Valuing Inventories on Tax Year

An inventory is necessary to clearly show income when the production, purchase or sale of merchandise is an income-producing factor. If the taxpayer must account for an inventory in his or her business, he or she must use an accrual method of accounting for his or her purchases and sales. 
To figure taxable income, the taxpayer must value his or her inventory at the beginning and end of each tax year. To determine the value, the taxpayer needs a method for identifying the items in his or her inventory and a method for valuing these items. The rules for valuing inventory are not the same for all businesses. 
The method the taxpayer uses must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. The taxpayer is inventory practices must be consistent from year to year.
The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is very important. Generally there are two methods for valuing inventory. These methods are cost or lower of cost or market.

• COST METHOD. To properly value your inventory using the cost method, you must include all direct and indirect costs associated with it.
• LOWER OF COST OR MARKET METHOD. Under the lower of cost or market method, compare the market value of each item on hand on the inventory date with its cost and use the lower value as its inventory value.

Accrual Method of Accounting

Under the accrual method of accounting, generally the taxpayer reports income in the year it is earned and deducts or capitalizes expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Generally, the taxpayer includes an amount in gross income for the tax year in which all events that fix his or her right to receive the income has occurred and he or she can determine the amount with reasonable accuracy. Under this rule, the taxpayer reports an amount in his or her gross income on the earliest of the following dates:

• When he or she receives payment;
• When the income amount is due to him or her;
• When he or she earns the income;
• When title has passed.

Generally, the taxpayer reports an advance payment for services to be performed in a later tax year as income in the year he or she receives the payment. However, if the taxpayer receives an advance payment for services he or she agrees to perform by the end of the next tax year, the taxpayer can elect to postpone including the advance payment in income until the next tax year. However, he or she cannot postpone including any payment beyond that tax year. The taxpayer can postpone reporting income from an advance payment he or she receives for a service agreement on property he or she sells, leases, builds, installs, or constructs. This includes an agreement providing for incidental replacement of parts or materials.  However, this applies only if the taxpayer offers the property without a service agreement in the normal course of business. Generally, a taxpayer cannot postpone an advance payment in income for services if either of the following applies:

• He or she is to perform any part of the service after the end of the tax year immediately following the year he or she receives the advance payment;
• He or she is to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately following the year he or she receives the advance payment.

Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of a taxpayer's trade or business. However, the rules do not apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received. 

Generally, include an advance payment in income in the year in which the taxpayer receives it. However, the taxpayer can use the alternative method. Under the alternative method, generally include an advance payment in income in the earlier tax year in which the taxpayer:

• Includes advance payments in gross receipts under the method of accounting he or she uses for tax purposes;
• Includes any part of advance payments in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.

Cash Method of Accounting

Most individuals and many small businesses use the cash method of accounting. Generally, if the taxpayer produces, purchases, or sells merchandise, he or she must keep an inventory and use an accrual method for sales and purchases of merchandise. Under the cash method, the taxpayer in his or her gross income all items of income he or she actually or constructively receives during the tax year. If the taxpayer receives property and services, he or she must include their fair market value (FMV) in income.
Under the cash method, generally, a taxpayer deducts expenses in the tax year in which he or she actually pays them. This includes business expenses for which he or she contests liability. However, the taxpayer may not be able to deduct an expense paid in advance. Instead, he or she may be required to capitalize certain costs.
An expense a taxpayer pays in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following:

• 12 months after the right or benefit begins;
• the end of the tax year after the tax year in which payment is made.

If the taxpayer has not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12 month rule to the expenses he or she paid in advance, the taxpayer must obtain approval from the IRS before using the general rule and/or the 12-month rule.

The following entities cannot use the cash method, including any combination of methods that includes the cash method:

• A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million;
• A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $5 million;
• A tax shelter.

Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business. For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of trees. (other than fruit or nut trees)

There is an exception to the requirement to use an accrual method for corporations with gross receipts of $1 million or less for each prior tax year after 1975. For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985.