Inventory and IRS Audits
The IRS frequently targets companies with inventory when they conduct audits. If you operate a company that maintains inventory, proper accounting is essential to avoid
Inventory is a frequent audit target. This audit issue will likely lessen for most small businesses, since for tax years beginning after 2017, a business is not required to use inventories or account for them using the accrual method if it meets the $25 million gross receipts test explained above for using the cash method of accounting. Therefore, the information below will now generally apply only to larger businesses that don’t meet the gross receipts test.
Rules For Inventory When Inventories Are Required
-
Inventories are necessary for a business to clearly reflect income when there is sale of goods., They must conform to the best accounting practice in a trade or business.
-
Inventories include all finished goods, goods in process, and raw materials and supplies that will become part of the product (including containers).
-
Physical possession of merchandise is not required for it to be part of inventory.
-
Methods used to handle and value inventory must be followed consistently.
-
Inventory must be valued at either (1) cost, or (2) lower of cost or market value.
Determining Inventory Cost
-
Cost: Use actual cost of merchandise, less discounts plus freight and other handling charges.
-
Uniform Capitalization (UNICAP): IRC Sec 263A significantly affects inventory rules., For inventory and property produced by a taxpayer, (a) the direct cost of such property, and (b) such property’s share of those indirect costs (including taxes) part or all of which are allocable to such property, must be capitalized., To value inventory under UNICAP, a producer must:
-
Classify all costs into these categories: (a) production, (b) general administration, and (c) mixed services.
-
Allocate mixed service costs (on a reasonable basis, e.g., according to number of employees, or using an elective method) to production and general administration expenses.
-
Allocate production costs between the cost of goods sold and ending inventory.
-
-
Lower of Cost or Market: This valuation method is available for most taxpayers except those who use the Last-In-First-Out Method (LIFO) method. LIFO users must value inventory at cost. Write-down of damaged merchandise is not considered an application of the lower of cost or market method. To use this method, each item in inventory must be valued at lower of cost or market.
Estimating Inventory Shrinkage
A taxpayer’s inventory must be maintained under a method that clearly reflects income. Normally inventory is valued at cost. Under former law, it was uncertain as to whether a taxpayer was in compliance with allowable inventory valuation rules when the taxpayer made adjustments to year-end inventory for estimated “shrinkage”--i.e., inventory decrease due to items such as undetected theft, breakage, bookkeeping errors, etc.
Under current law, the adjustment for estimated inventory shrinkage may only be claimed by the taxpayer (business) if:
-
The taxpayer normally does a physical count of inventories at each location on a regular, consistent basis, and
-
The taxpayer makes proper adjustment to those inventories and to estimating methods if those estimates are greater than or less than the actual shrinkage.