Discover How You Should Maintain Inventory in a Gig Economy

Discover How You Should Maintain Inventory in a Gig Economy

One of the most misunderstood accounting concepts in the e-commerce and reselling space involves how to deduct your inventory costs...

One of the most misunderstood accounting concepts in the e-commerce and reselling space involves how to deduct your inventory costs. Small businesses that sell on a digital platform such as eBay, Esty, Shopify, etc. must contend with rules relating to maintaining inventory.

Before 2018, all taxpayers were required to maintain inventory even if they were a cash basis taxpayer.

The Tax Cuts and Jobs Act (TCJA) of 2017 changed the inventory rules for the small business taxpayer. Recently in January 2021, the IRS issued final regulations to answer questions raised by the TCJA.

New Rules for Deducting Inventory

Under the TCJA, a small business taxpayer (basically any business with sales under $25 million) can account for inventory for tax purposes either:

1. as non-incidental materials and supplies (this is not new and is described below…hint: it doesn’t do you much good), or
2. as conforms to the taxpayer’s method of accounting.

The TCJA raised the threshold to $25 million[1] (it was $1 million for retailers before 2018) and now allows the small business taxpayer to report inventory for tax purposes according to his or her method of accounting.

Cash method vs. Accrual method

The difference between these two methods is timing.

Cash-basis

A business that is on a cash basis recognizes revenue when cash or a cash equivalent is received from a customer. It recognized expenses (deduction) when the cost item is paid.

Accrual-basis

With the accrual basis of accounting, revenue is recognized when it is earned. Expenses are recognized when they are incurred–which is often at a different time from when the payment is made. If a taxpayer maintains accounts payable or accounts receivable it is likely using the accrual method.

The Inventory Rules Before TCJA (pre-2018)

Most small businesses use the cash method for simplicity. Notwithstanding cash basis businesses with inventory were generally required to account for the inventory on an accrual basis. Accordingly, a cash basis taxpayer could deduct the cost of the inventory when the inventory was sold, not when it was purchased.

The IRS regulations provided certain businesses exempt from accounting for inventory using the accrual method. These were businesses that had less than $1 million average gross receipts. (the TCJA increases this threshold to $25 million.)

If the taxpayer qualified for the alternative treatment, which included most small businesses, it was not required to account for inventory using the accrual method. Having said that the taxpayer still had to account for non-incidental expenses but could deduct currently “Inventoriable items as materials and supplies that are not incidental”.

The regulations provided that if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the small business taxpayer [$1 million or less of average annual gross receipts] could use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers had to account for inventoriable items as materials and supplies that are not incidental.

In order to understand how accounting for inventory works we have to clarify what is meant by accounting for “inventoriable items as materials and supplies that are not incidental.”

Accounting for inventoriable items as materials and supplies that are not incidental

“Not incidental” materials are those that required to manufacture your products. They are essential to the creation and selling of your product. “Incidental” materials, on the other hand, are materials that are not directly involved in the production of your finished product.

The IRS regulations provide that “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later. This means that all materials and supplies that are directly used to produce your goods must be accounted for:

1. In the year you provided them as finished goods to customers, or
2. In the year you originally paid for the material

Whichever is later.

Most businesses pay for their goods before selling them. If that’s the case, you were required to account for your inventory using the accrual method–recognizing the cost when you sell it (#1). But if for some reason you don’t pay for your goods until after you sell them (#2), you can recognize the cost when you pay.

TCJA: “Taxpayer’s Method of Accounting”

The TCJA gave the taxpayer the option to report inventory using the “method of accounting used in the taxpayers’ books and records prepared in accordance with the taxpayer’s accounting procedures.”

What is meant by the “taxpayer’s method of accounting? and What is meant by “books and records”?

A “method of accounting” has the following characteristics:

•           It affects the computation of a material item;[2]

•           It is consistently applied and is predictable;[3]

•           It conforms to generally accepted accounting principles;[4]

•           It clearly reflects income;[5] and

•           It has been adopted.[6]

The IRS defines books as: “Except as provided in paragraph (b) [of Reg. §1.6001-1], any person subject to tax under subtitle A of the Code…or any person required to file a return of information with respect to income, shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.[7]”

Clearly Reflects Income

Neither the Code nor regulations define what clearly reflects income. The concept of “ clear reflection of income” is central to tax accounting; clear reflection of income is influenced by many factors but not controlled by anyone.[8] If a taxpayer’s method of accounting challenged by the Commissioner were to prevail, the taxpayer must demonstrate that the Commissioner’s determination is arbitrary, capricious, and without a sound basis in fact or law.[9] A method of accounting that reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.[10] However, the fact that an accounting method is consistent with GAAP does not, by itself, satisfy the clear-reflection-of-income standard.[11]

An often-cited definition is found in Caldwell v. Commissioner,[12] where the Second Circuit said “clear reflection of income” means that income should be reflected with as much accuracy as standard methods of accounting practice permit.[13] The IRS generally wants to see accounting treatment that “clearly reflects income.” Historically this has meant that the deduction of the inventory should be recognized at the same time as the sale.

The TCJA specifically stated that “the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either 1) treats inventory as non-incidental materials and supplies or 2) conforms to such taxpayer’s method of accounting.

Updated Tax Guidance (Jan 2021)

The IRS published final regulations on the TCJA in January of 2021.

The final regulations clarify in Reg §1.471-1(b)(6)(i) that costs that are generally required to be capitalized to inventory under  IRC §471(a) but that the taxpayer is not capitalizing in its books and records are not required to be capitalized to inventory. The IRS has also determined that, under this method, such costs are not treated as amounts paid to acquire or produce tangible property under Reg §1.263(a)-2 , and therefore, are generally deductible when they are paid or incurred if such costs may be otherwise deducted or recovered, notwithstanding Reg §1.471-1(b)(4) , under another provision of the Code and regulations.[14]

Additionally, the final regulations clarify that costs capitalized for the non-AFS IRC §471(c) inventory method are those costs that are related to the production or resale of the inventory to which they are capitalized in the taxpayer’s books and records. Similar clarifications have been made in Reg §1.471-1(b)(5) regarding the AFS IRC §471(c) inventory method.[15]

Hence If you are not valuing your inventory, or in other words, if you are not determining your ending inventory cost balance and they are not reflected in your books and records, then it appears that you can use or continue to use the inventory cash method, which means deducting your inventory when you purchase it, rather than when you sell it.

But if you are keeping track of your overall inventory balance, meaning the total cost of everything you have on hand, or making representations about it, then you’ll need to use the inventory accrual method, meaning that you’ll deduct your inventory when sold.

It’s good practice to use the accrual method for inventory. Accrual accounting provides the best information into how a business is performing. Notwithstanding the changes made by the TCJA and the ability to deduct costs before the goods are sold, the accrual method is recommended if your business is growing and it’s important to you to have good information about your businesses’ performance.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Frank Brunetti, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.

[1] The threshold is adjusted for inflation. For 2021 it was $26 million.

[2] Reg. §1.446-1(e)(2)(ii)(a) provides that a material item is any item that concerns the timing of income or deductions. In Revenue Procedures, the IRS has explained that an item concerns timing, and is therefore considered a method of accounting, if “the practice does not permanently affect the taxpayer’s lifetime income but does or could change the taxable year in which income is reported. The term “item” is used to indicate any recurring incidence of income or expense. Examples include: real estate taxes, Reg. §1.446-1(e)(2)(iii), Example 2; corporate officers’ bonuses are items, Connors, Inc. v. Comm’r, 71 T.C. 913 (1979); and employees’ vacation pay, Oberman Mfg. Co. v. Comm’r, 47 T.C. 471 (1967), acq., 1967-2 CB 3, See, e.g., TAM 8201015.

[3] Reg. §1.446-1(e)(2)(ii)(a) states that “in most instances,” a method of accounting is not established without a “pattern of consistent treatment” of an item. The “consistency” referred to is consistent treatment of a particular item over time, not consistency between the contemporary treatment of different items.

[4] Reg. §1.446-1(a)(2).

[5] IRC §446(b).

[6] As stated in Reg. §1.446-1(a)(2), “A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.”

[7] IRC §446(a); Reg. §1.446-1(a).

[8] See TAM 9603004 (advising that a method of accounting that was permissible by one taxpayer (using a sliding scale method of depreciation for television film contract rights) was not permissible by another taxpayer because it did not clearly reflect income for the other taxpayer).

[9] Ansley-Sheppard-Burgess Co. v. Comm’r, 104 T.C. 367 (1995). See Sierracin Corp. v. Comm’r, 90 T.C. 341, 368 (1988). That standard was described in Sierracin as follows:

Section 446(b) and sections 1.451-3(e), 1.446-1(a)(2), and 1.446-1(b)(1), Income Tax Regs., vest respondent with broad discretion in determining whether a taxpayer’s contracts should be severed so as to clearly reflect income. “Since the Commissioner has “[m]uch latitude for discretion,” his interpretation of the statute’s clear reflection standard “should not be interfered with unless clearly unlawful.” Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 532 (1979).

Similarly, under IRC §482, the IRS can distribute, apportion or allocate gross income, deductions, credits, or allowances between two or more businesses under common control to prevent tax evasion or for clear reflection of income.

[10] Reg. §1.446-1(a)(2).

[11] Thor Power Tool Co v. Comm’r, 439 U.S. 522, 79-1 USTC ¶9139 (1979).

[12] 202 F.2d 112, 53-1 USTC ¶9218 (2d Cir. 1953). See also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984), where the court found that the IRS did not abuse its discretion in forcing newspaper corps to change from cash to accrual method. Newspaper was material part of business requiring use of inventories which allowed the IRS to require the newspaper company to use the accrual method. The IRS’s consent to use cash method in earlier year did not bar the IRS from changing to accrual method during subsequent year in which it was apparent that cash method did not clearly reflect income.

[13] The problem, however, is that if taken literally, it would, among other things, virtually preclude the use of the cash method.

[14] Id.

[15] Id. Applicable date. The final regulations are applicable for tax years beginning on or after January 5, 2021.