September, 2006 Tax Tip
Keep Track of Your Inventory
Many taxpayers assume that they can write off merchandise held for resale or for productive use in the year they purchase it. Not so for tax purposes, nor is it proper accounting.
If producing, buying, or selling merchandise generates income to you, tax law requires that you write off the cost of an item of inventory only in the year that you sell it. To comply with this requirement you must maintain inventory records so that your cost in the goods you sell can be readily identified and determined, as can the inventory still on hand at year end. (See discussion below re inventory cost identification methods). The higher your inventory is valued at year end the higher your profit will be. Conversely, the lower the ending inventory, the lower the profit will be.
While there are other methods of valuing inventory, by far the two most common are cost and lower of cost or market. The major advantage in using lower of cost or market is that it allows you to take devalued or obsolete items into account in valuing ending inventory. Because this lowers ending inventory, it decreases profit thereby accelerating a deduction for inventory still on hand.
If, as usually is the case, it is not practicable to identify a specific item of inventory with its cost because it is intermingled with other similar items, there are two approved methods for determining cost. They are "first-in, first-out" (FIFO) and "last-in, first out" (LIFO). FIFO assumes that the ending inventory consists of the goods most recently purchased or produced; whereas LIFO treats the most recently purchased merchandise as the first sold, leaving the older (and likely lower) costs in ending inventory. In periods of high inflation, LIFO would produce a lower profit. As a general rule, LIFO can only be used when inventory is valued at cost, not lower of cost or market.
Therefore, when engaging in a business where the sale of inventory will provide your income, be mindful of the inventory tracking requirements.