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.

		Retail
Item	Cost	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.

		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 × $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.

Change in Accounting Method

You can generally choose any permitted accounting method when you file your first tax return. You do not need IRS approval to choose the initial method. You must, however, use the method consistently from year to year and it must clearly show your income. See Accounting Methods, earlier.

A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item. A material item is one that affects the proper time for inclusion of income or allowance of a deduction. Although an accounting method can exist without treating an item consistently, an accounting method is not established for that item, in most cases, unless the item is treated consistently.

IRS Approval

Once you have set up your accounting method and filed your first return, you must get IRS approval to change the method. If your current method clearly shows your income, the IRS will weigh the need for consistency in reporting against the need for change.

If you do not request IRS approval to change an accounting method, the absence of IRS approval will not be accepted as a defense to any penalty.

Approval required.   The following changes are examples of types of changes that require IRS approval.

1. A change from the cash method to an accrual method or vice versa.
2. A change in the method or basis used to value inventory.
3. A change in the method of figuring depreciation (except certain permitted changes to the straight-line method for property placed in service before 1981, as explained in Publication 534, Depreciating Property Placed in Service Before 1987).

Approval not required.   The following are not changes in accounting methods and do not require IRS approval.

1. Correction of a math or posting error.
2. Correction of an error in figuring tax liability (such as an error in figuring a credit).
3. An adjustment of any item of income or deduction that does not involve the proper time for including it in income or deducting it.
4. An adjustment in the useful life of a depreciable asset.

Filing Form 3115

In general, you must file a current Form 3115 to request a change in either an overall accounting method or the accounting treatment of any item. Attach any required user fee. No user fee is required for an automatic change (discussed later).

You must file Form 3115 during the tax year for which the change is requested. You should file as early in the year as possible to give the IRS enough time to respond to the form before the original due date of the return for the year of change. If you do not file a Form 3115 during the year of change, an extension to file the form will be granted only in unusual and compelling circumstances.

The IRS normally acknowledges receipt of a completed Form 3115 within 30 days after the applicant's filing date. See the form instructions if you do not receive an acknowledgment. The IRS does not acknowledge receipt of Form 3115 for automatic change procedures.

Conference.   If you think the IRS may give an unfavorable response to your request to change your accounting method, you can request a conference when you file Form 3115. The National Office will arrange one before the IRS formally replies to your Form 3115. If you do not specifically request a conference, the IRS presumes you do not want one.

More than one business.   You can use different methods of accounting for separate and distinct businesses. However, if you request a change in accounting method for one of the businesses, the IRS will consider whether the change creates or shifts profits or losses between the businesses and whether the proposed method clearly reflects your income. You must identify each business by name and method of accounting.

Incomplete Form 3115.   If your application is not properly completed according to the instructions for a current Form 3115, you will be notified and given 21 days from the date of the notification letter to furnish the necessary information. If you do not submit the required information within the reply period, the IRS will not process your Form 3115. However, the IRS can grant up to an additional 15 days to furnish the information. Your written request for the 15-day extension must be submitted within the 21-day period.

Taxpayers under examination.   If the IRS has contacted you to schedule an examination of any of your returns, you can request approval to change your accounting method under section 6 of Revenue Procedure 97-27 (or any successor) if that method of accounting is not an issue under consideration. You can request to make the change only under the following circumstances.

1. During the first 90 days of any tax year if you have been under examination for at least 12 months.
2. During the 120-day period following the date an examination ends, regardless of whether a subsequent examination has begun.
3. With the permission of the IRS director for your area.

Revenue Procedure 97-27 is in Cumulative Bulletin 1997-2.

Automatic Change Procedures

These are procedures under which certain taxpayers can presume to have IRS approval to change their method of accounting. The approval is granted for the tax year for which the taxpayer requests a change (year of change), if the taxpayer complies with the provisions of the automatic change procedures. No user fee is required for an application filed under an automatic change procedure. Generally, you must use Form 3115 to request an automatic change. See the form instructions and Revenue Procedure 99-49, as modified, (or any successor), for more information. Revenue Procedure 99-49 is in Cumulative Bulletin 1999-2.

How To Get Tax Help

You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get more information from the IRS in several ways. By selecting the method that is best for you, you will have quick and easy access to tax help.

Contacting your Taxpayer Advocate.   If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

• Call the Taxpayer Advocate at 1-877-777-4778.
• Call the IRS at 1-800-829-1040.
• Call, write, or fax the Taxpayer Advocate office in your area.
• Call 1-800-829-4059 if you are a TTY/TDD user.

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

Free tax services.   To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.

Personal computer. With your personal computer and modem, you can access the IRS on the Internet at www.irs.gov. While visiting our web site, you can select:

• Frequently Asked Tax Questions (located under Taxpayer Help & Ed) to find answers to questions you may have.
• Forms & Pubs to download forms and publications or search for forms and publications by topic or keyword.
• Fill-in Forms (located under Forms & Pubs) to enter information while the form is displayed and then print the completed form.
• Tax Info For You to view Internal Revenue Bulletins published in the last few years.
• Tax Regs in English to search regulations and the Internal Revenue Code (under United States Code (USC)).
• Digital Dispatch and IRS Local News Net (both located under Tax Info For Business) to receive our electronic newsletters on hot tax issues and news.
• Small Business and Self-Employed Community to get information on starting and operating a small business.

You can also reach us with your computer using File Transfer Protocol at ftp.irs.gov.

TaxFax Service. Using the phone attached to your fax machine, you can receive forms and instructions by calling 703-368-9694. Follow the directions from the prompts. When you order forms, enter the catalog number for the form you need. The items you request will be faxed to you.

Phone. Many services are available by phone.
 

• Ordering forms, instructions, and publications. Call 1-800-829-3676 to order current and prior year forms, instructions, and publications.
• Asking tax questions. Call the IRS with your tax questions at 1-800-829-1040.
• TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1-800-829- 4059 to ask tax questions or to order forms and publications.
• TeleTax topics. Call 1-800-829-4477 to listen to pre-recorded messages covering various tax topics.

• A second IRS representative sometimes monitors live telephone calls. That person only evaluates the IRS assistor and does not keep a record of any taxpayer's name or tax identification number.
• We sometimes record telephone calls to evaluate IRS assistors objectively. We hold these recordings no longer than one week and use them only to measure the quality of assistance.
• We value our customers' opinions. Throughout this year, we will be surveying our customers for their opinions on our service.