There are few aspects in the tax world more confusing or complex than those associated with inventories. Two questions often asked, what costs have to be capitalized and when can they be deducted, cannot easily be answered without understanding a variety of characteristics and tax attributes of the taxpayer. While a comprehensive discussion of all the tax aspects associated with inventories is beyond the scope of this article, there is a particular question that seems to come up quite often with taxpayers. When can I deduct my worthless inventory or write down the reduction in its value?
The answer to this question is determined by the taxpayer’s method of valuing its inventory. The method for valuing inventories is often broken down into the dollar amounts assigned to the inventory (Cost, Lower of Cost or Market, etc.) and the cost flow assumptions (FIFO, LIFO, weighted average, specific identification, etc.). While the latter is useful in quantifying the worthless amounts, the former will often determine the “trigger” of when to deduct those worthless amounts. In considering the various combinations of valuation that could potentially be employed, it is not difficult to see how the timing and amounts of deducting worthless inventory can also vary. Further, the GAAP treatment of worthless inventories used for financial statement purposes can also vary widely from the treatment for tax purposes.
Two of the most common methods for valuing inventory are Cost and Lower of Cost or Market (LCM). Under the Cost method, inventories for tax purposes are valued at their historic cost and include all costs required to be included in inventory. Generally speaking, these costs are not deductible until such time as the inventory is sold or otherwise disposed. By contrast, GAAP can require a contra-asset reserve to account for the lower net realizable value of inventory to be established in the period in which the declining value occurs. The result is often a current expense for GAAP purposes, but a lagging deduction for tax purposes that does not occur until the worthless, or devalued, inventory is physically disposed.
Under the LCM method, the value of inventory will be the lower of the historic cost or the market value. As one would expect, this can potentially allow for a deduction for the decrease in value of inventory that has not yet been disposed. At the core of the issue is how “market value” is defined in this context for tax purposes. Generally speaking, the market value will be the current bid price to replace or reproduce the inventory. However, an interesting exception may exist in situations where merchandise has been offered for sale in the regular course of business at prices lower than the current bid price. In this case, the inventory is valued at its net realizable value (selling price less any direct costs of disposition), and a deduction would be allowed for the difference between the item’s cost and its net realizable value.
A further exception may be available for “subnormal” goods, regardless of the taxpayer’s method of valuation. Subnormal goods are any goods that are unsalable at normal prices or unsalable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including second-hand goods taken in exchange. In general, subnormal goods should be valued at net realizable value based on a bona fide selling price. Bona fide selling price means an actual offering of goods during a period ending not later than 30 days after the inventory date. The burden of proof will rest upon the taxpayer to show that such exceptional goods are valued upon such selling basis to come within the classification described above. Further, taxpayers on a LIFO method of inventory cost flow generally may not value subnormal goods below cost and should consider all applicable limitations when determining inventory valuation.
In the context of inventories, the tax rules can be quite complicated and nuanced. Taxpayers should work closely with their tax advisors to better understand their valuation methods, as many of the important details governing deductions for inventory are not determinable solely from accounting records. As such, better information sharing can be extremely useful in both identifying opportunities and avoiding risk when it comes to answering the question “When can I deduct my worthless inventory?”.