Page 21 - Small Business Taxes

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The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
Example. You are a calendar year taxpayer and use Inventories 16:29 - 11-Jan-2023
an accrual method of accounting. You buy office supplies
in December 2022. You receive the supplies and the bill in Generally, if you produce, purchase, or sell merchandise
December, but you pay the bill in January 2023. You can in your business, you must keep an inventory and use an
deduct the expense in 2022 because all events that fix the accrual method for purchases and sales of merchandise.
fact of liability have occurred, the amount of the liability
could be reasonably determined, and economic perform- Exception for small business taxpayers. If you are a
ance occurred in that year. small business taxpayer, you can choose not to keep an
Your office supplies may qualify as a recurring ex- inventory, but you must still use a method of accounting
pense. In that case, you can deduct them in 2022 even if for inventory that clearly reflects income. If you choose not
the supplies are not delivered until 2023 (when economic to keep an inventory, you won’t be treated as failing to
performance occurs). clearly reflect income if your method of accounting for in-
Keeping inventories. When the production, purchase, ventory treats inventory as non-incidental material or sup-
plies, or conforms to your financial accounting treatment
or sale of merchandise is an income-producing factor in of inventories. If, however, you choose to keep an inven-
your business, you must generally take inventories into tory, you must generally use an accrual method of ac-
account at the beginning and the end of your tax year, un- counting and value the inventory each year to determine
less you are a small business taxpayer. If you must ac- your cost of goods sold in Part III of Schedule C.
count for an inventory, you must generally use an accrual
method of accounting for your purchases and sales. For Small business taxpayer. You qualify as a small
more information, see Inventories, later. business taxpayer if you (a) have average annual gross
receipts of $27 million or less for the 3 prior tax years, and
Special rule for related persons. You cannot deduct (b) are not a tax shelter (as defined in section 448(d)(3)). If
business expenses and interest owed to a related person your business has not been in existence for all of the
who uses the cash method of accounting until you make 3-tax-year period used in figuring average gross receipts,
the payment and the corresponding amount is includible base your average on the period it has existed, and if your
in the related person's gross income. Determine the rela- business has a predecessor entity, include the gross re-
tionship, for this rule, as of the end of the tax year for ceipts of the predecessor entity from the 3-tax-year period
which the expense or interest would otherwise be deducti- when figuring average gross receipts. If your business (or
ble. If a deduction is not allowed under this rule, the rule predecessor entity) had short tax years for any of the
will continue to apply even if your relationship with the per- 3-tax-year period, annualize your business’ gross receipts
son ends before the expense or interest is includible in the for the short tax years that are part of the 3-tax-year pe-
gross income of that person. riod. See Pub. 538 for more information.
Related persons include members of your immediate
family, including siblings (either whole or half), your Treating inventory as non-incidental material or
spouse, ancestors, and lineal descendants. For a list of supplies. If you account for inventories as materials and
other related persons, see section 267 of the Internal Rev- supplies that are not incidental, you deduct the amounts
enue Code. paid or incurred to acquire or produce the inventoriable
items treated as non-incidental materials and supplies in
Combination Method the year in which they are first used or consumed in your
operations. Inventory treated as non-incidental materials
You can generally use any combination of cash, accrual, and supplies is used or consumed in your business in the
year you provide the inventory to your customers.
and special methods of accounting if the combination
clearly shows your income and expenses and you use it Financial accounting treatment of inventories.
consistently. However, the following restrictions apply. Your financial accounting treatment of inventories is deter-
• If an inventory is necessary to account for your in- mined with regard to the method of accounting you use in
come, you must generally use an accrual method for your applicable financial statement (as defined in section
purchases and sales. (See, however, Inventories, 451(b)(3)) or, if you do not have an applicable financial
later.) You can use the cash method for all other items statement, with regard to the method of accounting you
of income and expenses. use in your books and records that have been prepared in
accordance with your accounting procedures.
• If you use the cash method for figuring your income,
you must use the cash method for reporting your ex- Changing your method of accounting for inven-
penses. tory. If you want to change your method of accounting for
inventory, you must file Form 3115, Application for
• If you use an accrual method for reporting your expen- Change in Accounting Method. See Change in Account-
ses, you must use an accrual method for figuring your ing Method, later.
income.
• If you use a combination method that includes the Items included in inventory. If you are required to ac-
cash method, treat that combination method as the count for inventories, include the following items when ac-
cash method. counting for your inventory.
• Merchandise or stock in trade.

Chapter 2 Accounting Periods and Methods Page 15