from IRS pub 538
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 will not be treated as failing to clearly reflect income if your method of accounting for inventory treats inventory as
non-incidental material or supplies, or conforms to your financial accounting treatment for inventories. If, however, you choose to keep an inventory, you generally must use an accrual method of accounting and value the inventory each year to determine your cost of goods sold.
Small business taxpayer. You qualify as a small business taxpayer if you
• Have average annual gross receipts of $25 million or less (indexed for inflation) for the 3 prior tax years, and
• Are not a tax shelter (as defined in section 448(d)(3)).
If your business has not been in existence for all of the 3 tax-year period used in figuring average gross receipts, base your average on the period it has existed. also include receipts of the predecessor entity from the 3 tax-year period when figuring average gross receipts. If your business (or predecessor entity) had short tax years for any of the 3 tax-year period, annualize your business’ gross receipts
for the short tax years that are part of the 3 tax-year period.
In a nutshell, the TCJA of 2017 says that small business taxpayers (basically any business with sales under $25 million) can account for inventory for tax purposes either:
1) as non-incidental materials and supplies - if paid for you don't get to expense it until sold *OR*
2) as conforms to the taxpayer’s method of accounting - so if you use the cash basis and don't account for inventories that' s ok for tax purposes
Accounting for inventoriable items as materials and supplies that are not incidental
“Not incidental” materials are those that required to manufacture your products. They are essential to the creation and selling of your product.
“Incidental” materials, on the other hand, are materials that are not directly involved in the production of your finished product.
The IRS guidance states that “not incidental” materials and supplies are deductible in the year they are used or paid, whichever is later.
The TCJA language gives you the option to now report your inventory conforming to your method of accounting.
What is meant by the “taxpayer’s method of accounting?
What if I don’t even have a method of accounting?
Or what if your method of accounting is all wrong? What if your method of accounting subtracts 5% from all sales, rounds up purchases by to the nearest $100 and then adds $1,000
According to TCJA, since that’s your “method of accounting,” can you just use those same numbers for your tax reporting?
the IRS is obviously not okay with fraudulent tax returns. just that there is ambiguity introduced by the TCJA with respect to inventory accounting for tax purposes.
If your method of accounting involves throwing all your receipts in a shoebox, then incorporating all of those receipts into your tax return at year end, you are operating within the bounds of the most recent IRS guidance.
Clearly reflect income
The IRS generally wants to see accounting treatment that “clearly reflects income.” Historically this has meant that the deduction of the inventory should be recognized at the same time as the sale.
I would be inclined to argue that since the IRS favors clearly reflecting income, the taxpayer’s method of accounting should only deduct inventory when sold.
However, the TCJA wording specifically states that “the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either 1) treats inventory as non-incidental materials and supplies OR 2) conforms to such taxpayer’s method of accounting,
"which does not account for inventory" (' .... " my word s to clarify)
