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Squeezing More Tax Deductions Out of Inventories

Dear Friends and Clients:

As a (manufacturer, retailer, wholesaler), inventory is one of your biggest assets. It also represents a significant cost. We are writing to discuss some strategies for accelerating your tax deductions for that cost.

In the past, the IRS has argued that a deduction for inventory shrinkage (that is, undetected losses due to theft, breakage, bookkeeping errors, and similar occurrences) could not be deducted unless a physical inventory was taken at year-end to confirm the amount of loss. Congress recently overruled this IRS position, and the tax law now allows most taxpayers to deduct estimated shrinkage each year, even if physical inventories are taken at some time other than year-end.

For retailers, a safe harbor method for estimating shrinkage is available. The business’s actual shrinkage for the past three years (as a percentage of sales for those years) is multiplied by current year sales between the date of the last physical inventory and year-end to compute the shrinkage deduction. Taxpayers that are not retailers (as well as retailers who choose not to use the safe harbor method) can use any other accounting method to estimate shrinkage, as long as it clearly reflects income. The advantage for retailers of using the safe harbor method is that the IRS will not challenge it. (The IRS expects to provide safe harbor methods for other types of taxpayers in the future.)

Another way to minimize taxable income is to establish effective procedures for identifying inventory that cannot be sold at normal prices (for example, damaged or obsolete items). You are allowed to write these so-called subnormal goods down to the price at which they are offered to the public. The key is to identify the goods and offer them for sale within 30 days of the inventory date.

An additional way for some businesses to increase their inventory write-offs is to adopt the lower of cost or market (LCM) method of accounting for the inventory. Under this method, you can claim a deduction for the amount by which the inventory’s market value declines below cost. If your inventory’s value is stable, or it turns over quickly, the additional work required under the LCM method may not be warranted. In some situations, however, especially businesses with slow-moving inventory or products that are subject to declines in value while in inventory, adopting the LCM method can be very beneficial.

If you’re interested in more details on any of these tax strategies for managing your inventory, please give us a call. 

Very truly yours,