Per Diem Rates from the U.S. General Services Administration

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Per Diem Rates

Inventoriable Items Treated as Nonincidental Materials and Supplies - Updated for Tax Cuts and Jobs Act

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Treatment of Inventories Under the Tax Cuts and Jobs Act (see pre-TCJA below)

Incidental vs nonincidental:

Incidental materials and supplies include items such as pens, paper, paper clips, rubber bands, etc. The cost of these items are deducted in the year paid, even if a quantity of such items remains on hand at year end. Generally, no record of consumption is kept, nor is a physical inventory taken either at the beginning or end of the year for incidental materials and supplies.

From a tax standpoint, since the cost of incidental materials and supplies are of such diminimus value, deducting the cost of unused items remaining in inventory at year-end would not materially distort net income.

Nonincidental materials and supplies include:

• Items acquired to maintain, repair, or improve a unit of tangible property, such as spare parts and lubricants, smallwares used in the food and beverage industry, and
• Inventoriable items purchased for resale by a taxpayer with average annual gross receipts of:
  • $26,000 million or less for the 3 prior tax years and is not a tax shelter, as defined in section 448(d)(3).
    • Gross receipts do not include sales taxes or other similar state and local taxes where such tax is legally imposed upon the purchaser and the taxpayer merely collects and remits the tax to the taxing authority.
  • Also see the inflation adjustment in Rev. Proc. 2018-57, which increased the threshold for small business taxpayers from $25 million to $26 million for taxable years beginning in 2019).

Treatment of Inventories Under the Tax Cuts and Jobs Act (TCJA)

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method of accoutning for purchases and sales of merchandise, unless you are a small business taxpayer, in which cas you may use the cash method of accounting.

Exception for Small Business Taxpayers:

You qualify as a small business taxpayer if you:

• (a) have average annual gross receipts of $26 million or less for the 3 prior tax years, and
• (b) are not a tax shelter (as defined in section 448(d)(3)).

If your business has not been in existence for all of the 3-tax-year period used in figuring average gross receipts, base your average on the period it has existed.

If your business has a predecessor entity, include the gross receipts of the predecessor when figuring average gross receipts for the 3-year period.

If your business (or predecessor entity) had short tax years for any of the 3-tax-year period, annualize your business’ gross receipts for the short tax years that are part of the 3-tax-year period.

If you're a small business taxpayer, you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income.

Under the new law (TCJA), if you choose not to keep an inventory, you won’t be treated as failing to clearly reflect income if your method of accounting for inventory treats inventory as non-incidental material or supplies, or conforms to your financial accounting treatment of inventories. Publication 334 (2021), Tax Guide for Small Business | Internal Revenue Service (irs.gov)

If you choose to keep an inventory, you generally must use the accrual method of accounting and value the inventory each year to determine your cost of goods sold in Part III of Schedule C.

How Cash Basis Taxpayers Treat Inventoriable Items:

If you account for inventoriable items as non-incidental materials and supplies, you must deduct the cost to acquire or produce such inventoriable items in the year in which they are first used or consumed in your operations.

For example, if you purchase 10 units of inventory during 2021 at $20 each, and sell 6 units during 2021, you may only deduct $120 (6 x $20) in 2021 as the cost of sales. The remaining $80 you paid in 2021 is not deductible until such inventory is sold.

Observations:

The treatment of non-incidental materials and supplies for qualified cash basis taxpayers (average gross receipts for three prior years $26 million or less) contradicts the cash method of accounting, which states that you may deduct expenses in the year paid.

However, unsold inventory purchased for resale (or for the production of finished goods) is an asset and not a current expense. To deduct the cost of unsold inventory could materially understate net income and understate the asset section of the business's balance sheet. While a cash basis business may file Schedule C, which does not require a balance sheet, for internal reporting and proper inventory management, a balance sheet should be prepared reflecting inventory on hand at year end.

In contrast, the entire cost of incidental materials and supplies (i.e. rubber bands, paper clips and pens) are deductibe in the year purchased even if some items remain on hand at year-end. This is because of the de minimis nature of these items, the cost of which would not distort net income to a material degree.

For example, if you paid $100 for incidental materials and supplies (i.e. office supplies - computer paper, ink, and paper clips) during December 2021, you may deduct the entire $100 in 2021 even if you still have some of that inventory on hand at year end. The idea of these rules is, the IRS wants a business to

Under Treasury Regulations section 1.162-3, the cost of such inventoriable items is deductible in the later of the year in which they are consumed (or used) or the year in which the taxpayer actually pays for them.

This means, the cost of inventoriable items...

• purchased for resale to customers. or
• for use as raw materials for producing finished goods for resale, or
• For use in the performance of a service (e.g., a roofing contractor that installs roofing) -

Must be deducted...

• In the year provided to customers, or
• In the year you pay for such items
• Whichever is later.

Valuing Inventoriable Items

A qualifying small business taxpayer may determine the amount of the allowable deduction for inventoriable items treated as nonincidental materials and supplies by using one of the following methods (LIFO may NOT be used):

• A first-in-first-out (FIFO) method
• An average cost method
• A specific identification method