Inventory: Who's Counting,and Who's Exempt

With contributions by Tara Morgan

March 2010

Inventory: Who’s Counting, and Who’s Exempt

Qualifying businesses may be exempt from the requirement of keeping inventories, accounting for inventory costs under the uniform capitalization rules, and using the accrual method of accounting

Unless your business solely provides services, you likely face the question of whether you should be maintaining inventory for tax purposes. You may also wonder about the implications of a requirement to keep inventory and the exceptions that might apply.

Let’s take a closer look at what kinds of businesses (a) should be accounting for inventory and (b) qualify for the available exemptions.

Inventory Requirement. In general, the Internal Revenue Code and Regulations require the use of inventories when the production, purchase or sale of merchandise is an income-producing factor. This applies to service providers who also produce, purchase or sell goods in conjunction with the services they provide. Additionally, inventories should not be viewed only as goods stored in a warehouse; products to which the taxpayer takes title, regardless of physical possession, are considered inventory.

When inventories are required to be maintained, the accrual method of accounting is typically required.

Exceptions. Based on the general guidelines, it would appear that virtually all producers and resellers would be subject to the inventory rules. That is not necessarily so; the IRS has created special rules that apply to some small businesses for the purpose of simplifying their bookkeeping requirements.

For example, taxpayers with average annual gross receipts of less than $1 million are exempt from the requirement of keeping inventories, accounting for inventory costs under the uniform capitalization rules, and using the accrual method of accounting. (As we progress through this article, we will refer to this situation as the “$1 million exemption.”)

In calculating average annual gross receipts, it should be noted that aggregation and constructive ownership rules apply. (“Constructive ownership” is a doctrine under which a taxing authority, for taxation purposes, assigns to one taxpayer the ownership interest of another taxpayer.) The example below illustrates these additional considerations.

Example. Husband owns 100% of Corporation A. Its gross receipts for a three-year period:

2006:	$700,000
2007:	$875,000
2008:	$600,000

Husband also owns 5% of Corporation B. Wife owns the remaining 95%. Corporation B’s gross receipts:

2006:	$200,000
2007:	$500,000
2008:	$350,000

Under the constructive ownership rules, Husband is considered to own the stock owned by Wife; therefore, Husband is deemed to own 100% of Corporation B.

Then, the aggregation rules define Corporation A and Corporation B as a brother-sister controlled group and require the gross receipts of Corporation B to be combined with the gross receipts of Corporation A when determining the group’s average annual gross receipts. Effectively, Corporation A does not qualify for the $1 million exemption, as its average annual gross receipts are:

2006:	$700,000 200,000
2007:	$875,000 500,000
2008:	$600,000 350,000
Total:	$3,225,000
Three-year average:	$1,075,000

Qualifying Taxpayers. Taxpayers that qualify under the $1 million exception are not subject to the inventory rules and are not required to be on the accrual method of accounting.

Rather than accounting for inventory, the applicable items are treated as non-incidental materials and supplies, and a deduction is allowed for the amount of non-incidental materials and supplies actually consumed and used in operations during the year. The beginning and ending materials and supplies must still be tracked in order to determine the current-year deduction as well as the expense that must be carried forward and deducted in future tax years as used.

In determining the deduction for materials and supplies used, any reasonable method may be used, as long as it is applied consistently from year to year. First-in-first-out (FIFO) or the average cost methods are considered reasonable methods; last-in-first-out (FIFO) is not.

Other Relief. If the $1 million exception isn’t applicable to your company, don’t’ despair: The IRS has provided further relief by allowing certain taxpayers with average annual gross receipts of more than $1 million, but less than $10 million, to use the cash method of accounting and avoid the requirement of maintaining inventory.

Although this appears to be a generous provision, there is a catch: Taxpayers engaged in the businesses of mining, manufacturing, wholesale trade, retail trade and information producing do not qualify for this exception.

If a taxpayer has more than one trade or business, two tests are available for determining the principal business activity for purposes of determining eligibility for this exemption. Also, the taxpayer qualifies only if it did not previously change, and was not previously required to change, from the cash method to an accrual method for any trade or business.

An additional caveat: The average annual gross receipts limit of $10 million applies only to entities organized as (i) S corporations or (ii) partnerships without C corporation partners. In determining if this exception is met, C corporations (or partnerships with C corporation partners), aside from those engaged in a farming business, are subject to additional restrictions in which the average annual gross receipts must be less than $5 million.

Taxpayers that qualify under the $10 million exception (or the $5 million exception for C corporations) do not have to maintain inventory for tax purposes, nor are they required to use the accrual method of accounting. Instead, they have the option to choose (i) their method of accounting and (ii) whether they want to maintain inventory versus take the materials and supplies deduction.

For example, the accrual method of accounting can be used while still taking a deduction for materials and supplies used during the year. Alternatively, a taxpayer can keep inventory while still using the cash method of accounting. Further, the cash method can be used in combination with the materials and supplies deduction. Consistent with the $1 million exemption, a reasonable method of determining the materials and supplies deduction must be applied consistently from year to year.

Conclusion. The Internal Revenue Code and Regulations are complex, and in many cases the facts and circumstances of a particular situation must be considered in determining the appropriate tax treatment. Therefore, if you have any questions about whether you qualify under one of the exemptions or should be keeping inventory, you should consult with your tax professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.