Small Business Inventory Rules, Part 2

Can certain small taxpayers simply expense inventory purchases?

The Tax Cuts and Jobs Act (TCJA) enacted a small business exception to using the §471(a) traditional inventory accounting rules. A small business that meets the §448(c) gross receipts test and is not a tax shelter is not required to maintain §471(a) inventories. Part 1 of this topic reviews these two qualifications in-depth.

A taxpayer who qualifies for the small business inventory exception is required to use one of three simplified inventory accounting methods:

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

2. Applicable financial statement (AFS) sec. 471(c) inventory method, or

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

This article reviews the three simplified inventory accounting methods and whether a taxpayer can expense inventory costs in the tax year of purchase.

Sec. 471(c) NIMS Inventory Method

Under Treas. Reg. §1.471-1(b)(4)(i), the costs of inventory treated as NIMS are recovered through the cost of goods sold in the later of:

• The tax year in which the inventory is used or consumed by the taxpayer, or

• The tax year in which the taxpayer pays for or incurs the inventory cost.

Inventory treated as NIMS is used or consumed in the tax year in which the taxpayer provides the item to a customer. In addition, inventory treated as NIMS is ineligible for the de minimis safe harbor election under Treas. Reg. § 1.263(a)-1(f).

The following example is based on Treas. Reg. §1.471-1(b)(4)(iv):

Denise is a baker who reports her baking trade or business on Schedule C, Profit or Loss From Business, and the baking business has average annual gross receipts for the three tax years prior to 2024 of less than $100,000. Denise uses the overall cash method of accounting, and the sec. 471(c) NIMS inventory method.

Denise purchased $50 of peanut butter in November 2023. In December 2023, she used all of the peanut butter to bake cookies available for immediate sale. Denise sold those peanut butter cookies to customers in January 2024. The peanut butter cookies were used or consumed in January 2024 when the cookies were sold to customers, and Denise will recover the cost of the peanut butter in tax year 2024.

AFS Sec. 471(c) Inventory Method

Under Treas. Reg. §1.471-1(b)(5)(i), instead of the inventory method described in §471(a), a taxpayer using the AFS sec. 471(c) inventory method recovers its inventory costs in accordance with the inventory method used in its AFS. However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable under the Internal Revenue Code.

An AFS is defined in Treas. Reg. §1.451-3(a)(5) includes financial statements certified as being in accordance with U.S. generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) for specific purposes, as well as a financial statement, other than a tax return, filed with the federal government, federal agency, a foreign government, or agency of a foreign government, other than the SEC, IRS, or an agency that is equivalent to the SEC or the IRS.

The following example is based on Treas. Reg. §1.471-1(b)(4)(v):

Horse, Inc. is a calendar year C corporation that is engaged in the trade or business of selling office supplies and providing copier repair services. It meets the §448(c) gross receipts test for tax year 2024. For AFS purposes, Horse uses an overall accrual method of accounting. For federal income tax purposes, Horse chooses to account for purchases and sales of inventory using the AFS section 471(c) inventory method of accounting and for all other items using the cash method.

Horse’s 2024 AFS incurred $2 million in purchases of office supplies held for resale and recovered the $2 million as cost of goods sold. On January 5, 2025, Horse paid $1.5 million for these office supplies. For purposes of the AFS section 471(c) inventory method of accounting, Horse can recover the $2 million of office supplies in 2024 because the amount has been included in the cost of goods sold in its AFS inventory method, and §461 has been satisfied.

Non-AFS Sec. 471(c) Inventory Method

The non-AFS sec. 471(c) inventory method is the method of accounting used for inventory in the taxpayer's books and records that properly reflect its business activities for non-tax purposes and are prepared in accordance with the taxpayer's accounting procedures. The taxpayer recovers its applicable costs through its book inventory method of accounting, and costs that the taxpayer does not capitalize in its books and records are not required to be capitalized to inventory. However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable under the Internal Revenue Code.

The Treasury regulations provide multiple examples that clarify this accounting method. The following example is based on Treas. Reg. §1.471-1(b)(6)(iii)(E):

Georgina is a baker who reports her baking trade or business on Schedule C. In 2024, her baking business met the §448(c) gross receipts test and did not have an AFS. For Federal income tax purposes, Georgina uses the overall cash method of accounting and the non-AFS sec. 471(c) inventory method.

In Georgina's books and records for 2024 that properly reflect its non-tax business activities, she capitalizes the cost of its cookie ingredients to inventory but immediately expenses the cost of labor for her employee who bakes the cookies.

Georgina treats the cost of her cookie ingredients as an inventory cost. She recovers such costs in accordance with the accounting procedures used to prepare her books and records or, if later, when paid. Although the direct labor costs are generally required to be capitalized to inventory under §471(a), they are not required to be capitalized to inventory for Georgina because that cost is not capitalized to inventory in her books and records. Because the direct labor costs are generally deductible under §162 and not otherwise required to be capitalized under §263(a), Georgina may deduct the labor costs in the year she pays that expense.

The following example is based on Treas. Reg. §1.471-1(b)(6)(iii)(A):

Exotic, Inc. is a C corporation engaged in the retail trade or business of selling beer, wine, and liquor. In 2024, it met the §448(c) gross receipts test and did not have an AFS. Exotic uses the overall cash method and the non-AFS sec. 471(c) inventory method of accounting for Federal income tax purposes.

Exotic's electronic bookkeeping software treats all costs paid during the tax year as presently deductible. As part of its regular business practice, Exotic's employees took a physical count of inventory on the selling floor and its warehouse on December 31, 2024. Exotic uses this physical count in its books and records to capitalize and allocate costs to inventory. Exotic also makes representations to its creditor of the cost of inventory on hand for specific categories of products it sells.

Exotic may not expense all its costs paid during the 2024 tax year because its books and records do not accurately reflect the inventory records used for non-tax purposes in its regular business activity. Instead, Exotic must use the physical inventory count taken at the end of 2024 to determine how its capitalized costs are allocated and recovered.

The following example is based on Treas. Reg. §1.471-1(b)(6)(iii)(F):

Herald, LLC is a partnership engaged in beer, wine, and liquor resale. In 2024, it met the §448(c) gross receipts test and did not have an AFS. Herald uses the overall cash method and the non-AFS sec. 471(c) inventory method of accounting for Federal income tax purposes. Herald uses the overall cash method in its books and records.

As part of its regular business practice, Herald's employees take regular physical counts of the inventory on the shop floor and in the storeroom; however, its method of accounting for inventory for its books and records does not allocate costs between ending inventory and cost of goods sold and instead expenses the cost of the inventory in the year it was paid for.

Before December 2024, Herald acquires and pays for $500,000 of beer, wine, and liquor. In addition, on December 1, 2024, it acquired $50,000 in beer and wine and paid for this beer and wine on December 20, 2024. Herald may recover as deductions in 2024 the $550,000 of inventory costs.

The following example is based on Treas. Reg. §1.471-1(b)(6)(iii)(G):

Juniper, LLP is a partnership engaged in beer, wine, and liquor resale. In 2024, it met the §448(c) gross receipts test and did not have an AFS. Juniper uses the overall cash method and the non-AFS sec. 471(c) inventory method of accounting for Federal income tax purposes. Juniper uses the overall cash method in its books and records.

Juniper maintains a point-of-sale computer system that tracks acquisition costs and beer, wine, and liquor inventory levels. The ledger is periodically reconciled with physical counts performed by its employees. Juniper must use the physical inventory count and ledger to determine its ending inventory. It includes in the 2024 cost of goods sold those inventory costs that are not allocated to ending inventory

Immediately Expensing Inventory Costs

With proper structuring of its non-tax records and method of accounting for federal tax purposes, a business can expense inventory costs in the tax year of purchase.

Here are the four requirements that must be met:

1. The business must qualify to use a small business inventory method by meeting the §448(c) gross receipts test and avoiding tax shelter status.

2. The business must use the non-AFS sec. 471(c) inventory method and the overall cash method of accounting for federal tax purposes, and the overall cash method of accounting for book purposes.

3. The business must expense its inventory costs in its bookkeeping system.

4. The business cannot allocate inventory costs to its inventory counts in any of its books and records, including, but not limited to, its bookkeeping system and point-of-sale system.

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