How To Handle Business Inventory

If your business carries inventory, effective inventory management is critical. Whether you’re running a food truck that needs to buy ingredients or a homemade craft store that sells paper and other supplies, you must keep track of your inventory.

We break down the basics of how inventory works and strategies to handle it when it comes to taxes.

What is inventory?

Inventory includes consumable items you need to run your business and finished goods you keep on hand to sell to your customers.

According to the IRS, all of the following are types of inventory:

• Merchandise or stock in trade
• Raw materials
• Work in progress
• Finished products
• Supplies that physically become part of an item intended for sale

For example, if you’re a business owner making and selling candles online, you’d consider any unsold candles inventory. You’d also classify unused scented oils and wax that you will turn into candles as inventory.

Or, if you run a cleaning business, soaps, detergents, and other cleaning supplies would be part of your current inventory.

Depending on the size and nature of your business, inventory may be considered an asset on your Balance Sheet or an expense on your Profit & Loss statement. The way you track inventory will have an impact on both your bookkeeping and tax reporting.

Tracking Inventory: Why is it important? 

For small business owners navigating the complexities of accounting and tax rules, understanding the distinction between inventory for internal reporting and inventory for tax reporting is crucial. Inventory is a generic concept, but there are two main purposes for tracking inventory.

Tracking inventory for managerial decision-making

Internal reporting involves tracking inventory for operational purposes, helping you manage stock levels, optimize ordering, and assess overall business performance. This often requires specialized inventory software or a highly detailed process to track inventory manually.

Tracking inventory for tax purposes

Inventory for tax reporting impacts the valuation of your business and directly impacts the taxable income of your business. Tracking inventory for tax purposes essentially determines the timing of a deduction: is inventory recorded as an expense when you buy the product or when it is sold to the customer?

The IRS identifies the difference by requiring business owners to track inventory as either an asset or as an expense. While either instance results in a tax deduction, the distinction between inventory as an asset vs. an expense has to do with timing. 

Seeking guidance from a professional accountant can be immensely beneficial, providing clarity and ensuring compliance with both internal and tax-related inventory requirements.

Reporting inventory on the tax return: asset or expense?

Reporting inventory can be complex. Businesses can opt to report inventory in two different ways on the business tax return: it can be an asset on the balance sheet or it can be an expense on the profit & loss statement. The purpose is to indicate to the IRS when you will claim a deduction for those purchases.

Inventory as an asset

Certain industries rely on inventory. In those instances, reporting inventory as an asset on the balance sheet contributes to the total valuation of the company and they report the expense of a product when a customer buys. Accounting for inventory as an asset requires more complex bookkeeping processes. 

Here are some examples of businesses that likely rely on detailed inventory tracking and are likely to report inventory as an asset:

• Retail businesses: Both physical stores and e-commerce platforms may require precise inventory management for an array of products and to fulfill in-store and online orders
• Manufacturing and wholesale: Involving the production of goods and distribution, necessitating efficient tracking of raw materials and finished products
• Food and beverage industry: Including restaurants and supermarkets, where inventory monitoring is vital for menu availability and stock levels

Inventory as an expense

In other businesses, it may not be an effective use of management time to track inventory on the balance sheet. It also keeps bookkeeping simple – a business owner will expense costs when they happen. Here are some examples that are less likely to require detailed inventory tracking: 

• Service-based businesses: Consulting services for various industries, where the primary offering is expertise rather than physical products. This includes businesses like marketing agencies, software development or IT services, event planning, education or professional services like legal and accounting services
• Freelancers and independent contractors: Providing services or digital goods, without the need for physical inventory.
• Online content creators: Like bloggers, YouTubers, or podcasters, where the focus is on content creation rather than tangible goods.
• Subscription-based businesses: Offering subscription services or memberships, with limited physical product involvement

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Tracking inventory and types of inventory management

If you’re in the retail or wholesale space, maintaining inventory can help you make important business decisions or avoid common mistakes, like overstocking and having excess inventory or running out of stock for popular products. This is why some wholesalers and business owners rely on a certain type of inventory management, like these:

• Just-in-Time (JIT): A method aimed at reducing warehousing costs and improving inventory turnover by ordering and receiving goods only when needed for production or sales
• First-In, First-Out (FIFO): Assumes the first unit purchased is the first sold during order fulfillment, suitable when inventory costs vary
• Last-In, First-Out (LIFO): Assumes each sale uses the most recently purchased unit of inventory, impacting profit margins based on inventory cost fluctuations

Warehouse management is critical because both shortages and failing to understand customer demand can hurt the goodwill of your loyal customers and your business profits. 

Tools for tracking inventory

Even if you don’t have to track your inventory closely for tax purposes, supply chain management can help you avoid stockouts that hurt your cash flow. Some apps and software options can monitor the amount of inventory you have better than Excel spreadsheets.

Here are a few popular inventory management systems and why they are provide ease and advantage to your inventory process:

Shopify

• Monitors SKUs, cost of goods sold (COGS), and assists with enterprise resource planning (ERP)
• Real-time updates through a point of sale (POS) system for purchase orders
• Automation capabilities for streamlined workflows to seamlessly sell and ship products

Zoho Inventory

• Beneficial for tracking inventory levels with additional features for order management and shipping
• Comprehensive tools to monitor stock levels, inventory control and end-to-end order management to fulfill customer orders

Sortly

• Bare-bones and basic inventory software
• Monitors basic metrics, like quantities and locations of items
• Includes barcode and QR code tool for efficient inventory tagging and retrieval

While an inventory tracking tool may not be necessary for all businesses, choosing the right inventory management software can make all the difference in how your business makes decisions. 

For a large retail organization, having in-depth detail and data points will allow a business owner to make more nuanced and comprehensive decisions. For small service-based businesses, with digital inventory or small-scale swag or products, a simpler software may provide just the right amount of detail to operate the business. 

The silver lining: inventory for small business taxpayers

The nuances of inventory tracking are tricky and complex, but the IRS allows special rules for small business owners. If your business meets certain criteria, these rules can make tracking and reporting inventory much easier.

To qualify as a small business taxpayer, your business must have average gross receipts of $27 million or less for the previous three tax years and not be considered a tax shelter as defined by IRC section 448(d)(3). However, these thresholds can vary from year to year.

Pro tip: Calculating your average gross receipts is simple. Total your gross receipts, as reported on the previous three years’ tax returns, and divide by three. For example:

If you qualify as a small business taxpayer, you’re not required to track inventory on your tax return. Instead, you treat inventory purchases as an expense and deduct the inventory cost in the tax year it’s purchased.

Why does this matter? If you’re a small business taxpayer, you’re exempt from complex inventory tracking and can simply operate your business tracking income and expenses as usual.

The bottom line

Inventory can be a complex topic for small businesses. For many ecommerce companies, expensing inventory rather than having to track it for tax purposes can make the administrative tasks much less burdensome.

That said, it’s important to understand why inventory matters, assess if your business heavily relies on inventory tracking and implement an effective inventory management process so you can continue to grow your business and serve your customers.