Whether a taxpayer may “write-down” year-end inventory depends upon 1) the inventory method chosen and, 2) the type of inventory involved. With respect to inventory methods, a taxpayer generally will have chosen to value ending inventory either at cost, or at lower of cost or market (LCM). And with respect to inventory type, a taxpayer will generally be sitting on either “normal” or “subnormal” goods. Normal goods in inventory may generally not be written down below cost unless the taxpayer has elected to use LCM, and the current bid price (replacement or reproduction cost) of all inventoriable costs is lower than cost reflected on taxpayer’s books, or the goods had in fact been offered for sale prior to the inventory date at a net realizable value lower than cost. Subnormal goods, on the other hand, may be valued at net realizable value regardless of whether the taxpayer has elected to use LCM.
The term “cost” is generally defined as the invoice price less trade or other discounts. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. For taxpayers acquiring merchandise for resale that are subject to the uniform capitalization rules of §263A, additional amounts may be required to be included in inventory costs. For merchandise purchased for resale by taxpayers with average 3-year annual gross receipts over $10 million, cost also includes purchasing, handling, storage, and a portion of general administrative costs. In the case of merchandise produced by the taxpayer, cost is generally defined to include the cost of raw materials and supplies consumed in connection with the product, expenditures for direct labor, and indirect production costs incident to and necessary for the production of the particular article.
For purposes of the LCM, “market” is generally based on the current bid price (replacement or reproduction cost), not the price at which the goods can be sold. The concept of net realizable value, although acceptable for financial reporting purposes, is only acceptable for tax purposes if the merchandise has been offered for sale prior to the inventory date at a price lower than its replacement cost. The final income tax regulations issued under §263A made revisions to the definition of market. The regulations now state that under ordinary circumstances and for normal goods in an inventory, market means the aggregate of the current bid prices prevailing at the date of the inventory. The basic elements of cost include direct materials, direct labor, and certain indirect costs. Thus, for taxpayers to which §263A applies, the basic elements of cost must reflect all direct costs and all indirect costs properly allocable to goods on hand as of the inventory date at the current bid price of those costs, including but not limited to the cost of purchasing, handling, and storage activities conducted by the taxpayer, both before and subsequent to acquisition or production of the goods.
For financial reporting purposes, a taxpayer has the option of performing an LCM analysis on the basis of item-by-item, group of items, category of inventory, business segment, or for inventory as a whole depending on the particular facts and circumstances. For tax purposes, however, the market value of each article on hand must be compared with the cost of the article to determine each article’s lower of cost or market value. The requirement of valuing each item separately prevents a taxpayer from using a percentage write-down approach even though it would be permitted for accounting purposes.
Regardless of the inventory valuation method employed by the taxpayer (cost or LCM), “subnormal” goods should be valued at net realizable value. Subnormal goods are any goods that are unsalable at normal prices or 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. Subnormal goods originally acquired for resale, or produced finished goods should be valued at bona fide selling prices less direct costs of disposition. Bona fide selling price means the price at which such subnormal goods are actually offered for sale during the tax year or within 30 days after the tax year. The “30-day rule” has been strictly applied by the IRS in cases involving goods acquired for resale and finished produced goods. Thus, even where subnormal goods exist, the taxpayer must be able to prove the actual offering at less than cost. Verification must be made through contemporaneous recordkeeping.
Mark R. Giallonardo, JD, LLM is a Principal in HbK’s Tax Department and currently supports HbK’s Florida offices. Mark has been developing tax planning strategies for owner-operated companies for more than 20 years and may be reached at (239) 263-2111 or firstname.lastname@example.org.