 Income Tax 2021 2022 Inventories. Get ready to get refunds to the max, dive into Income Tax 2021 2022. Most of this information can be found in Publication 334, Tax Guide for Small Business 2021. Looking at the income tax formula, the top line, the income line, noting that it would be supplemented with another schedule, basically an income statement, income and expenses. The expenses basically being the deductions, the net then rolling into the top line of the income tax formula, as well as the first page of the 1040, the tax return. We would generally have a schedule C rolling into the schedule one, rolling into page one of the form 1040, line number eight. Here's our schedule C profit and loss, basically an income statement. We're now looking into the inventories. Remember that inventories we mentioned a couple of times that if you're looking at the methods, cash method, accrual method, some kind of hybrid between the two methods, a combination method as they call it, then the inventories is one of those things that you might think would push you over to be using an accrual method, at least for those inventory type of transactions, because inventory itself is an accrual account normally. In other words, when you purchase inventory, even if paying cash for it, you usually put it on the books as an asset, not as an expense, which is what you would do on a cash basis, and then you expense it in the form of cost of goods sold when you use the inventory, selling the inventory, in order to generate revenue. That's an accrual thing, and that's why we typically think that if you have the inventory, then you might be choosing that accrual method unless you choose an exception or choose some reason not to. But remember, whatever method you put on the tax return, you want it to kind of mirror what you're doing, of course, on the bookkeeping side, one, because that's basically what the tax code wants, and two, because you don't want two different methods to be trying to keep track of as you're entering the data. So generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use an accrual method for purchase and sales of merchandise. That's the general rule, but exception here for small business taxpayers. If you are a small business taxpayer, you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income. So you could have certain situations then where you have the inventory, but you might basically still be kind of on a cash method. So you can imagine situations where possibly the inventory is not, you're not accumulating a lot of inventory, like you don't have like a stockpile of inventory, for example, and so you're like purchasing something and then selling it pretty close in time frames, for example, maybe in a situation where you can make an argument and say, well then I'd still kind of like to use a cash method, even though technically I have inventory involved because I don't want to be tracking inventory under the normal inventory tracking method because I have kind of a just in time type of system. I'm not holding on to the inventory that much. So once again, exception, if you are a small business taxpayer, you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income. If you choose not to keep an inventory, you won't be treated as failing to clearly reflect income. If your method of accounting for inventory treats inventory as non-incidental material or supplies. So basically you're saying it's not as big a significant factor in that instance, and therefore the IRS isn't gonna be like worried about it in that point in time to be on an accrual method, for example, or confirms your financial accounting treatment of inventory. And so you could see what the IRS would kind of be worried about here. Obviously if you had a lot of inventory, you can kind of manipulate a cash method with inventory because you could, for example, purchase a bunch of inventory that you're gonna sell by the end of the year and then record it as a cash expense at that point in time, even though you haven't used it in order to generate revenue, you're gonna use it to generate revenue when you sell it kind of in a future point in time. So by stockpiling increase in the supply of inventory, for example, on a cash method, you can kind of try to distort your income. And if that becomes significant, of course the IRS is concerned that people will manipulate their income in that instance. And so if, however, you choose to keep an inventory, you must generally use an accrual method of accounting and value the inventory each year to determine your cost of goods sold in part three of Schedule C. So you might say my inventory is small and so maybe I don't do that, but again, you wanna be careful because if your inventory gets larger and significant to the point where you're tracking it in your bookkeeping, you would like your bookkeeping to mirror what's on the tax return and you would have to then request that the IRS allow you to move to switch methods, which they would probably grant switching from a cash method to an accrual method, but it's still kind of a pain to go through that process. So pick a method that kind of mirrors with your bookkeeping, of course, keeping the exceptions in mind, but also maybe thinking out into the future what your bookkeeping might be in the future, noting that you can change the methods and that would probably be a reasonable reason to change from a cash to an accrual method, but still kind of a pain. Small Business Taxpayer. You qualify as a small business taxpayer if you A, have average annual grocery seats of 25 million or less, or the three prior tax years, and one more time, A, have average annual grocery seats of 26 million or less for the three prior tax years and B are not a tax shelter or defined in section 448D3. If your business has not been in existence for all of the three tax year period used in figuring average grocery seats, base your average on the period it has existed. So obviously they're looking at the average income basically of the 26 million, and then you can have this special situation saying, well, what if I've only been in business for two years or one and a half years? Well, then you figure the average generally on whatever the years that you have been in business. And if your business has a predecessor entity include the gross income of the predecessor entity from the three year tax period when figuring average grocery seats. So you might say, well, what if I changed my business entity from last entity to this entity? Well, then you should probably take the prior entity for the last three years would be the fairest thing to do. So if your business or predecessor entity had a short tax year for any of the three year period, annualize your business grocery seats for the short tax year that are part of the three year period. So in other words, what if I've only been in business for a year and a half? Can I take the, you know, the 50 million I made this year and add it to the 25 million I made last year or the 15 million I made last year, but it was only for six months or the other way around, you know, this last whatever. You can see half the income and then take the average. No, you can't do that because that would mean your income would be low your average would be that would be a way to manipulate the average because you didn't have a full year than that you're calculating the average. So you have to account for the fact that you only made revenue for a partial year and that instance to get an accurate number of the average for the test to be fair. Treating inventory as non-incidental materials or supplies. So remember, if it was incidental, that might be one of those kinds of exceptions that you can basically have kind of like inventory that would be an exception. So you can still use it a cash method. This is non-incidental. So treating inventory as non-incidental material or supplies, if you account for inventory as material and supplies that are not incidental, you deduct the amounts paid or incurred to acquire or produce the inventoryable items treated as non-incidental materials and supplies in the year in which they are first used or consumed in operation. So we're talking about the consumption or use of them at this point in time, they're not claiming the purchase point in time. Inventory treated as non-incidental materials and supplies is used or consumed in your business in the year you provide the inventory to your customers. So that's when you give it to the customers, that's when you actually, that's an accrual kind of component. So financial accounting treatment of inventories, your financial accounting treatment of inventories is determined with regard to the method of accounting you use in your applicable financial statement as defined in section 451B3 or if you do not have an applicable financial statement with regards to the method of accounting you use in your books and records that have been prepared in accordance with your accounting procedures. So generally you want your tax treatment to be lining up to your bookkeeping treatment which if you're required to make financial statements your financial statement treatment. So changing your method of accounting for inventory. So what if I need to change things? What if I marks it off as a cash method and I need to change it to an accrual method or something like that? Well, you can't do it without permission. That's for sure. So if you want to change your method of accounting for inventory, you must file form 3115. You can see change in accounting method later for that information. So items included in inventory, if you are required to account for inventories include the following items when accounting for your inventory. Merchandise or stock in trade, raw materials, work in process, finished goods, supplies that physically become a part of the item intended for sale. So usually inventory, if you're talking about like a retail type of thing you're purchasing something, marking it up and selling it pretty straightforward whatever you're buying that you're gonna then sell is inventory. But if you're making something then it gets a little bit more complex because you got the raw materials like if you make a guitar, you buy the wood or something like that. And then it's in process when I'm gluing stuff together, I'm gluing stuff together and I got glue and stuff that's like small materials which might be like overhead or something like that. And then you've got the finished product which is my finished guitar. And then I'm gonna sell that guitar all the stuff being included in it, the raw materials, which includes things like the labor, I mean the raw materials, the wood and so on and so forth. And then I include stuff like the incidental glue and stuff, work in process, the overhead kind of stuff and the labor and then the finished products. So that gets a bit more complicated when you're making stuff. Valuing inventory, you must value your inventory at the beginning and end of each tax year to determine your cost of goods sold. So we want the good old, this is schedule C line 42, the good old cost of goods sold calculation, beginning inventory plus purchases or if we made the inventory, the goods that are meant gives us the goods available for sale minus the ending inventory. That's gonna give us then the cost of the goods that are sold. They want that calculation. So to determine the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these items. Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must be clearly reflect income. So obviously valuing income gets a little bit tricky because for example, if you're buying inventory and then selling it, then you get in a situation you might have old inventory and it's like, well, what if the inventory got old? If it goes below the purchase price value, then you might have to revalue it, the lower of the cost or market or something like that for the inventory. So you gotta use whatever general accounting principles are for your particular business with regards to the valuation of inventory. Your inventory practice must be consistent from year to year. Once again, consistency. That's a key principle in accounting and in life, I would argue, but we're talking about taxes here. So taxes too, even though the tax code hasn't been very consistent with their laws and regulations lately, but we strive for that consistency.