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. However, see Cash Method of Accounting for Qualifying Taxpayers, earlier. See also 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

Your inventory should include all of the following.

1. Merchandise or stock in trade.
2. Raw materials.
3. Work in process.
4. Finished products.
5. Supplies that physically become a part of the item intended for sale.

Merchandise. Include the following merchandise in inventory.

1. 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.
2. Goods under contract for sale that you have not yet segregated and applied to the contract.
3. Goods out on consignment.
4. 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.

1. Goods you have sold, but only if title has passed to the buyer.
2. Goods consigned to you.
3. Goods ordered for future delivery if you do not yet have title.

Assets. Do not include the following in inventory.

1. Land, buildings, and equipment used in your business.
2. Notes, accounts receivable, and similar assets.
3. Real estate held for sale by a real estate dealer in the ordinary course of business.
4. 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 to the items in inventory.

Use the FIFO or LIFO method, explained next, if:

1. You cannot specifically identify items with their costs.
2. 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 similar items 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 the first items you sold, consumed, or otherwise disposed of. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and from those acquired during the 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 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 section1.472-8(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.

Differences Between FIFO and LIFO

Each method produces different income results, depending on the trend of price levels at the time. 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, the opposite will hold.

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.

The following methods, described below, are those generally available for valuing inventory.

• Cost
• Lower of cost or market
• Retail

Goods that cannot be sold. These are goods you cannot sell at normal prices or they are unusable 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 their bona fide selling price minus direct cost of disposition, no matter which 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 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.

1. For merchandise on hand at the beginning of the tax year, cost means the ending inventory price of the goods.
2. For merchandise purchased during the year, cost means the invoice price minus appropriate discounts plus transportation or other charges incurred in acquiring the goods. It can also include other costs that have to be capitalized under the uniform capitalization rules.
3. 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 either to deduct cash discounts or include them in income, but you must treat them consistently from year to year.

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 of the two as its inventory value.

This method applies to the following.

1. Goods purchased and on hand.
2. The basic elements of cost (direct materials, direct labor, and certain 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.

1. 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).
2. 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, minus 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 that vary materially from the actual prices will not be accepted as reflecting the market.

No market exists. If no market exists, or if quotations are nominal because of an inactive market, you must use the best available evidence of fair market price on the date or dates nearest your inventory date. This evidence could include the following items.

1. Specific purchases or sales you or others made in reasonable volume and in good faith.
2. 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 of each class of goods is reduced to approximate cost by using an average markup expressed as a percentage of the total retail selling prices.

To figure the average markup, apply the following steps in order.

1. 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).
2. 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.
3. Divide the balance in (2) by the total selling price in (1).

Then figure the approximate cost in two steps.

1. Multiply the total retail selling price by the average markup percentage. The result is the markup in closing inventory.
2. 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.

Item	Cost	Retail Value
Opening inventory	$52,000	$60,000
Purchases	53,000	78,500
Sales		98,000
Markups		2,000
Markdowns		500

Using the retail method, figure your closing inventory as follows.

Item	Cost	Retail 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 × $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. If you are using the retail method and LIFO, adjust the inventory value, determined using the retail method, 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 an 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, reliable, and suitable for their use. For more information, see Revenue Ruling 75-181, in Cumulative Bulletin 1975-1.

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 continue this practice only if you first get IRS approval. You can adopt and 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 do all the following.

1. State that you are using the retail method on your tax return.
2. Keep accurate records.
3. 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 either a perpetual or book inventory if inventory is kept by following sound accounting practices. Inventory accounts 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 their inventory value at the beginning of the tax 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.

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 as a casualty or theft loss. If you take the loss separately, adjust opening inventory or purchases to eliminate the loss items and avoid counting the loss twice.

If you take the loss separately, reduce the loss by the reimbursement you receive 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 income and 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 the loss on your return for the immediately preceding year. However, you must also 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, unless the property is produced for your use other than in a trade or business or an activity carried on for profit.

1. Produce real or tangible personal property.
2. 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. Tangible personal property 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.

Exceptions. The uniform capitalization rules do not apply to:

1. Resellers of personal property with average annual gross receipts of $10 million or less.
2. Property produced to use as personal or nonbusiness property or for uses not connected with a trade or business or an activity conducted for profit.
3. Research and experimental expenditures deductible under section 174.
4. 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.
5. Property produced under a long-term contract, except for certain home construction contracts described in section 460(e)(1).
6. Timber and certain ornamental trees raised, harvested, or grown, and the underlying land.
7. Qualified creative expenses incurred as a free-lance (self-employed) writer, photographer, or artist that are otherwise deductible on your tax return.
8. Costs allocable to natural gas acquired for resale to the extent these costs would otherwise be allocable to "cushion gas" stored underground.
9. Property produced if substantial construction occurred before March 1, 1986.
10. Property provided to customers in connection with providing services. It must be de minimus in amount and not be inventory in the hands of the service provider.
11. Loan origination.
12. 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.

1. A writer is an individual who creates a literary manuscript, a musical composition (including any accompanying words), or a dance score.
2. A photographer is an individual who creates a photograph or photographic negative or transparency.
3. An artist is an individual who creates a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print item. 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.

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, revalue the items or costs included in beginning inventory for the year of change as if the capitalization rules had been in effect for 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 that does not need IRS approval. Otherwise, IRS approval is required to make the change.

More information. For information about the uniform capitalization rules, see the section 263A regulations.

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