SellerActive Business Advisor Russell R. Boedeker (CMA, CSCA) offers expert tax advice for businesses that sell products and services online, including tips on PPP loans, inventory cost management, and tax deductions
It’s tax time again! Well, sort of.
While the IRS, and most states, have pushed out the 2020 tax deadline until May 17th this year, estimated tax payments are still due today, April 15th.
In any event, taxes are likely on your mind, especially if you’re an ecommerce retailer.
What are some of the current tax issues that you should be aware of, as well as what should you be thinking about for future tax planning?
In this article we cover a couple of key areas you should be thinking about for tax planning. While some are common across many industries, we also discuss those which are specific to ecommerce retailers.
It’s All Government Money – the Paycheck Protection Program (PPP)
If your company obtained a PPP loan during 2020, how does that impact both your financial reporting and taxes? The PPP is a unique and rather unprecedented program. While it is structured as a loan, providing you expend the funds over a specific period for payroll costs, as well as some specific allowable amounts for payments of rents and utilities, the loan is fully forgiven and does not need to be repaid.
Even for companies that are on a cash basis for taxes, your financial/accounting books are different from your tax books – think of them as second cousins. This is even more the case for the PPP.
First let’s cover the impact for your financial/accounting reporting. Even though the PPP is a loan, the general consensus is to treat the PPP funding as a grant from the US government. This is a new area for for-profit companies that aren’t used to having government grants.
While there are no established hard and fast practices, the approach I have taken is to record the amount of the PPP loan (at least the part that is forgivable) as Grant Income in the “Other Income” section of your financial statements. This keeps the concept of recording the grant as income but putting it below your operating income.
On the tax side, things look quite different. Under normal circumstances, the forgiveness of debt is a taxable event. However, as a “gift” from Congress, the PPP funding is not taxable. Further law and regulatory changes also made the expenses you used the PPP funds to pay for remain tax deductible. A rare case of Congress allowing you to “double-dip” on a tax deduction.
So while you may be reporting the PPP as Grant Income on your financial/accounting statements, the amount of the PPP funding is not included for taxes, hence reducing your taxable income.
As a note, if you have received loan forgiveness approval in 2020, excluding your PPP funding from 2020 taxable income is rather clear. What is unclear is if you have all expectations of receiving loan forgiveness but that was not forthcoming in 2020, can you exclude this amount from your income in 2020 or in 2021?
There is no exact “right” answer for this, and the IRS may never publish further guidance. You can make a justifiable case for either option. This is an area you certainly wish to obtain advice from your tax advisor.
Out with the Old! (Inventory Management)
Even the best retailer in the world will find themselves with inventory they simply can’t sell. A good time to review this is at the end of each year (or your fiscal year, if you have a seasonal business).
Hanging on to unsellable inventory not only overstates your assets, it also leaves you with unusable capital, and ongoing costs for the inventory storage. If you are using the fulfillment services of your selling channel (such as FBA) you’ll be hit with storage fees, and it’s painful to pay for storing something that isn’t sellable.
While keeping on top of this throughout the year, it’s especially important at the end of your tax year: Identify all your unsellable inventory and scrap it. Not only will this remove ongoing storage fees, but the scrap cost value will flush down on your Profit and Loss statement (P&L) as “cost” (accounting cost, not a cash cost), which will reduce your income and lower your taxes. The tax deduction will at least partially free up some additional working capital.
The downside is you really do need to scrap the inventory, and it can’t just be a book entry. This might mean you need to do a pull from stock request from your fulfillment center, pay a shipping fee, and then scrap it. You can do a cost/benefit analysis to determine if this makes sense in your situation.
But what if you’re left thinking you could sell this inventory, but at a dramatically reduced price? Good news, there’s a solution for this as well.
If you’re on accrual accounting, your inventory is required to be at what is called lower of cost or market. In simple terms, it means if the current market value of your inventory is lower than your purchase costs, you must write-down the record cost of the inventory. The reduced amount is also flushed down on your P&L, which reduces your income and lowers your taxes.
In performing a lower of cost or market analysis for any type of inventory, it is not as simple as taking just the current market sale price. You may have an inventory item with a purchased cost of $10 and the market price is $11, which seems you won’t have any adjustment to make.
However, “market price” is not just the sale price, but also includes your variable selling costs to transact the sale. These would typically be sales commissions and outbound shipping & handling fees. Let’s expand the example above:
Inventory Item ABC
Purchase costs on books: $10.00
Current market sale price: $11.00
Less: Sale Commissions $2.20
Less: Outbound shipping $2.50
“Market” $6.30
In this analysis we see the market value of selling product ABC is $6.30, which is $3.70 less than our purchase cost. We would do a write-down of inventory by $3.70 to restate the value to the lower market. This write-down is a book recorded loss that reduces your taxable income.
Who’s on First, What’s on Second? – How to Manage Inventory Cost
You know the basic drill. You buy products from suppliers, they are shipped to your inventory location, sit for a bit, then you sell them to your customers – hopefully for a profit!
Life would be simple if all your unit purchase costs were always at the same cost, but in real life you might buy a batch of products at $18.00 each, then another batch at $17.50, then another at $15.00. How you treat sales of these products, versus the order you purchased them at, will have an impact on both your reported income and taxable income.
Let’s do a brief overview of three inventory management methods.
LIFO – “Last in, first out”
This approach assumes the last items purchased will be the first ones you sell. If your products tend to have higher purchase costs over time, it’s likely the last batch you received will be at a higher price than early receipts. In this situation, your sales will go against the most recent units purchased, thus reducing your gross profit on the sale. Your reported income is lower, but so is your taxable income.
FIFO – “First in, last out”
FIFO assumes the first items purchased will be the first ones you sell. Using the same assumption as before, with gradually rising unit purchase costs, now your sales will go against the first ones you purchased, which may have a cost well below any recent procurement. Your reported income is now higher (you look more profitable), unfortunately that higher reported profit is also higher taxable income, and higher taxes are due.
Weighted Average Cost
This method averages all your purchase costs together. While your sales price is the same, the cost of the inventory you sell will be an average of the inventory value over the quantity of units in stock. This approach will typically give you a profit/taxable income value somewhere between that of LIFO and FIFO.
As you see from just these simple concepts, your choice of inventory costing methodology may have a material impact on your tax obligations. Your choice of inventory methods is depending on the specifics of your product line, as well as your business objectives. You may need to increase reported income, perhaps to qualify for bank loans, or you may wish to optimize taxes as much as possible.
If you find that your current inventory costing methodology isn’t aligned with your business needs, the start of a tax year is a perfect time to make changes. There is good news and bad news for making any changes in your inventory costing method.
Once you pick your inventory costing methodology, the IRS requires you keep that method for the first year and encourages you to keep it consistent going forward. The good news is you may make an inventory change in a subsequent year, but the bad news is you must file with the IRS an inventory method change form at the beginning of the year you make the change.
While not an automatic red flag, filing an inventory method change does give the IRS notice you are changing a fundamental cost approach to your business, and they might want to know why. The IRS may want to dig in a bit more into what’s going on. This is one area that you are certainly advised so seek qualified tax advice for your situation.
SellerActive Can Help
Trying to keep all this inventory straight, with what products are where on what channel, sales transactions can seem like a pile of data. Fortunately, SellerActive has a supported integration with QuickBooks that will pass your transactions back to your accounting tool. Your bookkeeper will thank you and you’ll have more up to date information to make your business decisions with.
Get in touch with us to start taking more control over your ecommerce accounting!
Disclaimer: This information is meant for educational use only and should not be relied upon as business or tax advice. You are encouraged to discuss these issues for how they may impact your business with a qualified business and tax advisor.