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Why do a Physical Inventory?

 

A Physical Inventory is an accounting procedure that all firms conducting business in the United States must do to conform to Internal Revenue Service tax regulations.   The physical inventory must be conducted at least once a year and conform to standard accounting practice so that inventories on-hand are properly valued.  This is defined in section 471 and 472 of the Internal Revenue Code.  Rules specific to the capitalization of inventory are detailed in section 263A of the Internal Revenue Code.  The U.S. tax code as of January 1999 is as follows:

 

Sec. 471. General rule for inventories

  • (a) General rule
    Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
  • (b) Estimates of inventory shrinkage permitted
    A method of determining inventories shall not be treated as failing to clearly reflect income solely because it utilizes estimates of inventory shrinkage that are confirmed by a physical count only after the last day of the taxable year if -
    • (1) the taxpayer normally does a physical count of inventories
      at each location on a regular and consistent basis, and
      (2) the taxpayer makes proper adjustments to such inventories
      and to its estimating methods to the extent such estimates are
      greater than or less than the actual shrinkage.
  • (c) Cross reference
    For rules relating to capitalization of direct and indirect
    costs of property, see section 263A.

Sec. 472. Last-in, first-out inventories

  • (a) Authorization
    A taxpayer may use the method provided in subsection (b) (whether or not such method has been prescribed under section 471) in inventorying goods specified in an application to use such method filed at such time and in such manner as the Secretary may prescribe. The change to, and the use of, such method shall be in accordance with such regulations as the Secretary may prescribe as necessary in order that the use of such method may clearly reflect income.
  • (b) Method applicable
    In inventorying goods specified in the application described in subsection (a), the taxpayer shall:
    • (1) Treat those remaining on hand at the close of the taxable
      year as being: First, those included in the opening inventory of
      the taxable year (in the order of acquisition) to the extent
      thereof; and second, those acquired in the taxable year;
    • (2) Inventory them at cost; and
      (3) Treat those included in the opening inventory of the
      taxable year in which such method is first used as having been
      acquired at the same time and determine their cost by the average
      cost method.
  • (c) Condition
    Subsection (a) shall apply only if the taxpayer establishes to the satisfaction of the Secretary that the taxpayer has used no procedure other than that specified in paragraphs (1) and (3) of subsection (b) in inventorying such goods to ascertain the income, profit, or loss of the first taxable year for which the method described in subsection (b) is to be used, for the purpose of a report or statement covering such taxable year -
    • (1) to shareholders, partners, or other proprietors, or to
      beneficiaries, or
    • (2) for credit purposes.
  • (d) 3-year averaging for increases in inventory value
    The beginning inventory for the first taxable year for which the method described in subsection (b) is used shall be valued at cost. Any change in the inventory amount resulting from the application of the preceding sentence shall be taken into account ratably in each of the 3 taxable years beginning with the first taxable year for which the method described in subsection (b) is first used.
  • (e) Subsequent inventories
    If a taxpayer, having complied with subsection (a), uses the method described in subsection (b) for any taxable year, then such method shall be used in all subsequent taxable years unless -
    • (1) with the approval of the Secretary a change to a different
      method is authorized; or,
    • (2) the Secretary determines that the taxpayer has used for any
      such subsequent taxable year some procedure other than that
      specified in paragraph (1) of subsection (b) in inventorying the
      goods specified in the application to ascertain the income,
      profit, or loss of such subsequent taxable year for the purpose
      of a report or statement covering such taxable year (A) to
      shareholders, partners, or other proprietors, or beneficiaries,
      or (B) for credit purposes; and requires a change to a method
      different from that prescribed in subsection (b) beginning with
      such subsequent taxable year or any taxable year thereafter. If paragraph (1) or (2) of this subsection applies, the change to, and the use of, the different method shall be in accordance with such regulations as the Secretary may prescribe as necessary in order that the use of such method may clearly reflect income.
  • (f) Use of government price indexes in pricing inventory
    The Secretary shall prescribe regulations permitting the use of suitable published governmental indexes in such manner and circumstances as determined by the Secretary for purposes of the method described in subsection (b).
  • (g) Conformity rules applied on controlled group basis
    • (1) In general
      Except as otherwise provided in regulations, all members of the
      same group of financially related corporations shall be treated
      as 1 taxpayer for purposes of subsections (c) and (e)(2).
    • (2) Group of financially related corporations
      For purposes of paragraph (1), the term ''group of financially
      related corporations'' means -
      • (A) any affiliated group as defined in section 1504
        determined by substituting ''50 percent'' for ''80 percent''
        each place it appears in section 1504(a) and without regard to
        section 1504(b), and
        (B) any other group of corporations which consolidate or
        combine for purposes of financial statements.

Sec. 263A. Capitalization and inclusion in inventory costs of certain expenses

  • (a) Nondeductibility of certain direct and indirect costs
    • (1) In general
      In the case of any property to which this section applies, any
      costs described in paragraph (2) -
      • (A) in the case of property which is inventory in the hands
        of the taxpayer, shall be included in inventory costs, and
        (B) in the case of any other property, shall be capitalized.
    • (2) Allocable costs
      The costs described in this paragraph with respect to any
      property are -
      • (A) the direct costs of such property, and
        (B) such property's proper share of those indirect costs
        (including taxes) part or all of which are allocable to such
        property.
        Any cost which (but for this subsection) could not be taken into
        account in computing taxable income for any taxable year shall
        not be treated as a cost described in this paragraph.
  • (b) Property to which section applies
    Except as otherwise provided in this section, this section shall apply to -
    • (1) Property produced by taxpayer
      Real or tangible personal property produced by the taxpayer.
    • (2) Property acquired for resale
      • (A) In general
        Real or personal property described in section 1221(1) which
        is acquired by the taxpayer for resale.
      • (B) Exception for taxpayer with gross receipts of $10,000,000
        or less
        Subparagraph (A) shall not apply to any personal property
        acquired during any taxable year by the taxpayer for resale if
        the average annual gross receipts of the taxpayer (or any
        predecessor) for the 3-taxable year period ending with the
        taxable year preceding such taxable year do not exceed
        $10,000,000.
      • (C) Aggregation rules, etc.
        For purposes of subparagraph (B), rules similar to the rules
        of paragraphs (2) and (3) of section 448(c) shall apply. For purposes of paragraph (1), the term ''tangible personal property'' shall include a film, sound recording, video tape, book, or similar property.
  • (c) General exceptions
    • (1) Personal use property
      This section shall not apply to any property produced by the
      taxpayer for use by the taxpayer other than in a trade or
      business or an activity conducted for profit.
    • (2) Research and experimental expenditures
      This section shall not apply to any amount allowable as a
      deduction under section 174.
    • (3) Certain development and other costs of oil and gas wells or
      other mineral property
      This section shall not apply to any cost allowable as a
      deduction under section 263(c), 263(i), 291(b)(2), 616, or 617.
    • (4) Coordination with long-term contract rules
      This section shall not apply to any property produced by the
      taxpayer pursuant to a long-term contract.
    • (5) Timber and certain ornamental trees
      This section shall not apply to -
      • (A) trees raised, harvested, or grown by the taxpayer other
        than trees described in clause (ii) of subsection (e)(4)(B)
        (after application of the last sentence thereof), and
        (B) any real property underlying such trees.
    • (6) Coordination with section 59(e)
      Paragraphs (2) and (3) shall apply to any amount allowable as a
      deduction under section 59(e) for qualified expenditures
      described in subparagraphs (B), (C), (D), and (E) of paragraph
      (2) thereof.
  • (d) Exception for farming businesses
    • (1) Section not to apply to certain property
      • (A) In general
        This section shall not apply to any of the following which is
        produced by the taxpayer in a farming business:
        • (i) Any animal.
        • (ii) Any plant which has a preproductive period of 2 years
          or less.
      • (B) Exception for taxpayers required to use accrual method
        Subparagraph (A) shall not apply to any corporation,
        partnership, or tax shelter required to use an accrual method
        of accounting under section 447 or 448(a)(3).
    • (2) Treatment of certain plants lost by reason of casualty
      • (A) In general
        If plants bearing an edible crop for human consumption were
        lost or damaged (while in the hands of the taxpayer) by reason
        of freezing temperatures, disease, drought, pests, or casualty,
        this section shall not apply to any costs of the taxpayer of
        replanting plants bearing the same type of crop (whether on the
        same parcel of land on which such lost or damaged plants were
        located or any other parcel of land of the same acreage in the
        United States).
      • (B) Special rule for person with minority interest who
        materially participates
        Subparagraph (A) shall apply to amounts paid or incurred by a
        person (other than the taxpayer described in subparagraph (A))
        if -
        • (i) the taxpayer described in subparagraph (A) has an
          equity interest of more than 50 percent in the plants
          described in subparagraph (A) at all times during the taxable
          year in which such amounts were paid or incurred, and
          (ii) such other person holds any part of the remaining
          equity interest and materially participates in the planting,
          maintenance, cultivation, or development of such the plants
          described in subparagraph (A) during the taxable year in
          which such amounts were paid or incurred.
          The determination of whether an individual materially
          participates in any activity shall be made in a manner similar
          to the manner in which such determination is made under section
          2032A(e)(6).
    • (3) Election to have this section not apply
      • (A) In general
        If a taxpayer makes an election under this paragraph, this
        section shall not apply to any plant produced in any farming
        business carried on by such taxpayer.
      • (B) Certain persons not eligible
        No election may be made under this paragraph by a
        corporation, partnership, or tax shelter, if such corporation,
        partnership, or tax shelter is required to use an accrual
        method of accounting under section 447 or 448(a)(3).
      • (C) Special rule for citrus and almond growers
        An election under this paragraph shall not apply with respect
        to any item which is attributable to the planting, cultivation,
        maintenance, or development of any citrus or almond grove (or
        part thereof) and which is incurred before the close of the 4th
        taxable year beginning with the taxable year in which the trees
        were planted. For purposes of the preceding sentence, the
        portion of a citrus or almond grove planted in 1 taxable year
        shall be treated separately from the portion of such grove
        planted in another taxable year.
      • (D) Election
        Unless the Secretary otherwise consents, an election under
        this paragraph may be made only for the taxpayer's 1st taxable
        year which begins after December 31, 1986, and during which the
        taxpayer engages in a farming business. Any such election,
        once made, may be revoked only with the consent of the
        Secretary.
  • (e) Definitions and special rules for purposes of subsection (d)
    • (1) Recapture of expensed amounts on disposition
      • (A) In general
        In the case of any plant with respect to which amounts would
        have been capitalized under subsection (a) but for an election
        under subsection (d)(3) -
        • (i) such plant (if not otherwise section 1245 property)
          shall be treated as section 1245 property, and
          (ii) for purposes of section 1245, the recapture amount
          shall be treated as a deduction allowed for depreciation with
          respect to such property.
      • (B) Recapture amount
        For purposes of subparagraph (A), the term ''recapture
        amount'' means any amount allowable as a deduction to the
        taxpayer which, but for an election under subsection (d)(3),
        would have been capitalized with respect to the plant.
    • (2) Effects of election on depreciation
      • (A) In general
        If the taxpayer (or any related person) makes an election
        under subsection (d)(3), the provisions of section 168(g)(2)
        (relating to alternative depreciation) shall apply to all
        property of the taxpayer used predominantly in the farming
        business and placed in service in any taxable year during which
        any such election is in effect.
      • (B) Related person
        For purposes of subparagraph (A), the term ''related person''
        means -
        • (i) the taxpayer and members of the taxpayer's family,
        • (ii) any corporation (including an S corporation) if 50
          percent or more (in value) of the stock of such corporation
          is owned (directly or through the application of section 318)
          by the taxpayer or members of the taxpayer's family,
        • (iii) a corporation and any other corporation which is a
          member of the same controlled group described in section
          1563(a)(1), and
          (iv) any partnership if 50 percent or more (in value) of
          the interests in such partnership is owned directly or
          indirectly by the taxpayer or members of the taxpayer's
          family.
      • (C) Members of family
        For purposes of this paragraph, the term ''family'' means the
        taxpayer, the spouse of the taxpayer, and any of their children
        who have not attained age 18 before the close of the taxable
        year.
    • (3) Preproductive period
      • (A) In general
        For purposes of this section, the term ''preproductive
        period'' means -
        • (i) in the case of a plant which will have more than 1 crop
          or yield, the period before the 1st marketable crop or yield
          from such plant, or
        • (ii) in the case of any other plant, the period before such
          plant is reasonably expected to be disposed of.
          For purposes of this subparagraph, use by the taxpayer in a
          farming business of any supply produced in such business shall
          be treated as a disposition.
      • (B) Rule for determining period
        In the case of a plant grown in commercial quantities in the
        United States, the preproductive period for such plant if grown
        in the United States shall be based on the nationwide weighted
        average preproductive period for such plant.
    • (4) Farming business
      For purposes of this section -
      • (A) In general
        The term ''farming business'' means the trade or business of
        farming.
      • (B) Certain trades and businesses included
        The term ''farming business'' shall include the trade or
        business of -
        • (i) operating a nursery or sod farm, or
        • (ii) the raising or harvesting of trees bearing fruit,
          nuts, or other crops, or ornamental trees.
          For purposes of clause (ii), an evergreen tree which is more
          than 6 years old at the time severed from the roots shall not
          be treated as an ornamental tree.
    • (5) Certain inventory valuation methods permitted
      The Secretary shall by regulations permit the taxpayer to use
      reasonable inventory valuation methods to compute the amount
      required to be capitalized under subsection (a) in the case of
      any plant.
  • (f) Special rules for allocation of interest to property produced
    by the taxpayer
    • (1) Interest capitalized only in certain cases
      Subsection (a) shall only apply to interest costs which are -
      • (A) paid or incurred during the production period, and
        (B) allocable to property which is described in subsection
        (b)(1) and which has -
        • (i) a long useful life,
        • (ii) an estimated production period exceeding 2 years, or
        • (iii) an estimated production period exceeding 1 year and a
          cost exceeding $1,000,000.
    • (2) Allocation rules
      • (A) In general
        In determining the amount of interest required to be
        capitalized under subsection (a) with respect to any property -
        • (i) interest on any indebtedness directly attributable to
          production expenditures with respect to such property shall
          be assigned to such property, and
          (ii) interest on any other indebtedness shall be assigned
          to such property to the extent that the taxpayer's interest
          costs could have been reduced if production expenditures (not
          attributable to indebtedness described in clause (i)) had not
          been incurred.
      • (B) Exception for qualified residence interest
        Subparagraph (A) shall not apply to any qualified residence
        interest (within the meaning of section 163(h)).
      • (C) Special rule for flow-through entities
        Except as provided in regulations, in the case of any
        flow-through entity, this paragraph shall be applied first at
        the entity level and then at the beneficiary level.
    • (3) Interest relating to property used to produce property
      This subsection shall apply to any interest on indebtedness
      allocable (as determined under paragraph (2)) to property used to
      produce property to which this subsection applies to the extent
      such interest is allocable (as so determined) to the produced
      property.
    • (4) Definitions
      For purposes of this subsection -
      • (A) Long useful life
        Property has a long useful life if such property is -
        • (i) real property, or
        • (ii) property with a class life of 20 years or more (as
          determined under section 168).
      • (B) Production period
        The term ''production period'' means, when used with respect
        to any property, the period -
        • (i) beginning on the date on which production of the
          property begins, and
          (ii) ending on the date on which the property is ready to
          be placed in service or is ready to be held for sale.
      • (C) Production expenditures
        The term ''production expenditures'' means the costs (whether
        or not incurred during the production period) required to be
        capitalized under subsection (a) with respect to the property.
  • (g) Production
    For purposes of this section -
    • (1) In general
      The term ''produce'' includes construct, build, install,
      manufacture, develop, or improve.
    • (2) Treatment of property produced under contract for the
      taxpayer
      The taxpayer shall be treated as producing any property
      produced for the taxpayer under a contract with the taxpayer;
      except that only costs paid or incurred by the taxpayer (whether
      under such contract or otherwise) shall be taken into account in
      applying subsection (a) to the taxpayer.
  • (h) Exemption for free lance authors, photographers, and artists
    • (1) In general
      Nothing in this section shall require the capitalization of any
      qualified creative expense.
    • (2) Qualified creative expense
      For purposes of this subsection, the term ''qualified creative
      expense'' means any expense -
      • (A) which is paid or incurred by an individual in the trade
        or business of such individual (other than as an employee) of
        being a writer, photographer, or artist, and
        (B) which, without regard to this section, would be allowable
        as a deduction for the taxable year.
        Such term does not include any expense related to printing,
        photographic plates, motion picture films, video tapes, or
        similar items.
    • (3) Definitions
      For purposes of this subsection -
      • (A) Writer
        The term ''writer'' means any individual if the personal
        efforts of such individual create (or may reasonably be
        expected to create) a literary manuscript, musical composition
        (including any accompanying words), or dance score.
      • (B) Photographer
        The term ''photographer'' means any individual if the
        personal efforts of such individual create (or may reasonably
        be expected to create) a photograph or photographic negative or
        transparency.
      • (C) Artist
  • (i) In general
    The term ''artist'' means any individual if the personal
    efforts of such individual create (or may reasonably be
    expected to create) a picture, painting, sculpture, statue,
    etching, drawing, cartoon, graphic design, or original print
    edition.
  • (ii) Criteria
    In determining whether any expense is paid or incurred in
    the trade or business of being an artist, the following
    criteria shall be taken into account:
    • (I) The originality and uniqueness of the item created
      (or to be created).
    • (II) The predominance of aesthetic value over utilitarian
      value of the item created (or to be created).
    • (D) Treatment of certain corporations
  • (i) In general
    If -
    • (I) substantially all of the stock of a corporation is
      owned by a qualified employee-owner and members of his
      family (as defined in section 267(c)(4)), and
      (II) the principal activity of such corporation is
      performance of personal services directly related to the
      activities of the qualified employee-owner and such
      services are substantially performed by the qualified
      employee-owner,
      this subsection shall apply to any expense of such corporation
      which directly relates to the activities of such
      employee-owner in the same manner as if such expense were
      incurred by such employee-owner.
  • (ii) Qualified employee-owner
    For purposes of this subparagraph, the term ''qualified
    employee-owner'' means any individual who is an
    employee-owner of the corporation (as defined in section
    269A(b)(2)) and who is a writer, photographer, or artist.
  • (i) Regulations
    The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section, including -
    • (1) regulations to prevent the use of related parties,
      pass-thru entities, or intermediaries to avoid the application of
      this section, and
      (2) regulations providing for simplified procedures for the
      application of this section in the case of property described in
      subsection (b)(2).

 




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