We never recommend using your Social Security Number as identity theft is prevalent and you will need to give this number to people to file 1099s and tax exempt purchases.
From there, you have business decisions on location, storage, refinishing and repairs, etc. All will impact your take home income and how that is calculated in regards to your taxable income. Now, inventory is one of your major decisions. You need to match your income from sales to your use of the inventories. The time for physical counts and the amount of revenue from the last 3 years will have an impact on whether you are allowed to use LIFO (Last In, First Out) method, or whether you use FIFO (First In, First Out), an Average Cost, Retail Cost, Simplified Versions, etc.. Of course, all the choices will affect your evaluation of income and deductions and that will affect your bottom line.
We chose an easy setup for inventory as there is no manufacturing or usage needed to prepare the salable item, e.g. bakeries. For those that use inventory to make salable items, the rules and regulations are far more complex. Let’s stay simple and use antiques as our example. Again, this may not be so simple. You purchase the antique dresser at an estate sale for $100.00 knowing that you got a great deal as the dresser was a 18th Century Original that you valued at $10,000. Do you need an appraisal? You decided to list this piece for auction. It sold for $8,000.00. How do you calculate your profit? Again, did you need an appraisal? What is the rule, it has to do with the value of the item. What is your basis in the piece? Is the basis what you paid for it or what the FMV was at the time of purchase? What costs are deductible as business expenses? Do you need to calculate what costs are added to the basis of the property? What about capitalized expenses (all depends on types of property, costs, holding periods, etc)?
Wow, are you overwhelmed yet? Even professionals tax accountants have to review and research the inventory rules as it can be extremely complicated and is based on multiple factors. Managing your inventory though can have profitable outcomes to your income; whereas, not managing your inventory can have serious pitfalls and costly outcomes to your income. The choices are major ones!