Does My Inventory Affect My Taxes?
Yes. At the end of the year, your business will be taxed on your profits, which your inventory indirectly affects because it will lower your earnings. This will then reduce your taxable income.
Your profits are your total revenue minus the cost of goods sold (COGS). Your COGS are your inventory at the beginning of the year plus anything purchased during the year, minus your ending stock. Because you’re taxed on your profits, and not your total revenue, you’re essentially deducting the cost of your inventory.
How should you value your inventory?
The IRS generally accepts three ways:
- Cost – purchase price of the item plus any additional costs, like shipping fees
- Cost vs. market value – compare the cost of each item with the market value and choose the lower of the two
- Retail – subtract a set markup percentage from your selling price.
Read also: Cost of Goods Sold
The cost method is the easiest one to keep track of, but once you choose a particular way, you must use it year after year. You can’t switch each year, depending on which method gives you the biggest deduction.
If you can’t determine the cost of individual items, or if they change throughout the year, you can use the first-in, first-out (FIFO) method.
The FIFO method assumes the first products you purchased were the first products you sold.
You bought products for resale in three batches during the year and sold 400.
- 100 products at $10 each = $1,000
- 250 products at $10.50 each = $2,625
- 150 products at $11 each = $1,650
Assuming the first items purchased were the first sold, you’d assume you sold 100 products at $10 each, 250 products at $10.50 each, and 50 products at $11 each. So, your total COGS would be $4,175.
What about items you can’t sell?
If you can no longer sell a product, it’s considered “worthless” and taken out of inventory. The loss will result in slightly higher COGS, which means a larger deduction and a lower profit.
Read also: Back to Basics: Gross Profit & Gross Profit Margin
There’s no tax advantage for keeping more inventory than you need, however. You can’t deduct your stock until it’s removed from inventory – either it’s sold or deemed “worthless.”