Spoiler Alert: Maybe. But only if you have nerves of steel… which I don’t.
In case you’d rather watch than read, you can check out our YouTube video.
Otherwise, read on!
FULL DISCLAIMER: Ok, so before I get into all of this, I’m going to throw out a big ole’ fat disclaimer that I am no longer a tax professional. For the past 7 years, I’ve spent all of my spare brain cells on learning all there is to know about ecommerce accounting, so I only have about two brain cells left to devote to taxes. BUT… I used to do taxes, and I do speak tax. So I’m going to translate all of this for you, but that doesn’t mean you shouldn’t go hire your own tax CPA to see how everything applies to your own personal tax situation. You should.
(And please, please, don’t go to H&R Block or Liberty Tax… they’ve had like 6 weeks of training. Please go to an actual, experienced CPA, preferably one with other ecommerce retail clients. It’s worth every penny.)
All right, so first, let me lay this all out for you.
The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. Most people think about whatever they’re hearing about on tv - the changes to the individual or corporate tax rates or the economic impact of the tax cuts. But there were a TON of changes embedded in there, and there was one change that has gathered a lot of chatter within and outside of eCommerceFuel.
This change is the one that allows “small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period to use the cash method of accounting.”
Let’s break this down.
Cash vs. Accrual Accounting Methods
In short, if you’re using the accrual method of accounting, you have to record your income and expenses when each are earned or incurred regardless of when cash came in or went out.
Oh, and here’s a YouTube video about cash basis vs. accrual basis in case you want more info.
So, as an example, if you had an attorney do work for you in December, but you paid the bill in January, you’d get the deduction in December even before you spent the money. And vice versa, if you sold products to wholesale customers in December but they didn’t pay you until January, you’d have to include that income in your books before you received any cash. Theoretically, this could be a huge challenge if you have extremely slow-paying customers; it’s possible you’d have to pay your taxes before you even received the money on the sales.
The cash basis, on the other hand, follows the money. You include income when you get paid; you include expenses when you pay someone. It’s simple to understand and it’s “fair” in the sense that you would only pay tax on money you have actually received.
The accrual method is generally preferred when you’re managing your business because all your income and expenses line up in the proper periods. So you can see business trends over time from month to month and year to year. It’s handy.
The cash method is generally preferred for tax filing purposes because you tend to have more control over the timing of expenses thereby minimizing your taxes.
NOTE: It’s also perfectly acceptable to keep your financial records on the accrual basis for managing your business but file using the cash basis for tax purposes. A tax CPA is able to make the appropriate adjustments to do this for you.
Pre-TCJA / The “Inventory Tax”
Before this new tax law went into effect, the rules were that if you averaged more than $5 million in gross receipts over the prior three years, you were REQUIRED to file your taxes as an accrual basis taxpayer. But if you were an inventory-based business, that threshold dropped down to $1 million.
Bummer. Lack of options.
The other issue was that regardless of whether you were a cash or accrual based business, you had to treat inventory like inventory. That is to say, you were only allowed to deduct the inventory that was actually SOLD. If you still had inventory on hand, you had to wait to deduct it until you sold it.
This “inventory tax” is at the heart of the challenge for ecommerce sellers. In short, that big outflow of cash for inventory isn’t taken as a reduction to your taxable income at the time you’re spending the cash, and that sucks for most businesses.
An inventory-based business has a constant need for replenishing its stock reserves, but if you’re spending all of your money on inventory - BUT IT’S NOT DEDUCTIBLE when you buy it - you may feel like you’re in a perpetual cash flow crunch not to mention super irritated when paying your taxes.
Post-TCJA / Before IRS Guidance
When this tax bill passed, one of the impacts was that the previous threshold of $5 MM ($1 MM for inventory retailers) was bumped WAY up to $25 million. So sellers in the few million dollar range are now suddenly allowed to file on the cash basis method. Hooray!
There was much rejoicing in the ecommerce community around this change, and many people assumed that they could now deduct their inventory when purchased instead of when sold.
However, the CPA community was split. I personally took the position that this really didn’t help anyone because raising the threshold didn’t change the underlying nature of the inventory. If you can’t deduct inventory until it’s sold, sorry, but you’re still outta luck, and this isn’t the amazing tax change that everyone was thinking it was.
On July 23, 2018, the American Institute of Certified Public Accountants (AICPA), an advocacy group for the accounting industry, sent a letter to the IRS asking for clarification on the standards. Amongst other items, they were specifically looking for guidance on “the tax consequences of changing to the cash method of accounting.”
They were also looking for automatic acceptance of a change from accrual to cash basis for anyone who met the requirements.
Post-TCJA / After IRS Guidance (Revenue Procedure 2018-40) - released 8/3/18
Here’s (part of) what the IRS had to say about this change.
Rev Proc 18-40 3.19 Small business taxpayer exception from requirement to account for inventories under § 471. 8 (1)
Description of change.
This change applies to a small business taxpayer, as defined in section 15.18(5)(a) of this revenue procedure, that wants to change its § 471 method of accounting for inventory items to one of the following: (a) treating inventory as non-incidental materials and supplies under § 1.162- 3; or (b) conforming to the taxpayer’s method of accounting reflected in its applicable financial statements, as defined in § 451(b)(3), with respect to the taxable year, or if the taxpayer does not have an applicable financial statement for the taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.
Get all that?
Ok, so instead of having to treat your inventory like inventory, you can either:
- Treat it as “non-incidental materials and supplies,” OR
- Treatment should conform to the taxpayer’s method of accounting
Non-Incidental Materials and Supplies
Treating inventory as non-incidental materials and supplies means that you can deduct your cost at the later of: when you bought the product or when it’s used or consumed.
This is the exact opposite of *incidental* materials and supplies which allows you to write everything off immediately.
So, is it just me, or isn’t that how it’s always been done? Umm… yeah.
This lines up pretty well with the existing treatment of expensing costs at the time of sale, so let’s move on to the second option.
Taxpayer’s Method of Accounting
No one should get all excited about the applicable financial statements either. Generally speaking, it means that if your financial statements are audited or filed with the SEC or government and are accepted by them, ok, the IRS will accept them too. But not only do few small businesses even have those, the ones who do will pretty much all be using Generally Accepted Accounting Principles (GAAP) which does not include writing off your inventory as soon as you buy it.
The language you actually care about, the super-vague and wide-open to interpretation language you’ve been looking for is this: “conforming to the taxpayer’s method of accounting reflected in... the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.”
This is what most people seem to be hanging their hat on.
The argument is that if you aren’t tracking your inventory in your ongoing books and records, it’s perfectly legitimate to treat it the same way for tax purposes. It doesn’t matter if your accounting sucks. It just matters that you’re treating your sucky records consistently between your books and your tax returns.
Now, I’m fairly confident this is not what the IRS had in mind with this language, but nevertheless, this massively ambiguous language is in there. It’s up to each taxpayer to decide how adventurous they are in taking advantage of that ambiguity.
There are two other gray areas I tripped upon that are worthy of note as well:
- De minimis - because the treatment can be as non-incidental materials and supplies instead of inventory, there’s actually a minimum threshold you can use. If the cost is under $500 per unit, technically, you should be able to write it off (as too small to worry about or track).
- Used or consumed - unlike inventory which requires items to be sold before expensing them, non-incidental materials and supplies state that items should be expensed when “used or consumed.”
Now everybody and their uncle is coming up with interesting interpretations of what that might mean. Aren’t raw materials used when they’ve been converted into finished goods? Are products used when given to Amazon?
My advice is that I would tread lightly when coming up with your own wild interpretations of the rules, because the IRS included in its guidance a blatant warning that just because you pick an alternate accounting method does not mean that it’ll necessarily be accepted by the IRS. They reserve the right to audit you, disagree with you, and then charge you interest and penalties if you get it all wrong.
I would also like to point out that the IRS has historically been pretty clear that inventory costs should typically line up with its related income. This should be a tip for you about what would be most acceptable for them to see. It’s probably a pretty good idea not to stray too far from this treatment.
You should discuss any and all of these items with your CPA if you are considering making a change to your accounting method.
Here’s also a great letter that’ll help break it down for you. I think it’s awesome.
I hope you found this article helpful. For more information on current topics, feel free to check out our YouTube channel.