Small Business Inventory Rules, Part 1

Can certain small taxpayers simply expense inventory purchases?

Businesses that sell goods in a trade or business generally have to account for items using inventories. §471(a) states:

Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Starting in tax year 2018 and forward, Congress created a small business exception to using the traditional inventory accounting rules for businesses with average annual gross receipts of $25 million ($31 million for tax year 2025) and under over the three prior tax years in §471(c)(1):

(c) Exemption for certain small businesses

(1) In general

In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year—

(A) subsection (a) shall not apply with respect to such taxpayer for such taxable year, and

(B) the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either—

(i) treats inventory as non-incidental materials and supplies, or

(ii) conforms to such taxpayer’s method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.

This provision does not mean that all small businesses meeting the exception can deduct inventory costs in the tax year of purchase; that is a common misconception. It allows a qualifying business to use one of three simplified inventory accounting methods as outlined in Treas. Reg. §1.471-1(b)(3):

1. Section 471(c) non-incidental materials and supplies (NIMS) inventory method

2. Applicable financial statement (AFS) section 471(c) inventory method

3. Non-AFS section 471(c) inventory method

Part 2 of this series will outline these three accounting methods; before getting to them, it is important to clarify what businesses can actually use this exception.

§448(c) Gross Receipts Test

The §448(c) gross receipts test is outlined in Treas. Reg. §1.448-2(c). Treas. Reg. §1.448-2(c)(2)(v)(B) provides a straightforward example:

Taxpayer A, a C corporation, is a plumbing contractor that installs plumbing fixtures in customers' homes or businesses. A's gross receipts for the 2017-2019 tax years are $20 million, $16 million, and $30 million, respectively. A's average annual gross receipts for the three taxable-year period preceding the 2020 taxable year is $22 million (($20 million + $16 million + $30 million)/3) = $22 million. A may use the cash method for its trade or business for the 2020 taxable year because its average annual gross receipts for the preceding three taxable years is not more than the gross receipts test amount of paragraph (c)(2)(vi) of this section, which is $26 million for 2020.

Gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources but do not include state and local sales tax amounts if the tax is not imposed on the business. The cost of goods sold amount does not reduce gross receipts, but the adjusted basis reduction from the sale of a capital asset does reduce the gross receipts amount. See Treas. Reg. §1.448-2(c)(2)(iv), which points to Treas. Reg. §1.448-1T(f)(2)(iv).

If businesses are part of a controlled group under §52(a) or §52(b), or an affiliated service group under §414(m) or §414(o), they are treated as one business when applying the §448(c) gross receipts test. Transactions between the businesses are disregarded when applying the test. See Treas. Reg. §1.448-2(c)(2)(ii), which points to Treas. Reg. §1.448-1T(f)(2)(ii).

If the three-year period includes a tax year of less than 12 months (a short taxable year), the gross receipts for that short year are annualized by multiplying the gross receipts for the short period by 12 and then dividing the result by the number of months in the short period. See Treas. Reg. §1.448-2(c)(2)(iii), which points to Treas. Reg. §1.448-1T(f)(2)(iii).

Tax Shelter Exception

§448(c)(1) excludes a §448(a)(3) “tax shelter” from using a simplified inventory accounting method. Treasury regulations provide an expansive definition of a tax shelter; it encompasses more businesses than one may realize.

Treas. Reg. §1.448-2(b)(2)(i) defines a tax shelter as any:

• Enterprise, other than a C corporation, if at any time, including taxable years beginning before January 1, 1987, interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or state agency having the authority to regulate the offering of securities for sale,

• Syndicate, within the meaning of Treas. Reg. §1.448-2(b)(2)(iii), or

• Tax shelter, within the meaning of §6662(d)(2)(C).

A tax shelter under §6662(d)(2)(C) is the classic definition: a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of federal income tax.

The problem is the definition of a syndicate. A syndicate is a partnership or other entity (other than a C corporation) if more than 35% of the entity's losses during the tax year are allocated to limited partners or limited entrepreneurs. Gains or losses from the sale of capital assets or §1221(a)(2) assets are not taken into account in this determination. A limited entrepreneur, defined in §461(k)(4), is a person who has an interest in an enterprise other than as a limited partner and does not actively participate in its management.

A business can be disqualified from using the small business inventory exception as a syndicate for only one year if it has a tax year in which it incurs a loss; however, it can qualify again as soon as it returns to profitability. To avoid this problem, the regulations allow an irrevocable annual election under Treas. Reg. §1.448-2(b)(2)(iii)(B) to use the prior tax year’s allocation in lieu of the current tax year for the syndicate determination.

The following is a syndicate example based on Treas. Reg. §1.448-2(b)(2)(iii)(C).

Zebra is a calendar-year partnership with a 60% general partner and a 40% limited partner. Its three-year average annual gross receipts are under the annual §448(c) threshold for each year. It has the following results:

• Tax year 2022: It is profitable with no losses to allocate

• Tax year 2023: It is not profitable and allocates losses

• Tax year 2024: It is not profitable and allocates losses

Zebra can use a simplified inventory accounting method for tax year 2022.

Zebra is a syndicate for tax year 2023; however, it can make the election under Treas. Reg. §1.448-2(b)(2)(iii)(B) to use the tax year 2022 allocation for the syndicate determination. If it makes the election, Zebra is not a syndicate for tax year 2023, and it can use a simplified inventory accounting method for tax year 2022.

Zebra is a syndicate for tax year 2024, and the election will not change the outcome since the prior year was a loss. The only possibility is for the partnership to attempt to take proactive actions to reverse the 2024 loss (e.g., elect out of §168(k) bonus depreciation, etc.). If it is a syndicate for tax year 2024, it cannot use a simplified inventory accounting method for tax year 2024.

Zebra must use Form 3115, Application for Change in Accounting Method, to change its inventory accounting method from a simplified method to a §471(a) method for the tax year 2024. For more information about this change, see Rev. Proc. 2024-23, Sec. 22.20. The Designated Automatic Accounting Change Number (DCN) is 263.

Join the Conversation

As a paid subscriber, you can discuss this topic in the comments section. Please keep the discussion related to this edition’s topic.

Learn More About Tom

Please take a look at my website to learn about the opportunities I offer the tax professional community.