Many construction businesses reach a point in their growth when they decide to maintain inventories. They might keep on hand items such as building materials, supplies, personal protective equipment and tools. Maybe yours already does.
A construction company’s tax accounting method for inventory can significantly affect its tax bill — especially when costs are trending upward. Whether your business has an inventory now or is mulling the concept of creating one, let’s review some of the major concepts involved.
Tax impact
Inventory items generally aren’t taxed until they’re sold. However, your inventory affects your taxes before then because of its role in determining your construction company’s taxable income. Specifically, your inventory is one of the components involved in calculating “cost of goods sold” (COGS), which for contractors includes direct costs associated with the performance and completion of projects.
COGS typically represents a substantial chunk of most construction companies’ tax-deductible expenses. Generally, the lower your COGS, the more income you’ll report to the IRS and, in turn, the more taxes you’ll pay. On the other hand, higher COGS usually means less taxable income and lower tax liability.
FIFO vs. LIFO
For all types of businesses, including construction companies, the two most common tax accounting methods for inventory are first-in, first-out (FIFO) and last-in, first-out (LIFO).
True to its name, FIFO assumes that your construction business uses its inventory in the order items are purchased. And this tends to be how most contractors handle their inventories: They use the oldest materials first to avoid obsolescence, among other reasons.
As a result, unused items are those most recently bought in your ending inventory — which is reported on your balance sheet as an asset. In an inflationary market, these newer unused items will be the most expensive. Conversely, inventory charged to COGS is typically cheaper. Thus, COGS for companies that use FIFO will be lower in most cases and, in turn, they’ll have more taxable income and higher tax liability.
Under LIFO, it’s assumed that you use your most recently bought materials first. This generally means your ending inventory includes older and less expensive items. In a market with rising prices, LIFO first charges the costs of newer items to COGS, boosting it and lowering taxable income. From this perspective, LIFO may also be beneficial if your construction company is moving up to a higher tax bracket.
However, if the cost of inventory items is dropping — a seemingly rare occurrence in recent years — LIFO is less beneficial because it charges those lower costs to COGS, potentially increasing taxable income.
Beyond taxes
Although LIFO may have the edge regarding federal income taxes when the costs of inventory items are high, FIFO has several nontax advantages worth considering. For example, it’s generally easier to start using and to manage.
No formal election is needed to use FIFO; businesses simply report it as their tax accounting method for inventory on their first tax returns. Conversely, you must affirmatively elect to use LIFO on IRS Form 970, “Application to Use LIFO Inventory Method.” The election is irrevocable unless you obtain IRS authorization to use FIFO.
In an inflationary market, FIFO also usually leads to a stronger balance sheet because your ending inventory, as an asset, is based on the cost of the most recently purchased items. Lower COGS, which tends to occur under FIFO, also generally translates to a higher profit on your income statement.
Moreover, as mentioned, FIFO likely reflects the way a construction business actually uses its inventory. Therefore, it takes a more accurate snapshot of your inventory’s value and your overall financial position. LIFO often results in lower inventory value based on items you may no longer have on hand.
Critical decision
Choosing a tax accounting method for inventory is a critical strategic decision. For instance, how it affects your construction company’s financial statements can, in turn, impact external financing from lenders or investors. Whether you’re just beginning to build an inventory or have one in place, we can help you make the right choice based on your circumstances and economic environment.
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