By Businesses that produce goods or purchase merchandise for resale have traditionally treated those items as inventory. Under the general tax rules, the business capitalizes inventory costs and deducts them only in the year the inventory is sold.
The Tax Cuts and Jobs Act changed these rules for many small businesses. As a result, qualifying businesses may be able to deduct certain inventory costs in the year they purchase the inventory instead of waiting until it is sold.
A small business generally qualifies if its average annual gross receipts for the prior three tax years do not exceed $32 million. Eligible businesses may use the cash method of accounting and choose one of three methods for treating inventory. They may treat inventory
- as nonincidental materials and supplies (NIMS);
- the same way they treat it in an applicable financial statement (AFS); or
- the same way they treat it in their books and records if they do not have an AFS.
Under the NIMS method, a business deducts inventory costs in the later of (1) the year it pays for the inventory or (2) the year it uses or consumes the inventory in its business. Inventory purchased for resale is considered used or consumed when it is sold, so this method generally does not accelerate the deduction.
Businesses with an applicable financial statement must follow that statement’s treatment of inventory. Because generally accepted accounting principles (GAAP) financial statements generally require inventory to be capitalized, this method typically does not permit immediate expensing.
Businesses without an applicable financial statement may deduct inventory costs in accordance with their books and records. If they expense inventory rather than capitalize it in their books, they may also deduct those costs for tax purposes in the year of purchase. All business records must consistently reflect this treatment.
An existing business that wants to adopt the cash method or change its inventory accounting method must file IRS Form 3115, Application for Change in Accounting Method. The IRS grants automatic consent for these changes when the requirements are met.
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