Your retail business operates by selling the purchased products, so your basic purpose is to sell everything that is purchased for inventory. However, you always have to handle inventory that is unsold at the end of the year as you are calculating your taxes. Unsold inventory has a significant impact on your tax bill; therefore, it is important to handle it with utmost care. Every business is taxed at the end of the year based on the profit, which is determined as followed.
- Your total revenue would equal your annual sales
- Beginning inventory plus new inventory minus ending inventory would result in your annual Cost of goods sold
- Remaining unsold goods is 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 what type of structure your organization follows. Companies have many types of structures, including Single-member LLC, Multimember LLC, Sole proprietorship, Partnership, and Corporation. 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).
The purchased items are valued at their cost, and 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 of cost or market
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.
Small businesses use all these cost methods to handle inventory as their operations are small-scaled, and it is the easiest way to calculate taxes on their inventory. However, determining the cost of every item in the inventory may not be as easy in many cases, and for that, you may need to use 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.
There is no use in keeping a large or no inventory at all when considering taxes. The inventory is only brought into taxation if the items are sold, considered worthless, or totally 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 to hire a professional who is adept at the task.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks™️ file, critical financial documents, and back-office tools in an efficient and secure environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.