At the end of the year, your business will be taxed on your profits. Your inventory will indirectly affect your profits. Your inventory will lower your profits, which will lower your taxable income.
Your profits are your total revenue minus your cost of goods sold (COGS). To calculate your COGS, add your inventory at the beginning of the year to any new inventory purchased during the year, then subtract your ending inventory.
Because you’re taxed on your profits, and not your total revenue, you’re essentially deducting the cost of your inventory.
How Should I Value My Inventory?
The IRS generally accepts three ways to value your inventory:
Cost: purchase price of the item plus any additional costs, like shipping fees;
Lower of Cost or Market Value: compare the cost of each item with the market value and choose the lower of the two;
Retail: subtract a set markup percentage from your selling price.
The cost method is the easiest method to keep track of, but you have to use the same method year-after-year. You can’t switch each year depending on which method gives you the biggest deduction.
First In, First Out
If you can’t determine the cost of individual items, or if your costs change throughout the year, you can use the first in, first out (FIFO) method.
The FIFO method assumes the first products you purchased were the first products sold.
You bought products for resale in three batches during the year and sold 400.
100 products at $10 each = $1,000
250 products at $10.50 each = $2,625
150 products at $11 each = $1,650
Assuming the first items purchased were the first sold, you’d assume you sold 100 products at $10 each, 250 products at $10.50 each, and 50 products at $11 each.
What About Items I Can’t Sell?
If you can no longer sell a product, it’s considered “worthless” and taken out of inventory. The loss will result in slightly higher COGS, which means a larger deduction and a lower profit.
There’s no tax advantage for keeping more inventory than you need. Your inventory isn’t a deduction until it’s removed from inventory – either it’s sold or deemed “worthless.”