Your retail business operates by selling the purchased products, so your primary purpose is to sell everything purchased for inventory. However, you always have to handle unsold inventory at the end of the year as you calculate your taxes. Unsold inventory has a significant impact on your tax bill; therefore, it is essential to handle it with utmost care. Every business is taxed at the end of the year based on the profit, which is determined as follows.
- Your total revenue would equal your annual sales.
- Beginning and new inventory minus ending inventory would increase your annual cost of goods sold.
- Remaining unsold goods are your inventory at the end of a year, so your profits would equal total revenue minus Cost of Goods Sold (COGS)
It is important to understand the calculation of profits because you will have to pay taxes based on that calculation. Also, the taxation will depend on how you handle inventory and your organization’s structure. Companies have many structures, including Single-member LLCs, Multimember LLCs, Sole proprietorships, Partnerships, and Corporations. There are different rules for each of these structures to file the tax returns, and you must investigate each individually depending on your particular structure.
How to Handle Inventory and Value it for Taxes
The basic rule is to value the inventory at your purchase cost, and all those items that do not have any value are not counted as your inventory. The loss incurred on the valueless items is shown as a higher COGS on the tax returns. This means that you have incurred a cost of the item, but there was revenue associated with it. When your COGS is higher, it would result in more deductions from your total sales and, eventually, lower your profits. Lower profits would result in lower taxable income, so you would have to pay less.
There are three basic ways to handle inventory for taxes, which are accepted by the Internal Revenue Service (IRS).
Cost-based
The purchased items are valued at their cost; any shipping or other fees are also included in determining the value. It is the simplest of methods and appropriate for simple items that do not have hidden costs.
Lower cost or market
According to this method, the items’ cost is compared to their market value on a specified date. Whatever the item’s value on the date, it is recorded in the books.
Retail
The cost of items is determined after the retail value is added, which is your selling price in most cases, and any set markup is then subtracted.
Conclusion
Small businesses use all these cost methods to handle inventory as their operations are small-scale, and it is the easiest way to calculate taxes on their inventory. However, determining the cost of every item in the inventory may be difficult. You may need advanced methods like First in, First Out (FIFO) and Last in, First Out (LIFO) to value the inventory and COGS.
If the cost of your purchased or manufactured products increases over time, you are better off using LIFO because it would result in lower taxable income. However, FIFO should be your method of choice to handle inventory if you want to maintain a healthy financial stature that would help you obtain bank loans and other remunerations.
When considering taxes, there is no use in keeping a large or no inventory. The inventory is only brought into taxation if the items are sold, considered worthless, or removed from the inventory. All the inventory-related purchases also have no impact on your tax bill. Though keeping a small inventory is generally good for your business since you would incur low depreciation costs, the best practice to handle inventory for tax purposes is hiring a professional adept at the task.
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