Publication 538 |
2000 Tax Year |
Inventories
An inventory is necessary to clearly show income when the
production, purchase, or sale of merchandise is an income-producing
factor. If you must account for an inventory in your business, you
must use an accrual method of accounting for your purchases and sales.
See Accrual Method, earlier.
To figure taxable income, you must value your inventory at the
beginning and end of each tax year. To determine the value, you need a
method for identifying the items in your inventory and a
method for valuing these items. See Identifying Cost
and Valuing Inventory, later.
The rules for valuing inventory cannot be the same for all kinds of
businesses. The method you use must conform to generally accepted
accounting principles for similar businesses and must clearly reflect
income. Your inventory practices must be consistent from year to year.
The rules discussed here apply only if they do not conflict with
the uniform capitalization rules of section 263A and the
mark-to-market rules of section 475.
Items Included in Inventory
Include the following items when accounting for your inventory.
- Merchandise or stock in trade.
- Raw materials.
- Work in process.
- Finished products.
- Supplies that physically become a part of the item intended
for sale.
Merchandise.
Include the following merchandise in inventory:
- Purchased merchandise if title has passed to you, even if
the merchandise is in transit or you do not have physical possession
for another reason.
- Goods under contract for sale that you have not yet
segregated and applied to the contract.
- Goods out on consignment.
- Goods held for sale in display rooms, merchandise mart
rooms, or booths located away from your place of business.
C.O.D. mail sales.
If you sell merchandise by mail and intend payment and delivery to
happen at the same time, title passes when payment is made. Include
the merchandise in your closing inventory until the buyer pays for it.
Containers.
Containers such as kegs, bottles, and cases, regardless of whether
they are on hand or returnable, should be included in inventory if
title has not passed to the buyer of the contents. If title has passed
to the buyer, exclude the containers from inventory. Under certain
circumstances, some containers can be depreciated. See Publication 946.
Merchandise not included.
Do not include the following merchandise in inventory.
- Goods you have sold, but only if title has passed to the
buyer.
- Goods consigned to you.
- Goods ordered for future delivery if you do not yet have
title.
Assets.
Do not include in inventory assets such as:
- Land, buildings, and equipment used in your business.
- Notes, accounts receivable, and similar assets.
- Real estate held for sale by a real estate dealer in the
ordinary course of business.
- Supplies that do not physically become part of the item
intended for sale.
Special rules apply to the cost of inventory or property imported
from a related person. See the regulations under section 1059A.
Identifying Cost
You can use any of the following methods to identify the cost of
items in inventory.
Specific Identification Method
Use the specific identification method when you can identify and
match the actual cost of the items in inventory.
You must use the FIFO or LIFO method, explained next, if:
- You cannot specifically identify items with their
costs.
- The same type of goods are intermingled in your inventory
and they cannot be identified with specific invoices.
FIFO Method
The FIFO (first-in first-out) method assumes the items you
purchased or produced first are the first items you sold, consumed, or
otherwise disposed of. The items in inventory at the end of the tax
year are matched with the costs of items of the same type that you
most recently purchased or produced.
LIFO Method
The LIFO (last-in first-out) method assumes the items of inventory
you purchased or produced last are sold or removed from inventory
first. Items included in closing inventory are considered to be from
the opening inventory in the order of acquisition and acquired in that
tax year.
LIFO rules.
The rules for using the LIFO method are very complex. Two are
discussed briefly here. For more information on these and the other
LIFO rules, see sections 472 through 474 and the corresponding
regulations.
Dollar-value method.
Under the dollar-value method of pricing LIFO inventories, goods
and products must be grouped into one or more pools (classes of
items), depending on the kinds of goods or products in the
inventories. See section 1.472-8 of the regulations.
Simplified dollar-value method.
Under this method, you establish multiple inventory pools in
general categories from appropriate government price indexes. You then
use changes in the price index to estimate the annual change in price
for inventory items in the pools.
An eligible small business (average annual gross receipts of $5
million or less for the 3 preceding tax years) can elect the
simplified dollar-value LIFO method.
For more information, see section 474. Taxpayers who cannot use the
method under section 474 should see section 1.472-8(e)(3) of the
regulations for a similar simplified dollar-value method.
Adopting LIFO method.
File Form 970, Application To Use LIFO Inventory
Method,
or a statement with all the information
required on Form 970 to adopt the LIFO method. You must file the form
(or the statement) with your timely filed tax return for the year in
which you first use LIFO.
Extension of time for filing.
You may qualify for an automatic extension of 12 months to make
this election.
Differences Between
FIFO and LIFO
Each method produces different income results, depending on the
trend of price levels of the goods included in those inventories. In
times of inflation, when prices are rising, LIFO will produce a larger
cost of goods sold and a lower closing inventory. Under FIFO, the cost
of goods sold will be lower and the closing inventory will be higher.
However, in times of falling prices, LIFO will generally produce a
smaller cost of goods sold and a higher closing inventory. Under FIFO,
the reverse will be true.
Valuing Inventory
The value of your inventory is a major factor in figuring your
taxable income. The method you use to value the inventory is very
important.
Goods that cannot be sold.
These are goods you cannot sell at normal prices or in the usual
way because of damage, imperfections, shop wear, changes of style, odd
or broken lots, or other similar causes, including secondhand goods
taken in exchange. You should value these goods at selling price minus
direct cost of disposition, no matter what method you use to value the
rest of your inventory. If these goods consist of raw materials or
partly finished goods held for use or consumption, you must value them
on a reasonable basis, considering their usability and condition. Do
not value them for less than scrap value. This method does not,
however, apply to goods accounted for under the LIFO method.
Cost Method
To properly value your inventory at cost, you must include all
direct and indirect costs associated with it. The following rules
apply.
- For merchandise on hand at the beginning of the tax year,
cost means the inventory price of the goods.
- For merchandise purchased during the year, cost means the
invoice price less appropriate discounts plus transportation or other
charges incurred in acquiring the goods. It can include other costs
that have to be capitalized under the uniform capitalization
rules.
- For merchandise produced during the year, cost means all
direct and indirect costs that have to be capitalized under the
uniform capitalization rules.
Discounts.
A trade discount is a discount allowed regardless of when the
payment is made. Generally, it is for volume or quantity purchases.
You must reduce the cost of inventory by a trade (or quantity)
discount.
A cash discount is a reduction in the invoice or purchase price for
paying within a prescribed time period. You can choose whether or not
to deduct cash discounts, but you must treat them the same from year
to year. If you do not deduct cash discounts from inventory costs, you
must include them in gross income.
Lower of Cost or Market Method
Under the lower of cost or market method, compare the market value
of each item on hand on the inventory date with its cost and use the
lower value as its inventory value.
This method applies to the following.
- Goods purchased and on hand.
- The basic elements of cost (direct materials, direct labor,
and an allocable share of indirect costs) of goods being manufactured
and finished goods on hand.
This method does not apply to the following. They must be
inventoried at cost.
- Goods on hand or being manufactured for delivery at a fixed
price on a firm sales contract (that is, not legally subject to
cancellation by either you or the buyer).
- Goods accounted for under the LIFO method.
Example.
Under the lower of cost or market method, the following items would
be valued at $600 in closing inventory.
Item |
Cost |
Market |
Lower |
R |
$300 |
$500 |
$300 |
S |
200 |
100 |
100 |
T |
450 |
200 |
200 |
Total |
$950 |
$800 |
$600 |
You must value each item in the inventory separately. You cannot
value the entire inventory at cost ($950) and at market ($800) and
then use the lower of the two figures.
Market value.
Under ordinary circumstances for normal goods, market value means
the usual bid price on the date of inventory. This price is based on
the volume of merchandise you usually buy. For example, if you buy
items in small lots at $10 an item and a competitor buys identical
items in larger lots at $8.50 an item, your usual market price will be
higher than your competitor's.
Lower than market.
When you offer merchandise for sale at a price lower than market,
in the normal course of business, you can value the inventory at the
lower price, less the direct cost of disposition. Figure these prices
from the actual sales for a reasonable period before and after the
date of your inventory. Prices significantly different from the actual
prices are not acceptable. They do not reflect the market.
No market exists.
If no market exists, or if quotations are given without reference
to actual conditions because of an inactive market, you must use the
available evidence of fair market price on the dates nearest your
inventory date. This evidence could include:
- Specific purchases or sales you or others made in reasonable
volume and in good faith, or
- Compensation amounts paid for cancellation of contracts for
purchase commitments.
Retail Method
Under the retail method, the total retail selling price of goods on
hand at the end of the tax year in each department or class of goods
is reduced to approximate cost by using the average markup expressed
as a percentage of the total retail selling prices.
To figure the average markup percentage, do the following in order.
- Add the total of the retail selling prices of the goods in
the opening inventory and the retail selling prices of the goods you
bought during the year (adjusted for all markups and
markdowns).
- Subtract from the total in (1) the cost of goods
included in the opening inventory plus the cost of goods you bought
during the year.
- Divide the balance in (2) by the total selling
price in (1).
Then figure the approximate cost in two steps.
- Multiply the total retail selling price by the average
markup percentage. The result is the markup in closing
inventory.
- Subtract the markup in (1) from the total retail
selling price. The result is the approximate cost.
Closing inventory.
The following example shows how to figure your closing inventory
using the retail method.
Example.
Your records show the following information on the last day of your
tax year.
| | Retail |
Item |
Cost |
Value |
Opening inventory |
$52,000 |
$60,000 |
Purchases during year |
53,000 |
78,500 |
Sales |
| 98,000 |
Markups |
| 2,000 |
Markdowns |
| 500 |
Using the retail method, figure your closing inventory as follows.
| | Retail |
Item |
Cost |
Value |
Opening inventory |
$52,000 |
$60,000 |
Plus: Purchases |
53,000 |
78,500 |
Net markups
($2,000 - $500 markdowns) |
|
$1,500 |
Total |
$105,000 |
$140,000 |
Minus: Sales |
98,000 |
Closing inventory at retail |
$42,000 |
Minus: Markup* (.25 x $42,000) |
10,500 |
Closing inventory at cost |
$31,500 |
* See Markup percentage, next, for an
explanation of how the markup percentage (25%) was figured for this
example. |
Markup percentage.
The markup ($35,000) is the difference between cost ($105,000) and
the retail value ($140,000). Divide the markup by the total retail
value to get the markup percentage (25%). You cannot use
arbitrary standard percentages of purchase markup to figure markup.
You must figure it as accurately as possible from department records
for the period covered by your tax return.
Markdowns.
When figuring the retail selling price of goods on hand at the end
of the year, markdowns are recognized only if the goods were offered
to the public at the reduced price. Markdowns not based on an actual
reduction of retail sales price, such as those based on depreciation
and obsolescence, are not allowed.
Retail method with LIFO.
If you use LIFO with the retail method, you must adjust your retail
selling prices for markdowns as well as markups.
Price index.
You must adjust the inventory value at the end of the year to
reflect price changes since the close of the preceding year.
Generally, to make this adjustment, you must develop your own retail
price index based on analysis of your own data under a method
acceptable to the IRS. However, a department store using LIFO that
offers a full line of merchandise for sale can use an inventory price
index provided by the Bureau of Labor Statistics. Other sellers can
use this index if they can demonstrate the index is accurate and
suitable for their use. For more information, see Revenue Ruling
75-181, 1975-1 C.B. 150.
Retail method without LIFO.
If you do not use LIFO and have been figuring your inventory under
the retail method except that, to approximate the lower of cost or
market, you have followed the consistent practice of adjusting the
retail selling prices of goods for markups (but not markdowns), you
can continue that practice. The adjustments must be bona fide,
consistent, and uniform and you must also exclude markups made to
cancel or correct markdowns. The markups you include must be reduced
by markdowns made to cancel or correct the markups.
If you do not use LIFO and you previously figured inventories
without eliminating markdowns in making adjustments to retail selling
prices, you can use this practice if you first get IRS approval. You
can use this practice on the first tax return you file for the
business, subject to IRS approval on examination of your tax return.
Figuring income tax.
Resellers who use the retail method of pricing inventories can
figure their tax on that basis.
To use this method, you must:
- State you are using the retail method on your tax
return.
- Keep accurate accounts.
- Use this method each year unless the IRS allows you to
change to another method.
You must keep records for each separate department or class of
goods carrying different percentages of gross profit. Purchase records
should show the firm name, date of invoice, invoice cost, and retail
selling price. You should also keep records of the respective
departmental or class accumulation of all purchases, markdowns, sales,
stock, etc.
Perpetual or Book Inventory
You can figure the cost of goods on hand by a perpetual or book
inventory if it is kept by following sound accounting practices.
Inventory accounts, however, must be charged with the actual cost of
goods purchased or produced and credited with the value of goods used,
transferred, or sold. Credits must be figured on the basis of the
actual cost of goods acquired during the year and the inventory value
at the beginning of the year.
Physical inventory.
You must take a physical inventory at reasonable intervals and the
book figure for inventory must be adjusted to agree with the actual
inventory.
Practices Not Approved
The following inventory practices, among others, are not recognized
for tax purposes.
- Deducting from inventory a reserve for price changes or an
estimated depreciation in the value of your inventory.
- Taking work in process or other parts of your inventory at a
nominal price or less than its full value.
- Omitting part of your stock on hand.
- Using a constant price or nominal value for so-called normal
quantity of materials or goods in stock.
- Including stock to which you do not hold title that is in
transit, shipped either to or by you.
- Separating indirect production costs into fixed and variable
production cost classifications and then allocating only the variable
costs to cost of goods produced while treating fixed costs as period
costs that are currently deductible. This is called the direct cost
method.
- Treating all or substantially all indirect production costs
(whether fixed or variable) as period costs that are currently
deductible. This is called the prime cost method.
Loss of Inventory
You claim a casualty or theft loss of inventory, including items
you hold for sale to customers, through the increase in the cost of
goods sold by properly reporting your opening and closing inventories.
You cannot claim the loss again as a casualty or theft loss. Any
insurance or other reimbursement you receive for the loss is taxable.
You can choose to take the loss separately. If you take the loss
separately, you must adjust opening inventory or purchases to
eliminate the items.
If you take the loss separately, reduce the loss by the
reimbursement you received or expect to receive. If you do not receive
the reimbursement by the end of the year, you cannot claim a loss for
any amounts you reasonably expect to recover.
Creditors or suppliers.
If your creditors forgive part of what you owe them because of your
inventory loss, this amount is treated as a reimbursement. It is
taxable.
Disaster loss.
If your inventory loss is due to a disaster in an area determined
by the President of the United States to be eligible for federal
assistance, you can choose to deduct your loss on your return for the
immediately preceding year. However, you must decrease your opening
inventory for the year of the loss so the loss will not show up again
in inventory.
Uniform Capitalization Rules
Under the uniform capitalization rules, you must capitalize the
direct costs and part of the indirect costs for production or resale
activities. Include these costs in the basis of property you produce
or acquire for resale, rather than claiming them as a current
deduction. You recover the costs through depreciation, amortization,
or cost of goods sold when you use, sell, or otherwise dispose of the
property.
Special uniform capitalization rules apply to a farming business.
See chapter 7 in Publication 225.
Activities subject to the rules.
You are subject to the uniform capitalization rules if you do any
of the following in the course of a trade or business or an activity
carried on for profit.
- Produce real or tangible personal property for use in the
business or activity.
- Produce real or tangible personal property for sale to
customers.
- Acquire property for resale. However, this rule does not
apply to personal property if your average annual gross receipts are
$10 million or less.
Producing property.
You produce property if you construct, build, install, manufacture,
develop, improve, create, raise, or grow the property. Property
produced for you under a contract is treated as produced by you to the
extent you make payments or otherwise incur costs in connection with
the property.
Tangible personal property.
Under the uniform capitalization rules, this includes films, sound
recordings, video tapes, books, artwork, photographs, or similar
property containing words, ideas, concepts, images, or sounds.
However, free-lance authors, photographers, and artists are exempt
from the uniform capitalization rules if they qualify as explained
next.
Exceptions.
The uniform capitalization rules do not apply to:
- Resellers of personal property with average annual gross
receipts of $10 million or less for the 3 prior tax years.
- Property used for personal or nonbusiness purposes or for
purposes not connected with a trade or business or an activity
conducted for profit.
- Research and experimental expenditures deductible under
section 174.
- Intangible drilling and development costs of oil and gas or
geothermal wells or any amortization deduction allowable under section
59(e) for intangible drilling, development, or mining exploration
expenditures.
- Property produced under a long-term contract, except for
certain home construction contracts described in section
460(e)(1).
- Timber and certain ornamental trees raised, harvested, or
grown, and the underlying land.
- Qualified creative expenses incurred as a free-lance
(self-employed) writer, photographer, or artist that are otherwise
deductible on your tax return.
- Costs allocable to natural gas acquired for resale, to the
extent these costs would otherwise be allocable to "cushion gas"
stored underground.
- Property produced if substantial construction occurred
before March 1, 1986.
- Property provided to customers in connection with providing
services. It must:
- Be de minimus, and
- Not be inventory in the hands of the service
provider.
- Loan origination.
- The costs of certain producers who use a simplified
production method and whose total indirect costs are $200,000 or less.
See section 1.263A-2(b)(3)(iv) of the regulations for more
information.
Qualified creative expenses.
Qualified creative expenses are expenses paid or incurred by a
free-lance (self-employed) writer, photographer, or artist whose
personal efforts create (or can reasonably be expected to create)
certain properties. These expenses do not include expenses related to
printing, photographic plates, motion picture films, video tapes, or
similar items.
These individuals are defined as follows.
- A writer is an individual who creates a literary manuscript,
a musical composition (including any accompanying words), or a dance
score.
- A photographer is an individual who creates a photograph or
photographic negative or transparency.
- An artist is an individual who creates a picture, painting,
sculpture, statue, etching, drawing, cartoon, graphic design, or
original print edition. The originality and uniqueness of the item
created and the predominance of aesthetic value over utilitarian value
of the item created are taken into account. This generally excludes
the production of jewelry, silverware, pottery, furniture, and other
similar household items.
Personal service corporation.
The exemption for writers, photographers, and artists also applies
to an expense of a personal service corporation that directly relates
to the activities of the qualified employee-owner. A "qualified
employee-owner" is a writer, photographer, or artist who owns, with
certain members of his or her family, substantially all the stock of
the corporation.
Inventories.
If you must adopt the uniform capitalization rules, you must
revalue the items or costs included in beginning inventory for the
year of change as if the capitalization rules had been in effect in
all prior periods. When revaluing inventory costs, the capitalization
rules apply to all inventory costs accumulated in prior periods. An
adjustment is required under section 481(a). It is the difference
between the original value of the inventory and the revalued
inventory.
If you must capitalize costs for production and resale activities,
you are required to make this change. If you make the change for the
first tax year you are subject to the uniform capitalization rules, it
is an automatic change of accounting method. You do not need IRS
approval. Otherwise, approval is required.
More information.
For information about the uniform capitalization rules, see section
1.263A of the regulations.
Previous| First | Next
Publication Index | IRS-Forms Main | Home
|