What Is Inventory?

By Attorney Stephen Fishman

Inventory (also called merchandise) is the goods and products that a business owns to sell to customers in the ordinary course of business. It includes almost anything a business offers for sale, not including real estate. It makes no difference whether you manufacture the goods yourself or buy finished goods from others and resell them to customers. Inventory includes not only finished merchandise, but also unfinished work in progress, as well as the raw materials and supplies that will become part of the finished merchandise.

Only things you hold title to—that is, things you own—constitute inventory. Inventory includes items you haven’t yet received or paid for, as long as you own them. For example, an item you buy with a credit card counts as inventory, even if you haven’t paid the bill yet. However, if you buy merchandise that is sent C.O.D., you acquire ownership only after the goods are delivered and paid for. Similarly, goods that you hold on consignment are not part of your inventory because you don’t own them.

Supplies Are Not Inventory

Materials and supplies that do not physically become part of the merchandise a business sells are not included in inventory. Unless they are incidental supplies as described below, the cost of these supplies must be deducted in the year in which they are used or consumed, which is not necessarily the year when you purchase them. This means that you must keep track of how many materials you use each year.

Incidental Supplies

There is an important exception to the rule that the cost of materials and supplies may be deducted only as they are used or consumed. The entire cost of supplies that are incidental to a taxpayer’s business may be deducted in the year they are purchased. Supplies are incidental if all of the following are true:

They are of minor or secondary importance to your business (see “Maintaining an Inventory,” below)—but if you treat the cost of supplies on hand as an asset for financial reporting purposes, they are not incidental. (Private Letter Ruling 9209007.)

• You do not keep a record of when you use the supplies.
• You do not take a physical inventory of the supplies at the beginning and end of the tax year. (Private Letter Ruling 8630003 and 9209007.)
• Deducting the cost of supplies in the year you purchase them does not distort your taxable income. (Treas. Reg. 1.162-3; Private Letter Ruling 9209007.)

Long-Term Assets

Long-term assets are things that last for more than one year—for example, equipment, tools, office furniture, vehicles, and buildings. Long-term assets that you purchase to use in your business are not a part of your inventory. They are deductible capital expenses that you may depreciate over several years or, in many cases, deduct in a single year under IRC Section 179.

Merchandise to Include in Inventory