Since inventory is the stock of the goods your business sells for its trade, at some point you must involve it in calculating taxable income. Due to its nature, inventory is only taxable when you sell it. The proceeds from the sale are income, but you decrease that amount by the Cost of Goods Sold. This deduction is dependent on inventory activity for the year.
Inventory is a series of asset accounts that represents the collection of goods owned by your business that you either intend to sell or use to produce salable products. While inventory is an asset, the tax code specifically excludes it from consideration as capital, which precludes sale of inventory from receiving beneficiary treatment. In addition, the tax code precludes you from depreciating inventory and using this to offset taxable income.
Taxable Income Defined
The general theory of taxable income has its basis in common law. Taxable income must be an accession to clearly realized wealth over which you have complete control. An accession to wealth is any economic benefit, both tangible and intangible, that you receive and that improves your position. Generally, you must actively pursue the wealth by working for it in some way. Realization occurs when you receive something different from what you had previously. You have control when you can use the new wealth without limitation by the person who provided the property. Therefore, inventory only becomes taxable when you sell it to a third party and your business receives cash or other property for that good.
Cost of Goods Sold
When your business sells its product, it may deduct the associated direct costs of manufacturing the product from the proceeds to determine the overall taxable income from the year’s sales. Inventory plays an important part in calculating the Cost of Goods Sold, or COGS. The IRS requires that you use Schedule C to determine your business’s COGS. You calculate this deduction by taking the amount of inventory at the beginning of the year and adding the value of all acquisitions made and labor done during the year for the production of your business's salable merchandise. Examples of these purchases include raw materials and the wage expense of a manufacturer working on a production line. This amount minus the value of your inventory at the end of the tax year equals your deductible COGS.
When completing your business’s tax returns, consult with a certified public accountant (CPA) to ensure that you file the returns appropriately. After filing your returns, keep the completed returns as well as copies of all supporting documents for your claim, for a period of at least 7 years in case of a future audit. While taking every effort to ensure completeness and accuracy, you should not consider this as legal advice.
- USlegal: Inventory Law & Legal Definitions
- IRS.gov: Publication 544 (2010), Sales and Other Dispositions of Assets
- IRS.gov: Publication 946 (2010), How To Depreciate Property -- 1. Overview of Depreciation -- What Property Can Be Depreciated?
- U.S. Supreme Court; Commissioner v. Glenshaw Glass; 1955
- IRS.gov; Publication 334 (2010), Tax Guide for Small Business; 6. How To Figure Cost of Goods Sold
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.