Sch C and inventory

[JenMO]

New Client: previous preparer did not figure the cost of goods with an inventory. Store owner is keeping inventory. Can I start in 2014? and how do I go about it? I have ending inventory 2013 and ending inventory 2014. Can I start just putting in these figures and go on?

[Bob McCoy]

Ending inventory for 2013 gives you the number to start out with for 2014, plus purchases in 2014 less ending inventory for 2014 equals cost of goods sold. Hopefully they have a good record of inventory purchased for the year. I am assuming its a retail operation, thus no labor costs for manufacturing when calculating cost of goods sold.

[kathyc2]

Ending inventory for 2013 gives you the number to start out with for 2014, plus purchases in 2014 less ending inventory for 2014 equals cost of goods sold. Hopefully they have a good record of inventory purchased for the year. I am assuming its a retail operation, thus no labor costs for manufacturing when calculating cost of goods sold.

I think this method would amount to double dipping as you would be treating the bb inventory as an asset when it had already been expenses in prior year(s)

[kathyc2]

New Client: previous preparer did not figure the cost of goods with an inventory. Store owner is keeping inventory. Can I start in 2014? and how do I go about it? I have ending inventory 2013 and ending inventory 2014. Can I start just putting in these figures and go on?

Since this a store, not handling the inventory correctly could be causing large percentage misstatements of profit/loss.

The biggest misstatement would have been an understatement of profits in first year and either over or understatement in subsequent years depending on if ending inventory increased or decreased.

Has the business been on-going for several years or only for a couple of years?

[kathyc2]

Actually, another thing may have happened if the client is using accounting software such as QuickBooks. If they put through an adjustment on balance sheet to properly account for inventory, the numbers for COS may be correct on the P&L, but just not presented properly on the tax return.

[JenMO]

no quick books - previous tax preparer just ignored the numbers the client put down. Client didn't look over well, plus didn't know what to look for.

[Roland Slugg]

Can I start in 2014? and how do I go about it?

If you do, it will be a "change in accounting method" requiring the submission of F-3115 and IRS approval. It may be one of the changes that get's "automatic" approval ... not sure ... consult the list of those.

Small businesses with less than $1,000,000 of annual gross receipts (the average of the last three years) may use the cash method of accounting for purchases of merchandise for resale and are not required to account for inventories. Thus, the previous preparer was using an acceptable method ... assuming the business is below the $1,000,000 threshold. Even some (but not all) taxpayers with average annual gross receipts between $1 million and $10 million may do this.

[kathyc2]

If you do, it will be a "change in accounting method" requiring the submission of F-3115 and IRS approval. It may be one of the changes that get's "automatic" approval ... not sure ... consult the list of those.

Small businesses with less than $1,000,000 of annual gross receipts (the average of the last three years) may use the cash method of accounting for purchases of merchandise for resale and are not required to account for inventories. Thus, the previous preparer was using an acceptable method ... assuming the business is below the $1,000,000 threshold. Even some (but not all) taxpayers with average annual gross receipts between $1 million and $10 million may do this.

This only apply to certain types of business where the primary source of revenue is service as opposed to product. Original post indicated that it was a store, so doubtful this would apply IMO.

[Roland Slugg]

This only apply to certain types of business where the primary source of revenue is service as opposed to product. Original post indicated that it was a store, so doubtful this would apply IMO.

Perhaps you would like to read Rev. Proc. 2001-10.

[Bob McCoy]

I think this method would amount to double dipping as you would be treating the bb inventory as an asset when it had already been expenses in prior year(s)

Just trying to wrap my mind around the double dipping part. The author of the thread is implying that there needs to be a starting point for calculating cost of goods sold. So say you paid $50,000 for inventory in 2013 and used it as an expense in arriving at gross income for that year. Then say you have $10,000 of that inventory still in stock to start out in 2014. You are no longer writing it off as an expense because it was previously paid for so you don't count it again.

You however count the income from the sale of the $10,000 in inventory to be added into 2014 gross income. I figured you needed to include the $10,000 so you can point to your source of where you derived your current year's income from, or at least a portion of it. The only inventory expense you would be counting would be purchases made during the current year. I am just missing where the double dipping comes into play? Perhaps I am overlooking something? If I missed something then maybe I am wrong and will admit it. Wouldn't be the first time.

[kathyc2]

Perhaps you would like to read Rev. Proc. 2001-10.

2001-10: "materials and supplies that are not incidental are deductible only in the year in which they are actually consumed and used"

RevProc 2002-28 offered more clarify to types of qualifying business that don't have to account for inventory and those that do. To be exempt need to meet one of three tests.

[kathyc2]

Just trying to wrap my mind around the double dipping part. The author of the thread is implying that there needs to be a starting point for calculating cost of goods sold. So say you paid $50,000 for inventory in 2013 and used it as an expense in arriving at gross income for that year. Then say you have $10,000 of that inventory still in stock to start out in 2014. You are no longer writing it off as an expense because it was previously paid for so you don't count it again.

You however count the income from the sale of the $10,000 in inventory to be added into 2014 gross income. I figured you needed to include the $10,000 so you can point to your source of where you derived your current year's income from, or at least a portion of it. The only inventory expense you would be counting would be purchases made during the current year. I am just missing where the double dipping comes into play? Perhaps I am overlooking something? If I missed something then maybe I am wrong and will admit it. Wouldn't be the first time.

But the 10K has already incorrectly been written off as a deduction so you have no tax basis in it. Even though you are not technically writing if off as an expense in 2014, you are using it as part of a formula to determine how much to write off.

Continuing on from your example say in 14 your purchase 60K of inventory and the EOY value is 15K. Using the formula as if no error on 2013 you would get COS of 55K (10 +60 -15).

The combined 2 year COS should be 95K which is total purchases of 110K (50 + 60) less OH inventory of 15K.
Using a value in BB inv the 2 year combined COS reported would be 105K- the incorrect 50K in 13 and then 55K in 14.

If preparer wants to correct in 2014, they would need to have BB inventory at 0. In the example we worked out, then 2013 profit understated by 10K and 2014 overstated by 10K, so a wash over the 2 years.

[Bob McCoy]

But the 10K has already incorrectly been written off as a deduction so you have no tax basis in it. Even though you are not technically writing if off as an expense in 2014, you are using it as part of a formula to determine how much to write off.

Continuing on from your example say in 14 your purchase 60K of inventory and the EOY value is 15K. Using the formula as if no error on 2013 you would get COS of 55K (10 +60 -15).

The combined 2 year COS should be 95K which is total purchases of 110K (50 + 60) less OH inventory of 15K.
Using a value in BB inv the 2 year combined COS reported would be 105K- the incorrect 50K in 13 and then 55K in 14.

If preparer wants to correct in 2014, they would need to have BB inventory at 0. In the example we worked out, then 2013 profit understated by 10K and 2014 overstated by 10K, so a wash over the 2 years.

Thanks for taking time to respond. Workarounds always seem to get complicated. Would have been a lot simpler if they would have just input the correct information to begin with.

[kathyc2]

Thanks for taking time to respond. Workarounds always seem to get complicated. Would have been a lot simpler if they would have just input the correct information to begin with.

But what fun would if be if it was simple?

[Roland Slugg]

All right, let's see if I can back up and clarify what I should have written in the first place:

If the business has gross receipts of $1,000,000 or less ... average of last three years ... it does not have to account for its inventory for tax purposes and for financial statement purposes the same way. It can use the accrual method for financial statement purposes and the cash method for tax purposes. Rev Proc 2001-10 was issued to provide this relief for qualifying small businesses, and this is what I thought was meant in the OP where it says the “store owner is keeping inventory.” My explanation did not go far enough however. It should have said that inventory which has been paid for but not sold at year-end may not be deducted until it is sold or (otherwise consumed). In fact this method of accounting for purchases of inventory applies to most small businesses with up to $10M in average gross receipts over their last three years. Rev Proc 2001-10 is about this very issue. Rev Proc 2002-28 is intended to clarify what businesses may use the cash method of accounting generally.

My initial interpretation of the OP was that the owner has inventory that was received but not paid for, and if that is, in fact, the case, then the accrual method does not have to be used for such goods if the business's gross receipts are less that $10M. However, if the business has inventory that it has paid for but not sold as of its fiscal year-end, then that inventory may not be accounted for using the cash method of accounting. This would require an adjustment to an "inventory" account on the business books as of each year-end.

The OP did not say if the inventory on hand at year-end was paid for or not yet paid for, but the portion that was paid for must be accounted for using an inventory account. Like the GEICO ads say, “everyone knows that.”

The OP did ask, however, how to correct this. If the business in question has gross receipts (over its last three years) of no more than $1 million, it qualifies for automatic consent from the IRS by filing Form 3115. This automatic consent provision applies to the taxpayer’s treatment of inventory as nonincidental materials or supplies. At the top of F-3115, the taxpayer should write “Filed under Revenue Procedure 2001-10.”

I apologize for the earlier posts which may have been (and probably were) based on a misreading of the OP, and I specifically thank kathyc2 for motivating me to write this correction.