Inventory is a list of goods and materials held available in stock by a company as part of business management. Generally, all goods considered to be part of a business’s assets that are ready or will be ready for sale are part of inventory. These goods may be raw materials, work-in-process goods, and finished goods.
The term inventory items is defined under 26 USCS § 751. Accordingly, it includes property not amounting to a capital asset. Also, under 26 USCS § 1221(a)(1)., a stock or other property of a kind in hand of a tax payer which would be included in the inventory at the close of the taxable year amounts to an inventory item. The property held by a taxpayer mainly for sale to customers in the ordinary course of his/her trade or business is included as an inventory item[i].
Inventory items do not include property used in trade or business and involuntary conversions[ii]. Property used in trade or business refers to property used in a business which is subject to a statutorily permitted depreciation allowance and is held for more than 1 year by the company. It includes real property used in the trade or business held for more than 1 year. Property distributed to a partner may not be an inventory item. Goods are included in inventory only if title to it is vested in the taxpayer. It will be determined by state law.
Generally, in addition to merchandise for sale, supplies acquired for sale which will physically become a part of merchandise also will be included in inventory. However, goods held for sale for a brief period are not classified as an inventory item because the goods cannot be stored. Emulsified asphalt is an example of a good that should be used within a few hours after its receipt. Drugs used in medical practice are also not part of merchandise and are not classified as an inventory item. It is only a supply which can be used as part of a service[iii]. When a supply is treated as inventory item, it will be charged against the cost of goods sold.
Inventory may be symbolized as one of the most important assets possessed by a business, because inventory turnover signifies revenue generation and subsequent earnings for the owners and shareholders of a company.
In order to reveal taxable income correctly, a taxpayer must use inventory and the accrual method of accounting when the production, purchase, or sale of merchandise is an income-producing factor[iv]. Thus, inventories are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor in the taxpayer’s business[v]
A container in which merchandise or sold goods are kept are also included in the seller’s inventory even though it is returnable[vi]. Real estate held by a person carrying on real estate business may not be treated as an inventory item. Likewise, the cost of construction of houses or partly finished houses incurred by a developer may not be included in inventory.
The possession of a high amount of inventory as well as a too low amount of inventory is not good for a company. High amount of inventory for long periods may cause loss because of storage and spoilage costs. A shortage of inventory creates a risk of losing potential sales.
The management of inventory through a just-in-time inventory system can help minimize inventory costs because goods are produced or bought as inventory only when needed.
[i] 26 USCS § 1221(a)(1).
[ii] 26 USCS § 1231(b)(1).
[iii] Mid-Del Therapeutic Ctr., Inc. v. Commissioner, T.C. Memo 2000-130 (T.C. 2000).
[iv] Jim Turin & Sons, Inc. v. Commissioner, 219 F.3d 1103 (9th Cir. Or. 2000).
[v] Mid-Del Therapeutic Ctr., Inc. v. Commissioner, T.C. Memo 2000-130 (T.C. 2000).
[vi] La Salle Cement Co. v. Commissioner, 59 F.2d 361 (7th Cir. 1932).