Page 17 - Tax Guide for Small Business

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The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
fact of liability have occurred, the amount of the liability Exception for small business taxpayers. If you are a
could be reasonably determined, and economic perform- small business taxpayer, you can choose not to keep an
ance occurred in that year. inventory, but you must still use a method of accounting
Your office supplies may qualify as a recurring ex- for inventory that clearly reflects income. If you choose not
pense. In that case, you can deduct them in 2019 even if to keep an inventory, you won’t be treated as failing to
the supplies are not delivered until 2020 (when economic clearly reflect income if your method of accounting for in-
performance occurs). ventory treats inventory as non-incidental material or sup-
plies, or conforms to your financial accounting treatment
Keeping inventories. When the production, purchase, of inventories. If, however, you choose to keep an inven-
or sale of merchandise is an income-producing factor in tory, you generally must use an accrual method of ac-
your business, you generally must take inventories into counting and value the inventory each year to determine
account at the beginning and the end of your tax year, un- your cost of goods sold in Part III of Schedule C.
less you are a small business taxpayer. If you must ac-
count for an inventory, you generally must use an accrual Small business taxpayer. You qualify as a small
method of accounting for your purchases and sales. For business taxpayer if you (a) have average annual gross
more information, see Inventories, later. receipts of $26 million or less for the 3 prior tax years, and
(b) are not a tax shelter (as defined in section 448(d)(3)). If
Special rule for related persons. You cannot deduct your business has not been in existence for all of the
business expenses and interest owed to a related person 3-tax-year period used in figuring average gross receipts,
who uses the cash method of accounting until you make base your average on the period it has existed, and if your
the payment and the corresponding amount is includible business has a predecessor entity, include the gross re-
in the related person's gross income. Determine the rela- ceipts of the predecessor entity from the 3-tax-year period
tionship, for this rule, as of the end of the tax year for when figuring average gross receipts. If your business (or
which the expense or interest would otherwise be deducti- predecessor entity) had short tax years for any of the
ble. If a deduction is not allowed under this rule, the rule 3-tax-year period, annualize your business’ gross receipts
will continue to apply even if your relationship with the per- for the short tax years that are part of the 3-tax-year pe-
son ends before the expense or interest is includible in the riod. See Pub. 538 for more information.
gross income of that person. Treating inventory as non-incidental material or
Related persons include members of your immediate
family, including brothers and sisters (either whole or supplies. If you account for inventories as materials and
supplies that are not incidental, you deduct the amounts
half), your spouse, ancestors, and lineal descendants. For paid to acquire or produce the inventoriable items treated
a list of other related persons, see section 267 of the Inter- as materials and supplies in the year in which they are first
nal Revenue Code. used or consumed in your operations.

Combination Method Financial accounting treatment of inventories.
Your financial accounting treatment of inventories is deter-
You generally can use any combination of cash, accrual, mined with regard to the method of accounting you use in
and special methods of accounting if the combination your applicable financial statement (as defined in section
clearly shows your income and expenses and you use it 451(b)(3)) or, if you do not have an applicable financial
consistently. However, the following restrictions apply. statement, with regard to the method of accounting you
• If an inventory is necessary to account for your in- use in your books and records that have been prepared in
accordance with your accounting procedures.
come, you generally must use an accrual method for
purchases and sales. (See, however, Inventories, Changing your method of accounting for inven-
later.) You can use the cash method for all other items tory. If you want to change your method of accounting for
of income and expenses. inventory, you must file Form 3115. See Change in Ac-
• If you use the cash method for figuring your income, counting Method, later.
you must use the cash method for reporting your ex- Items included in inventory. If you are required to ac-
penses. count for inventories, include the following items when ac-
• If you use an accrual method for reporting your expen- counting for your inventory.
ses, you must use an accrual method for figuring your • Merchandise or stock in trade.
income.
• If you use a combination method that includes the • Raw materials.
cash method, treat that combination method as the • Work in process.
cash method. • Finished products.

Inventories • Supplies that physically become a part of the item in-
tended for sale.
Generally, if you produce, purchase, or sell merchandise Valuing inventory. You must value your inventory at the
in your business, you must keep an inventory and use an beginning and end of each tax year to determine your cost
accrual method for purchases and sales of merchandise.

Chapter 2 Accounting Periods and Methods Page 15