May 2010 -- Tax accounting for inventory contains many detailed and specific rules. For income tax purposes, the starting point for valuing inventory is the value determined for financial accounting purposes under Generally Accepted Accounting Principles (GAAP). From that point, there are special costing rules to be considered (e.g., UNICAP) that are likely to increase the tax value of the inventory compared to its book value. For financial accounting purposes, reserves may be established against the inventory value for net realizable value, obsolescence, or other reasons; however, the ability to deduct these estimated inventory reserves against taxable income is limited. Nevertheless, there are opportunities to write down inventory and deduct the amount under the § 471 regulations.
The types of tax write-downs available depend upon whether the inventory components are considered "normal goods" or "abnormal goods" (defined below). For "normal goods," the available write-downs are limited to "market" write-downs if the taxpayer has elected to use the lower of cost or market method for inventory accounting. For "abnormal goods," there are write-downs available under specific circumstances described in the regulations.
The most common valuation methods for inventory are "cost" and "lower of cost or market". "Cost" typically includes the invoice price along with the direct and indirect costs of producing, acquiring and/or storing the inventory. The UNICAP rules of § 263A then require most taxpayers to capitalize into inventory additional costs that are usually expensed directly for financial accounting purposes. A write-down of "normal goods" from cost to "market" is determined on an item-by-item basis, not on an aggregate basis. "Market" is defined as the current bid price of the basic elements of cost (direct and indirect costs) for the particular goods. In other words, the current bid price is the cost of reproducing the goods in inventory, not the selling price of the goods. If there is an inactive market, a taxpayer may use other evidence to establish the market value.
In addition to writing "normal goods" down to market, there are other write-downs available for "abnormal goods" in determining taxable income. These write-downs are available whether or not the taxpayer uses "cost" or "lower of cost or market" for its inventory valuation method. Treasury Regulation §1.471-2(c) defines "abnormal goods" as goods that are "in inventory which are unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes …."
If the abnormal goods are finished goods, they can be valued at bona fide selling prices less direct costs of disposition, regardless of whether the "cost" or "lower of cost or market" method is used. The bona fide selling price for abnormal goods requires that the goods be offered for sale not later than 30 days after the inventory valuation date (the "30-day rule"). The burden of proof is on the taxpayer to support the value. If no market exists, then a taxpayer may be able to write off the entire cost because the goods have become completely obsolete.
If the abnormal goods are raw materials or partly finished goods, they can be valued using some reasonable basis. There is no 30-day rule in this case; however, the burden of proof is on the taxpayer to support the value. In no circumstance may the value be less than the scrap value.
Specifically excluded from the definition of "abnormal goods" are excess inventory and slow-moving inventory. While a book reserve may be set up for excess or slow-moving inventory, the inability to treat this inventory as "abnormal" may deny the ability to take the write-down.
Any change in how your inventory is valued from your current practice likely will be considered a change in accounting method. Taxpayers must receive advance permission from the IRS to change a method of accounting. An application for permission to change a method of accounting (Form 3115) must be filed by the end of the tax year for which you are requesting permission to change methods. Depending on the nature of the change, however, certain changes in accounting method are automatically approved by the IRS and Form 3115 does not need to be submitted until the tax return for that tax year is filed.
Inventory reserves require close scrutiny. In some cases, the tax deduction may be allowed if the specific rules of the Treasury Regulations are followed. The determination of whether the inventory items are "normal" or "abnormal" is crucial in the timing of the tax deduction. Contact your local CBIZ MHM tax professional to discuss whether you may qualify for these write-downs.
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