Inventory mess. How to fix it?

[IvanP]

Hi there and thank you for helping.

When I prepare my taxes and I put in beginning inventory and ending inventory my owed taxes jump significantly in turbotax. My 2020 beginning inventory is $5663 and ending inventory is $5252 (beginning inventory minus $411 which is the amount I paid for the goods in 2019)

I'm very confused about this and I'm not sure that I can explain it in a clear way, but I hope you'll understand. I'll use rough numbers but close to the real ones.

In 2019 I started an online t-shirt retail business. I paid a manufacturer $5,700 to manufacture and send me 300 t-shirts. The T-shirts cost me $19 per piece.  In 2019 aI sold 8 t-shirts.  When I filed my taxes I reported income of $200 (8 t-shirts sold for $25 each) and in inventory I put 0 as beginning inventory and $5548 as ending inventory (5700 - 8*19 which is the cost that I paid for the shirts I sold) My thinking was that I need to report the total value of all t-shirts in storage. Did I mess up here? 

In 2020 I sold 25 t-shirts for a total of $625 which I will report as 1099-K income. My question is why do my owed taxes jump when I report the end of year value of my inventory? Maybe I don't get the inventory part very well. Also what is the best way to proceed with this? I'll answer any questions you might have for me. Once again thank you for helping.

[ColeenD3]

You are doing it correctly. Your beginning inventory 2020, should be $5548 and ending should be $5073 with $625 in income. You "spent" $475 to make $625. 

[IvanP]

Coleen, thank you for your reply.

In this case why the tax that I owe goes up when I input the correct beginning and ending inventory numbers? This is the part that bothers me. My inventory decreases by $475 and my income from sales is $625. So I expect to owe tax on the $150 profit. But in my case, my owed Federal Tax jumps by nearly $700 and my state tax jumps by more than $200. 

[ColeenD3]

Print your forms and then delete the inventory. See exactly where the changes happen and then re-enter the information and check again.

[Carl]

See if this helps clarify things.

BOY = Beginning of Year

EOY = End of Year

COGS = Cost of Goods Sold

When dealing with inventory, your BOY inventory balance must match your prior year EOY balance. If it does not, then you will have some explaining to do do the IRS. There is absolutely no reason for the BOY inventory balance to not match the prior year's EOY balance. None what-so-ever.

Keeping this mind, in your first year of business (or first year dealing with inventory) your BOY balance must be zero. No exceptions. It doesn't matter if you actually purchased that inventory years ago either. If in the prior year you were not in business or did not report inventory, there is absolutely no possible way you can have an inventory balance greater than zero in that first year of dealing with inventory.

Also, understand that inventory is not a deductible business expense until the tax year you actually sell that inventory. There are no exceptions. So with all this, here's a few examples. Example 1 shows the first year of dealing with inventory. Example 2 shows the 2nd year of dealing with inventory.

Example 1:

BOY Inventory balance = $0 (What *you* paid for that inventory)

COGS = $5000 (What *you* paid for that inventory)

EOY Inventory balance - $2000 (What *you* paid for that inventory)

The above indicates that on Jan 1 of the tax year you had no inventory. Then during that tax year you sold $5000 of your inventory and ended the year with $2000 of inventory. Therefore with simple math one can see that you purchased a total of $7000 of inventory during the tax year, and in that same tax year you sold $5000 of that inventory. That $5000 is deductible.

Example 2:

BOY Inventory balance = $2000  Take special note that this balance matches the prior year's EOY inventory balance, exactly.

COGS = $4000 This is what I paid for the inventory that I actually sold during the tax year. It *does* *not* *matter* in what tax year I paid for it either.

EOY inventory balance - $3000 This is what I paid for the inventory I had left over on Dec 31 of the tax year. Again, it does not matter in what tax year I paid for that inventory either.

With the above, we can see that I started the tax year with $2000 of inventory. With some simple math we can see that an additional $7000 of inventory was purchased during the tax year, bringing my total inventory for the year to $9000. Of that, I sold $4000 of inventory leaving me with $3000 of inventory on Dec 31 of the tax year. The $3000 I paid for the inventory I sold, is deductible from my taxable business income now.

[IvanP]

Hi Carl and thank you so much for taking the time to explain. I really appreciate it.

My situation matches Example 1. This is what I put in my tax for 2019:

BOY = 0 

COGS = $150

EOY = $5,350

With this, I understand that with my 2019 filing I "told" the IRS that I purchased a total of $5,500 in inventory (non-deductible until sold) of which I sold $150 (which is the only deductible part) and I have $5,350 inventory on Dec 31.

Am I correct until this point?

Now for 2020, I did not purchase any new inventory.

BOY = $5,350... the same amount with which I ended 2019.

COGS = $350 - the cost of the 25 t-shirts which I sold in 2020 (regardless of the fact that I paid for them in 2019).

Therefore my EOY should be $5,350-$350=$5,000.  Am I correct?

When I input it like this, the federal tax I owe jumps with $630, and the state tax jumps with $263.  What I expect when I input it like this is to get a $350 deduction from the income ($600) and pay tax on my $250 profit. Am I correct? Can you help me with why this is happening?

[Carl]

One thing you need to understand and be cognizant of, is this.

The program can only work with the information it has *at* *this* *specific* *point* *in* *time*.

So as an example, it's perfectly viable that those business deductions put your income (again, at *this* specific point in time) that the program knows about, below a threshhold that qualifies you for a deduction - such as the the Earned Income Credit. (Remember, this is only an example).  So you're going to see that number for both federal and state, literally jump all over the place. That number is absolutely meaningless until you have completed your tax return in it's absolute entirety *and* all the final checks have been run on it, which occurs just 2-3 screens before that screen with the big orange TRANSMIT MY RETURNS NOW button on it.

Since the data you are referring to is entered in the federal section, and the program will carry it forward to the state return to a point that actually means something, means that what your state return says has absolutely no merit what-so-ever, since at this point you haven't even started the state return yet.

     Now, according to what I see on my screen, you are using the online version called Turbotax Self-Employed. Assuming you are using the program the way it is designed and intended to be used, that means  the business income/expenses is *the* *very* *first* section you're dealing with in the program, after having dealt with all the other non-financial information in the Personal Info section. So basically, you have "barely" started your return, and the absolute only income the program has to work with *at* *this* *specific* *point* *in* *time*, is your business income. Who knows how much other income the program is not even aware of yet, because you haven't entered it?

[tagteam]

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@IvanP wrote:

Now for 2020, I did not purchase any new inventory.

BOY = $5,350... the same amount with which I ended 2019.

COGS = $350 - the cost of the 25 t-shirts which I sold in 2020 (regardless of the fact that I paid for them in 2019).

Therefore my EOY should be $5,350-$350=$5,000.  Am I correct?

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The basic formula is the following (and it has never changed):

Beginning Inventory Plus Purchases Minus Ending Inventor Equals Cost of Goods Sold.

If you follow the other response in this thread, you are doing it backwards. You do not need to know your cost of goods sold in order to determine your ending inventory. You need to know your ending inventory in order to calculate your cost of goods sold.

Therefore, if your beginning inventory was $5,350, you purchased no new inventory during the year, and your ending inventory was $5,000, then your cost of goods sold was $350.